form10_q.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 September 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 Indentification No.)
 
100 North Michigan Street
South Bend, IN
46614
(Address of principle 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 October 15, 2010 – 24,203,450 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.
32
Item 4.
32
 
PART II. OTHER INFORMATION
 
Item 1.
 32 
Item 1A.
32
Item 2.
33
Item 3.
 33 
Item 4.
 33 
Item 5.
 33 
Item 6.
 33 
 
   34 
 
CERTIFICATIONS
   
     
Exhibit 31.1     
Exhibit 31.2     
Exhibit 32.1     
Exhibit 32.2     

 
- 2 -

 
 
 
1st SOURCE CORPORATION
           
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
           
(Unaudited - Dollars in thousands)
           
   
September 30,
   
December 31,
 
   
2010
   
2009
 
ASSETS
           
Cash and due from banks
  $ 60,395     $ 72,872  
Federal funds sold and
               
interest bearing deposits with other banks
    79,082       141,166  
Investment securities available-for-sale
               
(amortized cost of $848,409 and $893,439
               
at September 30, 2010 and December 31, 2009, respectively)
    874,514       901,638  
Other investments
    21,012       21,012  
Trading account securities
    125       125  
Mortgages held for sale
    114,947       26,649  
Loans and leases - net of unearned discount
               
Commercial and agricultural loans
    535,874       546,222  
Auto, light truck and environmental equipment
    397,297       349,741  
Medium and heavy duty truck
    174,459       204,545  
Aircraft financing
    620,996       617,384  
Construction equipment financing
    304,035       313,300  
Loans secured by real estate
    979,442       952,223  
Consumer loans
    100,076       109,735  
Total loans and leases
    3,112,179       3,093,150  
Reserve for loan and lease losses
    (89,509 )     (88,236 )
Net loans and leases
    3,022,670       3,004,914  
Equipment owned under operating leases, net
    84,430       97,004  
Net premises and equipment
    36,133       37,907  
Goodwill and intangible assets
    89,287       90,222  
Accrued income and other assets
    149,718       148,591  
Total assets
  $ 4,532,313     $ 4,542,100  
                 
LIABILITIES
               
Deposits:
               
Noninterest bearing
  $ 495,778     $ 450,608  
Interest bearing
    3,070,416       3,201,856  
Total deposits
    3,566,194       3,652,464  
Federal funds purchased and securities
               
sold under agreements to repurchase
    145,887       123,787  
Other short-term borrowings
    26,337       26,323  
Long-term debt and mandatorily redeemable securities
    34,987       19,761  
Subordinated notes
    89,692       89,692  
Accrued expenses and other liabilities
    72,893       59,753  
Total liabilities
    3,935,990       3,971,780  
                 
SHAREHOLDERS' EQUITY
               
Preferred stock; no par value
               
Authorized 10,000,000 shares; issued 111,000 at September 30, 2010,
               
and at December 31, 2009
    105,917       104,930  
Common stock; no par value
               
Authorized 40,000,000 shares; issued 25,643,506 at September 30, 2010,
               
and at December 31, 2009
    350,278       350,269  
Retained earnings
    155,633       142,407  
Cost of common stock in treasury (1,440,056 shares at September 30, 2010, and
               
1,532,483 shares at December 31, 2009)
    (31,723 )     (32,380 )
Accumulated other comprehensive income
    16,218       5,094  
Total shareholders' equity
    596,323       570,320  
Total liabilities and shareholders' equity
  $ 4,532,313     $ 4,542,100  
                 
The accompanying notes are a part of the consolidated financial statements.
               

 
- 3 -

 
 
 
1st SOURCE CORPORATION
                         
CONSOLIDATED STATEMENTS OF INCOME
                         
(Unaudited - Dollars in thousands, except per share amounts)
                         
   
Three Months Ended
     
Nine Months Ended
 
   
September 30,
     
September 30,
 
   
2010
   
2009
     
2010
   
2009
 
Interest income:
                         
Loans and leases
  $ 43,722     $ 43,436       $ 129,091     $ 132,507  
Investment securities, taxable
    4,931       4,357         15,611       12,600  
Investment securities, tax-exempt
    1,369       1,651         4,258       5,046  
Other
    219       297         743       894  
Total interest income
    50,241       49,741         149,703       151,047  
                                   
Interest expense:
                                 
Deposits
    10,790       15,460         34,768       49,662  
Short-term borrowings
    219       265         613       909  
Subordinated notes
    1,648       1,648         4,942       4,942  
Long-term debt and mandatorily redeemable securities
    400       322         1,045       853  
Total interest expense
    13,057       17,695         41,368       56,366  
                                   
Net interest income
    37,184       32,046         108,335       94,681  
Provision for loan and lease losses
    5,578       6,469         15,764       22,741  
Net interest income after provision for
                                 
loan and lease losses
    31,606       25,577         92,571       71,940  
                                   
Noninterest income:
                                 
Trust fees
    3,870       3,782         11,677       11,473  
Service charges on deposit accounts
    4,918       5,402         14,813       15,367  
Mortgage banking income
    2,549       965         3,751       6,874  
Insurance commissions
    1,180       1,022         3,706       3,614  
Equipment rental income
    6,495       6,347         19,912       18,896  
Other income
    2,656       2,022         8,357       6,613  
Investment securities and other investment gains
    1,083       716         2,059       673  
Total noninterest income
    22,751       20,256         64,275       63,510  
                                   
Noninterest expense:
                                 
Salaries and employee benefits
    18,980       18,425         56,638       55,340  
Net occupancy expense
    2,200       2,221         6,626       7,095  
Furniture and equipment expense
    3,227       3,241         9,223       10,487  
Depreciation - leased equipment
    5,173       5,021         15,841       15,065  
Professional fees
    1,563       1,020         4,495       2,897  
Supplies and communication
    1,387       1,473         4,094       4,468  
FDIC and other insurance
    1,420       1,582         4,761       6,851  
Business development and marketing expense
    845       655         2,292       1,934  
Loan and lease collection and repossession expense
    1,449       1,147         5,822       2,776  
Other expense
    1,566       1,785         4,777       5,646  
Total noninterest expense
    37,810       36,570         114,569       112,559  
                                   
Income before income taxes
    16,547       9,263         42,277       22,891  
Income tax expense
    5,344       2,530         13,600       3,624  
                                   
Net income
    11,203       6,733         28,677       19,267  
Preferred stock dividends and discount accretion
    (1,721 )     (1,701 )       (5,149 )     (4,710 )
Net income available to common shareholders
  $ 9,482     $ 5,032       $ 23,528     $ 14,557  
                                   
Per common share
                                 
Basic net income per common share
  $ 0.39     $ 0.21       $ 0.96     $ 0.60  
Diluted net income per common share
  $ 0.39     $ 0.21       $ 0.96     $ 0.60  
Dividends
  $ 0.15     $ 0.15       $ 0.45     $ 0.43  
Basic weighted average common shares outstanding
    24,247,236       24,164,884         24,247,468       24,166,887  
Diluted weighted average common shares outstanding
    24,253,883       24,212,042         24,254,026       24,215,542  
                                   
The accompanying notes are a part of the consolidated financial statements.
                                 

 
- 4 -

 
 

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     $ -     $ 342,982     $ 136,877     $ (32,019 )   $ 5,824  
Comprehensive Income, net of tax:
                                               
Net Income
    19,267       -       -       19,267       -       -  
Change in unrealized appreciation
                                               
of available-for-sale securities, net of tax
    3,813       -       -       -       -       3,813  
Total Comprehensive Income
    23,080       -       -       -       -       -  
Issuance of 83,402 common shares
                                               
under stock based compensation awards,
                                               
including related tax effects
    1,663       -       -       725       938       -  
Cost of 52,876 shares of common
                                               
stock aquired for treasury
    (862 )                             (862 )        
Issuance of preferred stock
    103,725       103,725       -       -       -       -  
Preferred stock discount accretion
    -       887               (887 )                
Issuance of warrants to purchase common stock
    7,275       -       7,275       -       -       -  
Preferred stock dividend (paid and/or accrued)
    (3,823 )     -       -       (3,823 )     -       -  
Common stock dividend ($0.43 per share)
    (10,401 )     -       -       (10,401 )     -       -  
Stock based compensation
    9       -       9       -       -       -  
Balance at September 30, 2009
  $ 574,330     $ 104,612     $ 350,266     $ 141,758     $ (31,943 )   $ 9,637  
                                                 
Balance at January 1, 2010
  $ 570,320     $ 104,930     $ 350,269     $ 142,407     $ (32,380 )   $ 5,094  
Comprehensive Income, net of tax:
                                               
Net Income
    28,677       -       -       28,677       -       -  
Change in unrealized appreciation
                                               
of available-for-sale securities, net of tax
    11,124       -       -       -       -       11,124  
Total Comprehensive Income
    39,801       -       -       -       -       -  
Issuance of 187,354 common shares
                                               
under stock based compensation awards,
                                               
including related tax effects
    2,871       -       -       636       2,235       -  
Cost of 94,927 shares of common
                                               
stock acquired for treasury
    (1,578 )     -       -       -       (1,578 )     -  
Preferred stock discount accretion
    -       987       -       (987 )     -       -  
Preferred stock dividend (paid and/or accrued)
    (4,163 )     -       -       (4,163 )     -       -  
Common stock dividend ($0.45 per share)
    (10,937 )     -       -       (10,937 )     -       -  
Stock based compensation
    9       -       9       -       -       -  
Balance at September 30, 2010
  $ 596,323     $ 105,917     $ 350,278     $ 155,633     $ (31,723 )   $ 16,218  
                                                 
The accompanying notes are a part of the consolidated financial statements.
                                 

 
- 5 -

 
 

1st SOURCE CORPORATION
           
CONSOLIDATED STATEMENTS OF CASH FLOWS
           
(Unaudited - Dollars in thousands)
           
   
Nine Months Ended September 30,
 
   
2010
   
2009
 
Operating activities:
           
Net income
  $ 28,677     $ 19,267  
Adjustments to reconcile net income to net cash
               
(used) provided by operating activities:
               
Provision for loan and lease losses
    15,764       22,741  
Depreciation of premises and equipment
    3,103       3,515  
Depreciation of equipment owned and leased to others
    15,841       15,065  
Amortization of investment security premiums
               
and accretion of discounts, net
    1,232       4,477  
Amortization of mortgage servicing rights
    2,277       2,517  
Mortgage servicing asset impairment (recovery)
    821       (1,793 )
Deferred income taxes
    (3,800 )     3,460  
Investment securities and other investment gains
    (2,059 )     (673 )
Originations/purchases of loans held for sale, net of principal collected
    (299,298 )     (512,286 )
Proceeds from the sales of loans held for sale
    215,678       522,780  
Net gain on sale of loans held for sale
    (4,678 )     (3,170 )
Change in trading account securities
    -       (17 )
Change in interest receivable
    795       1,352  
Change in interest payable
    664       2,173  
Change in other assets
    (4,084 )     (8,109 )
Change in other liabilities
    9,495       4,249  
Other
    616       754  
Net change in operating activities
    (18,956 )     76,302  
                 
Investing activities:
               
Proceeds from sales of investment securities
    72,417       147,658  
Proceeds from maturities of investment securities
    330,904       323,295  
Purchases of investment securities
    (357,465 )     (630,642 )
Net change in short-term and other investments
    62,084       (60,757 )
Loans sold or participated to others
    13,186       13,482  
Net change in loans and leases
    (46,707 )     173,687  
Net change in equipment owned under operating leases
    (3,267 )     (23,541 )
Purchases of premises and equipment
    (1,577 )     (1,772 )
Net change in investing activities
    69,575       (58,590 )
                 
Financing activities:
               
Net change in demand deposits, NOW
               
accounts and savings accounts
    (23,309 )     74,639  
Net change in certificates of deposit
    (62,961 )     (102,468 )
Net change in short-term borrowings
    22,114       (141,197 )
Proceeds from issuance of long-term debt
    15,418       240  
Payments on long-term debt
    (363 )     (10,392 )
Net proceeds from issuance of treasury stock
    2,871       1,663  
Acquisition of treasury stock
    (1,578 )     (862 )
Net proceeds from issuance of preferred stock & common stock warrants
    -       111,000  
Cash dividends paid on preferred stock
    (4,163 )     (3,114 )
Cash dividends paid on common stock
    (11,125 )     (10,584 )
Net change in financing activities
    (63,096 )     (81,074 )
                 
Net change in cash and cash equivalents
    (12,477 )     (63,363 )
                 
Cash and cash equivalents, beginning of year
    72,872       119,771  
                 
Cash and cash equivalents, end of period
  $ 60,395     $ 56,408  
                 
Non-cash transactions:
               
Loans transferred to other real estate and repossessed assets
  $ 15,501     $ 12,489  
Common stock matching contribution to KSOP plan
    2,545       1,254  
                 
The accompanying notes are a part of the consolidated financial statements.
               

 
- 6 -

 


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 July 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2010-20 “Receivables (Topic 310) – Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.”  ASU 2010-20 requires extensive new disclosures about financing receivables, including credit risk exposures and the allowance for credit losses.  For public entities, ASU 2010-20 disclosures of period-end balances are effective for interim or annual reporting periods ending on or after December 15, 2010.  Disclosures related to activity that occurs during the reporting period are required for interim and annual reporting periods beginning on or after December 15, 2010.  We are assessing the impact of ASU 2010-20 on our disclosures.

Receivables:  In April 2010, the FASB issued 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 accounting 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 was 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.  ASU 2010-18 did not 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.

 
- 7 -

 


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 12 - 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.

 
- 8 -

 


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
 
September 30, 2010
                       
U.S. Treasury and Federal agencies securities
  $ 347,564     $ 7,563     $ -     $ 355,127  
U.S. States and political subdivisions securities
    160,583       7,529       (1,550 )     166,562  
Mortgage-backed securities - Federal agencies
    306,711       10,757       (30 )     317,438  
Corporate debt securities
    28,564       261       (6 )     28,819  
Foreign government and other securities
    3,724       37       (2 )     3,759  
Total debt securities
    847,146       26,147       (1,588 )     871,705  
Marketable equity securities
    1,263       1,549       (3 )     2,809  
Total investment securities available-for-sale
  $ 848,409     $ 27,696     $ (1,591 )   $ 874,514  
                                 
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  
 
At September 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 September 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
  $ 41,678       $ 41,955  
Due after one year through five years
    374,298         384,449  
Due after five years through ten years
    110,756         115,646  
Due after ten years
    13,703         12,217  
Mortgage-backed securities
    306,711         317,438  
Total debt securities available-for-sale
  $ 847,146       $ 871,705  
 
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 nine months of 2010 primarily reflect the disposition of FNMA and FHLMC debt securities.  The gross gains in the first nine months of 2009 reflect gains on the sale of FHLB and FNMA debt securities.  The gross losses in the first nine 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 no gains or losses for the nine months ended September 30, 2010 and net gains of $17 thousand recorded for the nine months ended September 30, 2009 on $0.13 million in trading securities outstanding at both September 30, 2010, and December 31, 2009.
 
 
- 9 -

 


(Dollars in thousands)
 
Three Months Ended
     
Nine Months Ended
 
   
September 30,
     
September 30,
 
   
2010
   
2009
     
2010
   
2009
 
Gross realized gains
  $ -     $ 356       $ 292     $ 1,010  
Gross realized losses
    (24 )     -         (36 )     (707 )
Net realized gains (losses)
  $ (24 )   $ 356       $ 256     $ 303  

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
 
September 30, 2010
                                   
U.S. States and political subdivisions securities
  $ 2,523     $ (46 )   $ 11,450     $ (1,504 )   $ 13,973     $ (1,550 )
Mortgage-backed securities - Federal agencies
    1,627       (10 )     5,275       (20 )     6,902       (30 )
Corporate debt securities
    4,520       (6 )     -       -       4,520       (6 )
Foreign government and other securities
    1,038       (2 )     -       -       1,038       (2 )
Total debt securities
    9,708       (64 )     16,725       (1,524 )     26,433       (1,588 )
Marketable equity securities
    1       -       4       (3 )     5       (3 )
Total investment securities available-for-sale
  $ 9,709     $ (64 )   $ 16,729     $ (1,527 )   $ 26,438     $ (1,591 )
                                                 
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 September 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 auction rate 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 September 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 September 30, 2010 and December 31, 2009, investment securities with carrying values of $370.43 million and $351.84 million, respectively, were pledged as collateral to secure government deposits, security repurchase agreements, and for other purposes.
 
 
- 10 -

 

 
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.  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
     
Nine Months Ended
 
(Dollars in thousands)
 
September 30,
     
September 30,
 
   
2010
   
2009
     
2010
   
2009
 
Mortgage servicing assets:
                         
Balance at beginning of period
  $ 8,168     $ 9,335       $ 8,749     $ 6,708  
Additions
    1,493       1,447         3,034       6,370  
Amortization
    (816 )     (945 )       (2,277 )     (2,517 )
Sales
    (657 )     (392 )       (1,318 )     (1,116 )
Carrying value before valuation allowance at end of period
    8,188       9,445         8,188       9,445  
Valuation allowance:
                                 
Balance at beginning of period
    (971 )     (566 )       (1 )     (2,073 )
Impairment recoveries (charges)
    149       286         (821 )     1,793  
Balance at end of period
  $ (822 )   $ (280 )     $ (822 )   $ (280 )
Net carrying value of mortgage servicing assets at end of period
  $ 7,366     $ 9,165       $ 7,366     $ 9,165  
Fair value of mortgage servicing assets at end of period
  $ 7,646     $ 9,648       $ 7,646     $ 9,648  
 
 
- 11 -

 
 
 
During the nine months ended September 30, 2010 and 2009, management determined that it was not necessary to permanently write-down any previously established valuation allowance.  At September 30, 2010, the fair value of mortgage servicing assets exceeded the carrying value reported in the consolidated statement of financial condition by $0.28 million.  This difference represents increases in the fair value of certain mortgage servicing assets that could not be recorded above cost basis.

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

   
September 30,
 
   
2010
   
2009
 
Expected weighted-average life (in years)
    3.59        3.49  
Weighted-average constant prepayment rate (CPR)
       29.76 %          23.16 %  
Weighted-average discount rate
        8.41 %            8.54 %  

Mortgage loan contractual servicing fees, including late fees and ancillary income, were $1.00 million and $0.96 million for the three months ended September 30, 2010 and 2009, respectively.  Mortgage loan contractual servicing fees were $2.98 million and $2.71 million for the nine months ended September 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.
 
 
- 12 -

 
 
 
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.
 
At September 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
 
                                       
September 30, 2010
                                     
Interest rate swap contracts
  $ 423,069      
Other assets
      $ 18,933      
Other liabilities
      $ 19,473  
Loan commitments
    118,840      
Mortgages held for sale
        476       N/A         -  
Forward contracts
    173,340       N/A         -      
Mortgages held for sale
        849  
                                                 
Total
                      $ 19,409                 $ 20,322  
                                                 
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 nine months ended September 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
     
Nine Months Ended
 
 
Statement of
 
September 30,
     
September 30,
 
(Dollars in thousands)
Income location
 
2010
   
2009
     
2010
   
2009
 
                             
Interest rate swap contracts
Other expense
  $ 110     $ (121 )     $ (68 )   $ (53 )
Loan commitments
Mortgage banking income
    3       (249 )       399       (1,277 )
Forward contracts
Mortgage banking income
    1,093       (258 )       (1,260 )     714  
Total
    $ 1,206     $ (628 )     $ (929 )   $ (616 )
 
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 $18.07 million and $19.02 million at September 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.
 
 
- 13 -

 
 
 
Participating securities include non-vested restricted stock awards.  Non-vested restricted stock awards are considered participating securities to the extent the holders of these securities receive non-forfeitable dividends at the same rate as holders of common stock.  Diluted earnings per common share is computed using the weighted-average number of shares determined for the basic earnings per common share computation plus the dilutive effect of stock compensation using the treasury stock method.  Stock options 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 September 30, 2010 and 2009.  Stock warrants of 837,947 were considered antidilutive as of September 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 nine months ended September 30, 2010 and 2009.
 
   
Three Months Ended
     
Nine Months Ended
 
(Dollars in thousands - except per share amounts)
 
September 30,
     
September 30,
 
   
2010
   
2009
     
2010
   
2009
 
Distributed earnings allocated to common stock
  $ 3,641     $ 3,626       $ 10,900     $ 10,386  
Undistributed earnings allocated to common stock
    5,732       1,381         12,390       4,095  
Net earnings allocated to common stock
    9,373       5,007         23,290       14,481  
Net earnings allocated to participating securities
    109       25         238       76  
Net income allocated to common stock and participating securities
  $ 9,482     $ 5,032       $ 23,528     $ 14,557  
                                   
Weighted average shares outstanding for basic earnings per common share
    24,247,236       24,164,884         24,247,468       24,166,887  
Dilutive effect of stock compensation
    6,647       47,158         6,558       48,655  
Weighted average shares outstanding for diluted earnings per common share
    24,253,883       24,212,042         24,254,026       24,215,542  
                                   
Basic earnings per common share
  $ 0.39     $ 0.21       $ 0.96     $ 0.60  
Diluted earnings per common share
  $ 0.39     $ 0.21       $ 0.96     $ 0.60  
 
Note 8.              Stock-Based Compensation

As of September 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 nine months ended September 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 third quarter of 2010 (September 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 September 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 $9 thousand, net of tax, for both the nine months ended September 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, September 30, 2010
      62,508         $17.18         1.36       $117  
                                         
                                         
Vested and expected to vest at September 30, 2010
      62,508         $17.18         1.36       $117  
Exercisable at September 30, 2010
      59,758         $17.42         1.31       $103  
 
No options were granted during the nine months ended September 30, 2010.
 
As of September 30, 2010, there was $3.16 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 3.38 years.
 
The following table summarizes information about stock options outstanding at September 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
     
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