form_10q.htm



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

FORM 10-Q
(Mark One)
  x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended     June 30, 2010

OR
 
   o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
        For the transition period from ________________ to ________________
 
Commission file number 0-6233

(Exact name of registrant as specified in its charter)

INDIANA
 
35-1068133
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)

100 North Michigan Street
South Bend, Indiana
46601
(Address of principal executive offices) (Zip Code)

(574) 235-2000
(Registrant’s telephone number, including area code)

Not Applicable
(Former name, former address and former fiscal year, if changed since last report.)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     x Yes         o No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   o Yes        o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):
 
 
   Large accelerated filer     o  Accelerated filer                       x  
   Non-accelerated filer      o (Do not check if a smaller reporting company)  Smaller reporting company     o  
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o Yes         x No

Number of shares of common stock outstanding as of July 16, 2010 – 24,276,906 shares

 
- 1 -

 
 

TABLE OF CONTENTS


PART I.  FINANCIAL INFORMATION
 
   
Page
Item 1.
Financial Statements (Unaudited)
 
 
3
 
4
 
5
 
6
 
7
Item 2.
22
Item 3.
33
Item 4.
33
     
PART II.  OTHER INFORMATION
 
     
Item 1.
33
Item 1A.
33
Item 2.
34
Item 3.
34
Item 4.
34
Item 5.
34
Item 6.
34
     
35
     
CERTIFICATIONS
 
   
Exhibit 31.1   
Exhibit 31.2   
Exhibit 32.1   
Exhibit 32.2   
   
   



1st SOURCE CORPORATION
           
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
           
(Unaudited - Dollars in thousands, except share amounts)
           
   
June 30,
   
December 31,
 
   
2010
   
2009
 
ASSETS
           
Cash and due from banks
  $ 65,337     $ 72,872  
Federal funds sold and
               
interest bearing deposits with other banks
    42,979       141,166  
Investment securities available-for-sale
               
(amortized cost of $909,516 and $893,439
               
at June 30, 2010 and December 31, 2009, respectively)
    932,583       901,638  
Other investments
    21,012       21,012  
Trading account securities
    113       125  
Mortgages held for sale
    59,084       26,649  
Loans and leases - net of unearned discount
               
Commercial and agricultural loans
    539,003       546,222  
Auto, light truck and environmental equipment
    416,152       349,741  
Medium and heavy duty truck
    185,954       204,545  
Aircraft financing
    596,138       617,384  
Construction equipment financing
    308,602       313,300  
Loans secured by real estate
    983,054       952,223  
Consumer loans
    102,846       109,735  
Total loans and leases
    3,131,749       3,093,150  
Reserve for loan and lease losses
    (88,014 )     (88,236 )
Net loans and leases
    3,043,735       3,004,914  
Equipment owned under operating leases, net
    91,288       97,004  
Net premises and equipment
    36,573       37,907  
Goodwill and intangible assets
    89,618       90,222  
Accrued income and other assets
    148,991       148,591  
Total assets
  $ 4,531,313     $ 4,542,100  
                 
LIABILITIES
               
Deposits:
               
Noninterest bearing
  $ 487,719     $ 450,608  
Interest bearing
    3,121,867       3,201,856  
Total deposits
    3,609,586       3,652,464  
Federal funds purchased and securities
               
sold under agreements to repurchase
    113,638       123,787  
Other short-term borrowings
    28,136       26,323  
Long-term debt and mandatorily redeemable securities
    29,854       19,761  
Subordinated notes
    89,692       89,692  
Accrued expenses and other liabilities
    70,905       59,753  
Total liabilities
    3,941,811       3,971,780  
                 
SHAREHOLDERS' EQUITY
               
Preferred stock; no par value
               
Authorized 10,000,000 shares; issued 111,000 at June 30, 2010,
               
and at December 31, 2009
    105,583       104,930  
Common stock; no par value
               
Authorized 40,000,000 shares; issued 25,643,506 at June 30, 2010,
               
and at December 31, 2009
    350,275       350,269  
Retained earnings
    149,799       142,407  
Cost of common stock in treasury (1,365,484 shares at June 30, 2010, and
               
1,532,483 shares at December 31, 2009)
    (30,486 )     (32,380 )
Accumulated other comprehensive income
    14,331       5,094  
Total shareholders' equity
    589,502       570,320  
Total liabilities and shareholders' equity
  $ 4,531,313     $ 4,542,100  
                 
The accompanying notes are a part of the consolidated financial statements.
               



1st SOURCE CORPORATION
                       
CONSOLIDATED STATEMENTS OF INCOME
                       
(Unaudited - Dollars in thousands, except per share amounts)
                       
   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2010
   
2009
   
2010
   
2009
 
Interest income:
                       
Loans and leases
  $ 43,099     $ 44,474     $ 85,369     $ 89,071  
Investment securities, taxable
    5,279       4,207       10,680       8,243  
Investment securities, tax-exempt
    1,422       1,685       2,889       3,395  
Other
    250       264       524       597  
Total interest income
    50,050       50,630       99,462       101,306  
                                 
Interest expense:
                               
Deposits
    11,573       16,596       23,978       34,202  
Short-term borrowings
    206       295       394       644  
Subordinated notes
    1,647       1,647       3,294       3,294  
Long-term debt and mandatorily redeemable securities
    375       179       645       531  
Total interest expense
    13,801       18,717       28,311       38,671  
                                 
Net interest income
    36,249       31,913       71,151       62,635  
Provision for loan and lease losses
    5,798       8,487       10,186       16,272  
Net interest income after provision for
                               
loan and lease losses
    30,451       23,426       60,965       46,363  
                                 
Noninterest income:
                               
Trust fees
    4,062       3,887       7,807       7,691  
Service charges on deposit accounts
    5,275       5,219       9,895       9,965  
Mortgage banking income
    425       3,339       1,202       5,909  
Insurance commissions
    1,061       1,076       2,526       2,592  
Equipment rental income
    6,672       6,402       13,417       12,549  
Other income
    3,012       2,356       5,701       4,591  
Investment securities and other investment gains (losses)
    95       426       976       (43 )
Total noninterest income
    20,602       22,705       41,524       43,254  
                                 
Noninterest expense:
                               
Salaries and employee benefits
    18,848       16,829       37,658       36,915  
Net occupancy expense
    1,939       2,273       4,426       4,874  
Furniture and equipment expense
    3,196       3,765       5,996       7,246  
Depreciation - leased equipment
    5,304       5,088       10,668       10,044  
Professional fees
    1,418       815       2,932       1,877  
Supplies and communication
    1,338       1,428       2,707       2,995  
FDIC and other insurance
    1,667       3,719       3,341       5,269  
Business development and marketing expense
    880       794       1,447       1,279  
Loan and lease collection and repossession expense
    3,267       1,070       4,373       1,629  
Other expense
    1,792       1,568       3,211       3,861  
Total noninterest expense
    39,649       37,349       76,759       75,989  
                                 
Income before income taxes
    11,404       8,782       25,730       13,628  
Income tax expense
    3,609       2,499       8,256       1,094  
                                 
Net income
    7,795       6,283       17,474       12,534  
Preferred stock dividends and discount accretion
    (1,717 )     (1,696 )     (3,428 )     (3,009 )
Net income available to common shareholders
  $ 6,078     $ 4,587     $ 14,046     $ 9,525  
                                 
Per common share
                               
Basic net income per common share
  $ 0.25     $ 0.19     $ 0.57     $ 0.39  
Diluted net income per common share
  $ 0.25     $ 0.19     $ 0.57     $ 0.39  
Dividends
  $ 0.15     $ 0.14     $ 0.30     $ 0.28  
Basic weighted average common shares outstanding
    24,284,519       24,185,415       24,247,586       24,167,905  
Diluted weighted average common shares outstanding
    24,292,491       24,226,542       24,254,098       24,208,966  
                                 
The accompanying notes are a part of the consolidated financial statements.
                               



1st SOURCE CORPORATION
                                   
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
                         
(Unaudited - Dollars in thousands, except per share amounts)
                         
                                     
                           
Cost of
   
Accumulated
 
                           
Common
   
Other
 
         
Preferred
   
Common
   
Retained
   
Stock
   
Comprehensive
 
   
Total
   
Stock
   
Stock
   
Earnings
   
in Treasury
   
Income (Loss), Net
 
Balance at January 1, 2009
  $ 453,664     $ 0     $ 342,982     $ 136,877     $ (32,019 )   $ 5,824  
Comprehensive Income, net of tax:
                                               
Net Income
    12,534       -       -       12,534       -       -  
Change in unrealized appreciation
                                               
of available-for-sale securities, net of tax
    (536 )     -       -       -       -       (536 )
Total Comprehensive Income
    11,998       -       -       -       -       -  
Issuance of 83,202 common shares
                                               
under stock based compensation awards,
                                               
including related tax effects
    1,659       -       -       723       936       -  
Cost of 13,483 shares of common
                                               
stock aquired for treasury
    (231 )     -       -       -       (231 )     -  
Issuance of preferred stock
    103,725       103,725       -       -       -       -  
Preferred stock discount accretion
    -       573       -       (573 )     -       -  
Issuance of warrants to purchase common stock
    7,275       -       7,275       -       -       -  
Preferred stock dividend (paid and/or accrued)
    (2,436 )     -       -       (2,436 )     -       -  
Common stock dividend ($0.28 per share)
    (6,770 )     -       -       (6,770 )     -       -  
Stock based compensation
    6       -       6       -       -       -  
Balance at June 30, 2009
  $ 568,890     $ 104,298     $ 350,263     $ 140,355     $ (31,314 )   $ 5,288  
                                                 
Balance at January 1, 2010
  $ 570,320     $ 104,930     $ 350,269     $ 142,407     $ (32,380 )   $ 5,094  
Comprehensive Income, net of tax:
                                               
Net Income
    17,474       -       -       17,474       -       -  
Change in unrealized appreciation
                                               
of available-for-sale securities, net of tax
    9,237       -       -       -       -       9,237  
Total Comprehensive Income
    26,711       -       -       -       -       -  
Issuance of 188,470 common shares
                                               
under stock based compensation awards,
                                               
including related tax effects
    2,884       -       -       628       2,256       -  
Cost of 21,471 shares of common
                                               
stock acquired for treasury
    (362 )     -       -       -       (362 )     -  
Preferred stock discount accretion
    -       653       -       (653 )     -       -  
Preferred stock dividend (paid and/or accrued)
    (2,775 )     -       -       (2,775 )     -       -  
Common stock dividend ($0.30 per share)
    (7,282 )     -       -       (7,282 )     -       -  
Stock based compensation
    6       -       6       -       -       -  
Balance at June 30, 2010
  $ 589,502     $ 105,583     $ 350,275     $ 149,799     $ (30,486 )   $ 14,331  
                                                 
The accompanying notes are a part of the consolidated financial statements.
                         


 
1st SOURCE CORPORATION
           
CONSOLIDATED STATEMENTS OF CASH FLOWS
           
(Unaudited - Dollars in thousands)
           
   
Six Months Ended June 30,
 
   
2010
   
2009
 
Operating activities:
           
Net income
  $ 17,474     $ 12,534  
Adjustments to reconcile net income to net cash
               
provided (used) by operating activities:
               
Provision for loan and lease losses
    10,186       16,272  
Depreciation of premises and equipment
    2,156       2,428  
Depreciation of equipment owned and leased to others
    10,668       10,044  
Amortization of investment security premiums
               
and accretion of discounts, net
    795       3,337  
Amortization of mortgage servicing rights
    1,461       1,572  
Mortgage servicing asset impairment (recovery)
    970       (1,507 )
Deferred income taxes
    8,637       597  
Investment securities and other investment (gains) losses
    (976 )     43  
Originations/purchases of loans held for sale, net of principal collected
    (138,692 )     (388,345 )
Proceeds from the sales of loans held for sale
    107,651       300,667  
Net gain on sale of loans held for sale
    (1,394 )     (2,141 )
Change in trading account securities
    12       (4 )
Change in interest receivable
    1,255       911  
Change in interest payable
    3,238       6,010  
Change in other assets
    (3,482 )     (4,447 )
Change in other liabilities
    (6,355 )     (10,184 )
Other
    387       566  
Net change in operating activities
    13,991       (51,647 )
                 
Investing activities:
               
Proceeds from sales of investment securities
    71,917       103,203  
Proceeds from maturities of investment securities
    215,792       259,862  
Purchases of investment securities
    (303,604 )     (525,625 )
Net change in short-term and other investments
    98,187       (22,594 )
Loans sold or participated to others
    9,886       8,982  
Net change in loans and leases
    (58,893 )     121,890  
Net change in equipment owned under operating leases
    (4,952 )     (14,077 )
Purchases of premises and equipment
    (1,041 )     (953 )
Net change in investing activities
    27,292       (69,312 )
                 
Financing activities:
               
Net change in demand deposits, NOW
               
accounts and savings accounts
    44,177       144,403  
Net change in certificates of deposit
    (87,055 )     (43,902 )
Net change in short-term borrowings
    (8,336 )     (122,182 )
Proceeds from issuance of long-term debt
    10,346       166  
Payments on long-term debt
    (289 )     (10,310 )
Net proceeds from issuance of treasury stock
    2,884       1,659  
Acquisition of treasury stock
    (362 )     (231 )
Net proceeds from issuance of preferred stock & common stock warrants
    -       111,000  
Cash dividends paid on preferred stock
    (2,775 )     (1,727 )
Cash dividends paid on common stock
    (7,408 )     (6,890 )
Net change in financing activities
    (48,818 )     71,986  
                 
Net change in cash and cash equivalents
    (7,535 )     (48,973 )
                 
Cash and cash equivalents, beginning of year
    72,872       119,771  
                 
Cash and cash equivalents, end of period
  $ 65,337     $ 70,798  
                 
Non-cash transactions:
               
Loans transferred to other real estate and repossessed assets
  $ 10,939     $ 9,498  
Common stock matching contribution to ESOP plan
    2,545       1,254  
                 
The accompanying notes are a part of the consolidated financial statements.
               


 
1ST SOURCE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1.              Basis of Presentation

The accompanying unaudited consolidated financial statements reflect all adjustments (all of which are normal and recurring in nature) which are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, the results of operations, changes in shareholders’ equity, and cash flows for the periods presented. These unaudited consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and footnote disclosures normally included in financial statements prepared in accordance with U. S. generally accepted accounting principles (GAAP) have been omitted. The Notes to the Consolidated Financial Statements appearing in 1st Source Corporation’s Annual Report on Form 10-K (2009 Annual Report), which include descriptions of significant accounting policies, should be read in conjunction with these interim financial statements. The balance sheet at December 31, 2009 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by U. S. generally accepted accounting principles for complete financial statements. Certain amounts in the prior period consolidated financial statements have been reclassified to conform with the current year presentation.

Note 2.              Recent Accounting Pronouncements

Receivables:  In April 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2010-18 “Receivables (Topic 310) – Effect of a Loan Modification When the Loan is Part of a Pool that is Accounted for as a Single Asset – a consensus of the FASB Emerging Issues Task Force.”  ASU 2010-18 provides guidance on account for acquired loans that have evidence of credit deterioration upon acquisition. It allows acquired assets with common risk characteristics to be accounted for in the aggregate as a pool.  ASU 2010-18 is effective for modifications of loans accounted for within pools under Subtopic 310-30 in the first interim or annual reporting period ending on or after July 15, 2010.  We do not expect ASU 2010-18 to have an impact on our financial condition, results of operations, or disclosures.

Financial Services – Insurance:  In April 2010, the FASB issued ASU No. 2010-15 “Financial Services – Insurance (Topic 944) – How Investments Held through Separate Accounts Affect an Insurer’s Consolidation Analysis of Those Investments – a consensus of the FASB Emerging Issues Task Force.”  ASU 2010-15 affects insurance entities that have separate accounts that meet the definition of a separate account in paragraph 944-80-25-2 when evaluating whether to consolidate an investment held through its separate account or through a combination of investments in its separate and general accounts.  ASU 2010-15 is effective for fiscal years and interim periods within those fiscal years, beginning after December 15, 2010.  We do not expect ASU 2010-15 to have an impact on our financial condition, results of operations, or disclosures.

Subsequent Events:  In February 2010, the FASB issued ASU No. 2010-09 “Subsequent Events (Topic 855) – Amendments to Certain Recognition and Disclosure Requirements.”  ASU 2010-09 amends the subsequent events disclosure guidance.  The amendments include a definition of an SEC filer, requires an SEC filer or conduit bond obligor to evaluate subsequent events through the date the financial statements are issued, and removes the requirement for an SEC filer to disclose the date through which subsequent events have been evaluated.  ASU 2010-09 was effective upon issuance for us.  The impact of ASU 2010-09 on our disclosures is reflected in Note 11 - Subsequent Events.



Fair Value Measurements and Disclosures:  In January 2010, the FASB issued ASU No. 2010-06 “Fair Value Measurements and Disclosures (Topic 820) – Improving Disclosures about Fair Value Measurements.”  ASU 2010-06 amends the fair value disclosure guidance.  The amendments include new disclosures and changes to clarify existing disclosure requirements.  ASU 2010-06 was effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements of Level 3 fair value measurements.  Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.  The impact of ASU 2010-06 on our disclosures is reflected in Note 10 - Fair Value Measurements.

Consolidations:  In December 2009, the FASB issued ASU No. 2009-17 (formerly Statement No. 167), “Consolidations (Topic 810) – Improvements to Financial Reporting for Enterprises involved with Variable Interest Entities”. ASU 2009-17 amends the consolidation guidance applicable to variable interest entities. The amendments to the consolidation guidance affect all entities, as well as qualifying special-purpose entities (QSPEs) that are currently excluded from previous consolidation guidance. ASU 2009-17 was effective as of the beginning of the first annual reporting period that begins after November 15, 2009. ASU 2009-17 did not have an impact on our financial condition, results of operations, or disclosures.

Accounting for Transfers of Financial Assets:  In December 2009, the FASB issued ASU No. 2009-16 (formerly Statement No. 166), “Transfers and Servicing (Topic 860) – Accounting for Transfers of Financial Assets”. ASU 2009-16 amends the derecognition accounting and disclosure guidance. ASU 2009-16 eliminates the exemption from consolidation for QSPEs and also requires a transferor to evaluate all existing QSPEs to determine whether they must be consolidated. ASU 2009-16 was effective as of the beginning of the first annual reporting period that begins after November 15, 2009. ASU 2009-16 did not have an impact on our financial condition, results of operations, or disclosures.

Note 3.              Investment Securities

Investment securities available-for-sale were as follows:

   
Amortized
   
Gross
   
Gross
       
(Dollars in thousands)
 
Cost
   
Unrealized Gains
   
Unrealized Losses
   
Fair Value
 
June 30, 2010
                       
U.S. Treasury and Federal agencies securities
  $ 389,715     $ 6,823     $ -     $ 396,538  
U.S. States and political subdivisions securities
    166,746       5,852       (1,953 )     170,645  
Mortgage-backed securities - Federal agencies
    326,037       10,181       (61 )     336,157  
Corporate debt securities
    24,043       266       -       24,309  
Foreign government and other securities
    1,687       7       -       1,694  
Total debt securities
    908,228       23,129       (2,014 )     929,343  
Marketable equity securities
    1,288       1,980       (28 )     3,240  
Total investment securities available-for-sale
  $ 909,516     $ 25,109     $ (2,042 )   $ 932,583  
                                 
December 31, 2009
                               
U.S. Treasury and Federal agencies securities
  $ 390,189     $ 760     $ (1,780 )   $ 389,169  
U.S. States and political subdivisions securities
    188,706       5,450       (2,337 )     191,819  
Mortgage-backed securities - Federal agencies
    286,415       5,996       (1,434 )     290,977  
Corporate debt securities
    26,166       194       (38 )     26,322  
Foreign government and other securities
    675       -       -       675  
Total debt securities
    892,151       12,400       (5,589 )     898,962  
Marketable equity securities
    1,288       1,417       (29 )     2,676  
Total investment securities available-for-sale
  $ 893,439     $ 13,817     $ (5,618 )   $ 901,638  
 
 
- 8 -

 
At June 30, 2010, the residential mortgage-backed securities we held consisted primarily of GNMA, FNMA and FHLMC pass-through certificates which are guaranteed by those respective agencies of the United States government (or Government Sponsored Enterprise, GSEs).

The contractual maturities of debt securities available-for-sale at June 30, 2010 are shown below.  Expected maturities will differ from contractual maturities, because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
(Dollars in thousands)
           
   
Amortized Cost
   
Fair Value
 
Due in one year or less
  $ 48,467     $ 48,759  
Due after one year through five years
    395,701       404,563  
Due after five years through ten years
    124,660       128,306  
Due after ten years
    13,363       11,558  
Mortgage-backed securities
    326,037       336,157  
Total debt securities available-for-sale
  $ 908,228     $ 929,343  
 
The following table shows the gross realized gains and losses on sale of securities from the securities available-for-sale portfolio, including marketable equity securities.  Realized gains and losses on the sales of all securities are computed using the specific identification cost basis.  The gross gains and losses in the first six months of 2010 primarily reflect the disposition of FNMA and FHLMC debt securities.  The gross gains in the first six months of 2009 reflect gains on the sale of FHLB and FNMA debt securities.  The gross losses in the first six months of 2009 primarily reflect losses on the sale of preferred equities.  There have been no other than temporary impairment (OTTI) writedowns in 2010.  There were net (losses)/gains of $(12) thousand and $4 thousand recorded for the six months ended June 30, 2010 and 2009 on $0.11 million and $0.13 million in trading securities outstanding at June 30, 2010, and December 31, 2009, respectively.
 
(Dollars in thousands)
 
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2010
   
2009
   
2010
   
2009
 
Gross realized gains
  $ -     $ 60     $ 292     $ 654  
Gross realized losses
    -       -       (12 )     (707 )
Net realized gains (losses)
  $ -     $ 60     $ 280     $ (53 )


The following tables summarize our gross unrealized losses and fair value by investment category and age:

   
Less than 12 Months
   
12 months or Longer
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
(Dollars in thousands)
 
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
June 30, 2010
                                   
U.S. States and political subdivisions securities
  3,881     (82 )   12,504     (1,871 )   16,385     (1,953 )
Mortgage-backed securities - Federal agencies
    35       (1 )     5,902       (60 )     5,937       (61 )
Total debt securities
    3,916       (83 )     18,406       (1,931 )     22,322       (2,014 )
Marketable equity securities
    -       -       5       (28 )     5       (28 )
Total investment securities available-for-sale
  $ 3,916     $ (83 )   $ 18,411     $ (1,959 )   $ 22,327     $ (2,042 )
                                                 
December 31, 2009
                                               
U.S. Treasury and Federal agencies securities
  $ 245,921     $ (1,780 )   $ -     $ -     $ 245,921     $ (1,780 )
U.S. States and political subdivisions securities
    9,501       (178 )     16,718       (2,159 )     26,219       (2,337 )
Mortgage-backed securities - Federal agencies
    90,592       (1,137 )     22,330       (297 )     112,922       (1,434 )
Corporate debt securities
    7,149       (38 )     -       -       7,149       (38 )
Total debt securities
    353,163       (3,133 )     39,048       (2,456 )     392,211       (5,589 )
Marketable equity securities
    2       (2 )     4       (27 )     6       (29 )
Total investment securities available-for-sale
  $ 353,165     $ (3,135 )   $ 39,052     $ (2,483 )   $ 392,217     $ (5,618 )

The initial indication of OTTI for both debt and equity securities is a decline in fair value below amortized cost.  Quarterly, the impaired securities are analyzed on a qualitative and quantitative basis in determining OTTI.  Declines in the fair value of available-for-sale debt securities below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses.  The amount of impairment related to other factors is recognized in other comprehensive income.  In estimating OTTI impairment losses, we consider among other things, (i) the length of time and the extent to which fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) whether it is more likely than not that we will not have to sell any such securities before a recovery of cost.

At June 30, 2010, we do not have the intent to sell any of the available-for-sale securities in the table above and believe that it is more likely than not that we will not have to sell any such securities before an anticipated recovery of cost.  The unrealized losses are due to increases in market interest rates over the yields available at the time the underlying securities were purchased and market illiquidity on adjustable rate coupon securities which are reflected in U.S. States and Political subdivisions securities.  The fair value is expected to recover on all debt securities as they approach their maturity date or repricing date or if market yields for such investments decline.  We do not believe any of the securities are impaired due to reasons of credit quality.  Accordingly, as of June 30, 2010, we believe the impairments detailed in the table above are temporary and no impairment loss has been realized in our consolidated statements of income.

At June 30, 2010 and December 31, 2009, investment securities with carrying values of $337.79 million and $351.84 million, respectively, were pledged as collateral to secure government deposits, security repurchase agreements, and for other purposes.

Note 4.              Reserve for Loan and Lease Losses

The reserve for loan and lease losses is maintained at a level believed to be adequate by management to absorb probable losses inherent in the loan and lease portfolio.  The determination of the reserve requires significant judgment reflecting management’s best estimate of probable loan and lease losses related to specifically identified loans and leases as well as probable losses in the remainder of the various loan and lease portfolios.  
 
 
- 10 -

 
The methodology for assessing the appropriateness of the reserve consists of several key elements, which include: specific reserves for impaired loans, percentage allocations for special attention loans and leases (classified loans and leases and internal watch list credits) without specific reserves, formula reserves for each business lending division portfolio, and reserves for pooled homogeneous loans and leases.  Management’s evaluation is based upon a continuing review of these portfolios, estimates of customer performance, collateral values and dispositions, and assessments of economic and geopolitical events, all of which are subject to judgment and will change.

Note 5.              Mortgage Servicing Assets

We recognize the rights to service residential mortgage loans for others as separate assets, whether the servicing rights are acquired through a separate purchase or through the sale of originated loans with servicing rights retained.  We allocate a portion of the total cost of a mortgage loan to servicing rights based on the fair value.

Mortgage servicing assets are evaluated for impairment.  For purposes of impairment measurement, mortgage servicing assets are stratified based on the predominant risk characteristics of the underlying servicing, principally by loan type and interest rate.  If temporary impairment exists within a tranche, a valuation allowance is established through a charge to income equal to the amount by which the carrying value exceeds the fair value.  If it is later determined all or a portion of the temporary impairment no longer exists for a particular tranche, the valuation allowance is reduced through a recovery of income.

Changes in the carrying value of mortgage servicing assets and the associated valuation allowance follow:

   
Three Months Ended
   
Six Months Ended
 
(Dollars in thousands)
 
June 30,
   
June 30,
 
   
2010
   
2009
   
2010
   
2009
 
Mortgage servicing assets:
                       
Balance at beginning of period
  $ 8,116     $ 7,857     $ 8,749     $ 6,708  
Additions
    970       2,428       1,541       4,923  
Amortization
    (700 )     (848 )     (1,461 )     (1,572 )
Sales
    (218 )     (102 )     (661 )     (724 )
Carrying value before valuation allowance at end of period
    8,168       9,335       8,168       9,335  
                                 
Valuation allowance:
                               
Balance at beginning of period
    -       (2,638 )     (1 )     (2,073 )
Impairment (charges) recoveries
    (971 )     2,072       (970 )     1,507  
Balance at end of period
  $ (971 )   $ (566 )   $ (971 )   $ (566 )
Net carrying value of mortgage servicing assets at end of period
  $ 7,197     $ 8,769     $ 7,197     $ 8,769  
Fair value of mortgage servicing assets at end of period
  $ 7,489     $ 9,538     $ 7,489     $ 9,538  

During the six months ended June 30, 2010 and 2009, management determined that it was not necessary to permanently write-down any previously established valuation allowance.  At June 30, 2010, the fair value of mortgage servicing assets exceeded the carrying value reported in the consolidated statement of financial condition by $0.29 million.  This difference represents increases in the fair value of certain mortgage servicing assets that could not be recorded above cost basis.

 
- 11 -


The key economic assumptions used to estimate the fair value of the mortgage servicing rights follow:

   
June 30,
 
   
2010
   
2009
 
Expected weighted-average life (in years)
    3.56       3.53  
Weighted-average constant prepayment rate (CPR)
      29.46 %         22.44 %  
Weighted-average discount rate
        8.99 %           8.61 %  

Mortgage loan contractual servicing fees, including late fees and ancillary income, were $0.96 million and $0.89 million for the three months ended June 30, 2010 and 2009, respectively.  Mortgage loan contractual servicing fees were $1.98 million and $1.75 million for the six months ended June 30, 2010 and 2009, respectively.  Mortgage loan contractual servicing fees are included in mortgage banking income in the consolidated statements of income.

Note 6.              Financial Instruments with Off-Balance-Sheet Risk and Derivative Transactions

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

We have certain interest rate derivative positions that are not designated as hedging instruments.  These derivative positions relate to transactions in which we enter into an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution.  In connection with each transaction, we agree to pay interest to the client on a notional amount at a variable interest rate and receive interest from the client on the same notional amount at a fixed interest rate.  At the same time, we agree to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount.  The transaction allows our client to effectively convert a variable rate loan to a fixed rate.  Because the terms of the swaps with our customers and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact our results of operations.

1st Source Bank (Bank), a subsidiary of 1st Source Corporation, grants mortgage loan commitments to borrowers, subject to normal loan underwriting standards.  The interest rate risk associated with these loan commitments is managed by entering into contracts for future deliveries of loans.  Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Commitments to originate or purchase residential mortgage loans held for sale and forward commitments to sell residential mortgage loans are considered derivative instruments.

 
- 12 -



At June 30, 2010 and December 31, 2009, the amounts of non-hedging derivative financial instruments are shown in the chart below:

(Dollars in thousands)
     
Asset derivatives
 
Liability derivatives
 
 
Notional or
   
Statement of
       
Statement of
     
 
contractual
   
Financial Condition
   
Fair
 
Financial Condition
 
Fair
 
 
amount
   
location
   
value
 
location
 
value
 
                         
June 30, 2010
                       
Interest rate swap contracts
$ 460,900    
Other assets
    $ 17,696  
Other liabilities
  $ 18,346  
Loan commitments
  92,227    
Mortgages held for sale
      472   N/A     -  
Forward contracts
  103,453     N/A       -  
Mortgages held for sale
    1,941  
                               
Total
              $ 18,168       $ 20,287  
                               
December 31, 2009
                             
Interest rate swap contracts
$ 412,717    
Other assets
    $ 13,516  
Other liabilities
  $ 13,988  
Loan commitments
  48,821    
Mortgages held for sale
      77   N/A     -  
Forward contracts
  38,940    
Mortgages held for sale
      411   N/A     -  
                               
Total
              $ 14,004       $ 13,988  

For the three and six months ended June 30, 2010 and 2009, the amounts included in the consolidated statements of income for non-hedging derivative financial instruments are shown in the chart below:

     
Gain (loss)
 
     
Three Months Ended
   
Six Months Ended
 
 
Statement of
 
June 30,
   
June 30,
 
(Dollars in thousands)
Income location
 
2010
   
2009
   
2010
   
2009
 
                           
Interest rate swap contracts
Other expense
  $ (143 )   $ 64     $ (178 )   $ 68  
Loan commitments
Mortgage banking income
    289       (1,712 )     396       (1,028 )
Forward contracts
Mortgage banking income
    (2,028 )     2,278       (2,353 )     971  
Total
    $ (1,882 )   $ 630     $ (2,135 )   $ 11  

We issue letters of credit which are conditional commitments that guarantee the performance of a customer to a third party.  The credit risk involved and collateral obtained in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.  Standby letters of credit totaled $22.83 million and $19.02 million at June 30, 2010 and December 31, 2009, respectively.  Standby letters of credit generally have terms ranging from six months to one year.

Note 7.              Earnings Per Share

Earnings per common share is computed using the two-class method.  Basic earnings per common share is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during the applicable period, excluding outstanding participating securities.  Participating securities include non-vested restricted stock awards.  Non-vested restricted stock awards are considered participating securities to the extent the holders of these securities receive non-forfeitable dividends at the same rate as holders of common stock.  Diluted earnings per common share is computed using the weighted-average number of shares determined for the basic earnings per common share computation plus the dilutive effect of stock compensation using the treasury stock method.  
 
 
- 13 -

 
Stock options and warrants, where the exercise price was greater than the average market price of the common shares, were excluded from the computation of diluted earnings per common share because the result would have been antidilutive.  Stock options of 40,508 and 54,472 were considered antidilutive as of June 30, 2010 and 2009.  Stock warrants of 837,947 were considered antidilutive as of June 30, 2010 and 2009.

The following table presents a reconciliation of the number of shares used in the calculation of basic and diluted earnings per common share for the three and six months ended June 30, 2010 and 2009.

   
Three Months Ended
   
Six Months Ended
 
(Dollars in thousands - except share and per share amounts)
 
June 30,
   
June 30,
 
   
2010
   
2009
   
2010
   
2009
 
Distributed earnings allocated to common stock
  $ 3,643     $ 3,385     $ 7,259     $ 6,760  
Undistributed earnings allocated to common stock
    2,380       1,180       6,658       2,714  
Net earnings allocated to common stock
    6,023       4,565       13,917       9,474  
Net earnings allocated to participating securities
    55       22       129       51  
Net income allocated to common stock and participating securities
  $ 6,078     $ 4,587     $ 14,046     $ 9,525  
                                 
Weighted average shares outstanding for basic earnings per common share
    24,284,519       24,185,415       24,247,586       24,167,905  
Dilutive effect of stock compensation
    7,972       41,127       6,512       41,061  
Weighted average shares outstanding for diluted earnings per common share
    24,292,491       24,226,542       24,254,098       24,208,966  
                                 
Basic earnings per common share
  $ 0.25     $ 0.19     $ 0.57     $ 0.39  
Diluted earnings per common share
  $ 0.25     $ 0.19     $ 0.57     $ 0.39  

Note 8.              Stock-Based Compensation

As of June 30, 2010, we had five stock-based employee compensation plans, which are more fully described in Note 16 of the Consolidated Financial Statements in 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2009.  These plans include two stock option plans, the Employee Stock Purchase Plan, the Executive Incentive Plan, and the Restricted Stock Award Plan.

Stock-based compensation expense for all stock-based compensation awards granted is based on the grant-date fair value.  For all awards except stock option awards, the grant date fair value is either the fair market value per share or book value per share (corresponding to the type of stock awarded) as of the grant date.  For stock option awards, the grant date fair value is estimated using the Black-Scholes option pricing model.  For all awards we recognize these compensation costs only for those shares expected to vest on a straight-line basis over the requisite service period of the award, for which we use the related vesting term.  We estimate forfeiture rates based on historical employee option exercise and employee termination experience.  We have identified separate groups of awardees that exhibit similar option exercise behavior and employee termination experience and have considered them as separate groups in the valuation models and expense estimates.
 
The stock-based compensation expense recognized in the condensed consolidated statement of income for the six months ended June 30, 2010 and 2009 was based on awards ultimately expected to vest, and accordingly has been adjusted by the amount of estimated forfeitures.  GAAP requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.  Forfeitures were estimated based partially on historical experience.
 
 
- 14 -

 
The aggregate intrinsic value in the table below represents the total pretax intrinsic value (the difference between 1st Source’s closing stock price on the last trading day of the second quarter of 2010 (June 30, 2010) and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on June 30, 2010.  This amount changes based on the fair market value of 1st Source’s stock.  Total fair value of options vested and expensed was $6 thousand, net of tax, for both the six months ended June 30, 2010 and 2009.

               
Average
       
         
Weighted
   
Remaining
   
Total
 
         
Average
   
Contractual
   
Intrinsic
 
   
Number of
   
Exercise
   
Term
   
Value
 
   
Shares
   
Price
   
(in years)
   
(in 000's)
 
                         
Options outstanding, beginning of year
    71,763       $18.19              
Granted
    -       -              
Exercised
    -       -              
Forfeited
    (9,255 )     25.03              
Options outstanding, June 30, 2010
    62,508       $17.18       1.61       $107  
                                 
                                 
Vested and expected to vest at June 30, 2010
    62,508       $17.18       1.61       $107  
Exercisable at June 30, 2010
    57,008       $17.68       1.50       $81  

No options were granted during the six months ended June 30, 2010.
 
As of June 30, 2010, there was $3.50 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements.  That cost is expected to be recognized over a weighted-average period of 3.55 years.
 
The following table summarizes information about stock options outstanding at June 30, 2010:

 
Options Outstanding
 
Options Exercisable
   
Weighted
       
   
Average
Weighted
   
Weighted
Range of
Number
Remaining
Average
 
Number
Average
Exercise
of shares
Contractual
Exercise
 
of shares
Exercise
Prices
Outstanding
Life
Price
 
Exercisable
Price
$12.04 to $17.99
29,508
2.24
$13.38
 
24,008
$13.69
$18.00 to $26.99
33,000
1.06
20.58
 
33,000
20.58


The fair value of each stock option was estimated on the date of grant using the Black-Scholes option-pricing model.

Note 9.              Income Taxes

The total amount of unrecognized tax benefits that would affect the effective tax rate if recognized was $1.53 million at June 30, 2010 and $1.30 million at December 31, 2009.  Interest and penalties were recognized through the income tax provision.  For the six months ending June 30, 2010 and the twelve months ending December 31, 2009, we recognized approximately $0.11 million and $(0.73) million in interest, net of tax effect, and penalties, respectively.  Interest and penalties of approximately $0.66 million and $0.55 million were accrued at June 30, 2010 and December 31, 2009, respectively.
 
 
- 15 -

 
Tax years that remain open and subject to audit include the federal 2006-2009 years and the Indiana 2006-2009 years.  Additionally, during the first quarter of 2009 we reached a resolution of audit examinations for the 2002-2007 years and as a result recorded a reduction of unrecognized tax benefits in the amount of $4.85 million that affected the effective tax rate and increased earnings in the amount of $2.60 million.  We do not anticipate a significant change in the amount of uncertain tax positions within the next 12 months.

Note 10.            Fair Value Measurements
 
 
We record certain assets and liabilities at fair value.  Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  Fair value measurements are also utilized to determine the initial value of certain assets and liabilities, to perform impairment assessments, and for disclosure purposes.  We use quoted market prices and observable inputs to the maximum extent possible when measuring fair value.  In the absence of quoted market prices, various valuation techniques are utilized to measure fair value.  When possible, observable market data for identical or similar financial instruments are used in the valuation.  When market data is not available, fair value is determined using valuation models that incorporate management’s estimates of the assumptions a market participant would use in pricing the asset or liability.

Fair value measurements are classified within one of three levels based on the observability of the inputs used to determine fair value, as follows:

§  
Level 1 – The valuation is based on quoted prices in active markets for identical instruments.

§  
Level 2 – The valuation is based on observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

§  
Level 3 – The valuation is based on unobservable inputs that are supported by minimal or no market activity and that are significant to the fair value of the instrument.  Level 3 valuations are typically performed using pricing models, discounted cash flow methodologies, or similar techniques that incorporate management’s own estimates of assumptions that market participants would use in pricing the instrument, or valuations that require significant management judgment or estimation.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

We elected fair value accounting for new mortgages held for sale (MHFS) originations starting on January 1, 2008.  We believe the election for MHFS (which are hedged with free-standing derivatives (economic hedges)) will reduce certain timing differences and better match changes in the value of these assets with changes in the value of derivatives used as economic hedges for these assets.  At June 30, 2010, all MHFS are carried at fair value.

 
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The following table reflects the differences between fair value carrying amount of mortgages held for sale measured at fair value and the aggregate unpaid principal amount we are contractually entitled to receive at maturity on June 30, 2010:

(Dollars in thousands)
 
Fair value carrying amount
   
Aggregate unpaid principal
   
Excess of fair value carrrying amount over (under) unpaid principal
   
                     
Mortgages held for sale reported at fair value:
                   
  Total loans
  $ 59,084     $ 57,854     $ 1,230 (1 )
  Nonaccrual loans
    -       -       -    
  Loans 90 days or more past due and still accruing
    -       -       -    
                           
(1) The excess of fair value carrying amount over unpaid principal is included in mortgage banking income and includes changes in fair value at and subsequent to funding,
 
gains and losses on the related loan commitment prior to funding, and premiums on acquired loans.
   

Financial Instruments on Recurring Basis:

The following is a description of the valuation methodologies used for financial instruments measured at fair value on a recurring basis:

Investment securities available for sale are valued primarily by a third party pricing agent and both the market and income valuation approaches are implemented using the following types of inputs:

●   
U.S. treasuries are priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.
 
●   
Government-sponsored agency debt securities and corporate bonds are primarily priced using available market information through processes such as benchmark curves, market valuations of like securities, sector groupings and matrix pricing.
 
●   
Other government-sponsored agency securities, mortgage-backed securities and some of the actively traded REMICs and CMOs, are primarily priced using available market information including benchmark yields, prepayment speeds, spreads and volatility of similar securities.
 
●   
Other inactive government-sponsored agency securities are primarily priced using consensus pricing and dealer quotes.
 
●   
State and political subdivisions are largely grouped by characteristics, i.e., geographical data and source of revenue in trade dissemination systems.  Since some securities are not traded daily and due to other grouping limitations, active market quotes are often obtained using benchmarking for like securities.  Local tax anticipation warrants, with very little market activity, are priced using an appropriate market yield curve.
 
●   
Marketable equity (common) securities are primarily priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.
 
●   
Marketable equity (preferred) securities are primarily priced using available market information through processes such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing.

 
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Trading account securities are priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.

Mortgages held for sale and the related loan commitments and forward contracts (hedges) are valued using a market value approach and utilizing an appropriate current market yield and a loan commitment closing rate based on historical analysis.

Interest rate swap positions, both assets and liabilities, are valued by a third-party pricing agent using an income approach and utilizing models that use as their basis readily observable market parameters.  This valuation process considers various factors including interest rate yield curves, time value and volatility factors.

The table below presents the balance of assets and liabilities at June 30, 2010, measured at fair value on a recurring basis:

(Dollars in thousands)
 
Level 1
   
Level 2
   
Level 3
   
Total
 
                         
Assets:
                       
Investment securities available-for-sale:
                       
U.S. Treasury and Federal agencies securities
  $ 20,233     $ 376,304     $ -     $ 396,537  
U.S. States and political subdivisions securities
    -       161,322       9,324       170,646  
Mortgage-backed securities - Federal agencies
    -       336,157       -       336,157  
Corporate debt securities
    -       24,309       -