FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
___________________

[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended JuneSeptember 30, 2012

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from _______ to _______

Commission File Number 0-17071

FIRST MERCHANTS CORPORATION
(Exact name of registrant as specified in its charter)

Indiana                                                                            35-1544218
(State or other jurisdiction of                                   (I.R.S. Employer
incorporation or organization)                               Identification No.)

200 East Jackson Street, Muncie, IN                  47305-2814
(Address of principal executive offices)                   (Zip code)

(Registrant’s telephone number, including area code): (765) 747-1500

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. Yes [X]   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 (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes [X]   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 definition of “large accelerated filer,”  “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer [ ]   Accelerated filer [X]   Non-accelerated filer [ ] (Do not check if smaller reporting company)  Smaller reporting company [ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ]   No [X]

As of JulyOctober 31, 2012, there were 28,650,64628,672,461 outstanding common shares of the registrant.

 
 
 

FIRST MERCHANTS CORPORATIONINDEX
FORM 10Q

Part I,I. Financial Information
Page No.
Item 1.
Financial  Statements:
 
 
Consolidated Condensed Balance Sheets
3
 
Consolidated Condensed Statements of Income
4
 
Consolidated Condensed Statements of Comprehensive Income
5
 
Consolidated Condensed Statement of Stockholders' Equity
6
 
Consolidated Condensed Statements of Cash Flows
7
 
Notes to Consolidated Condensed Financial Statements
8
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
40
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
51
Item 4.
Controls and Procedures
51
Part II. Other Information
  
Part II. Other Information
Item 1.
Legal Proceedings
52
Item 1.A.
Risk Factors
52
Item 2.
Unregistered Sales of Equity Securities and useUse of Proceeds
52
Item 3.
Defaults Upon Senior Securities
52
Item 4.
Mine Safety Disclosures
52
Item 5.
Other Information
52
Item 6.
Exhibits
53
 
Signatures
54
 
Index to Exhibits
55


 
2
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
PART I.  FINANCIAL INFORMATION
ITEM 1.  FINANCIAL STATEMENTS
CONSOLIDATED CONDENSED BALANCE SHEETS
(Dollars in thousands)

 June 30, December 31,  September 30, December 31, 
 2012 2011  2012 2011 
 
(Unaudited)
    
(Unaudited)
   
ASSETS
          
Cash and cash equivalents
 
$
68,493
 
$
73,312
  
$
57,027
 
$
73,312
 
Interest-bearing time deposits
 
41,760
 
52,851
  
35,324
 
52,851
 
Investment securities available for sale
 
547,551
 
518,491
  
551,619
 
518,491
 
Investment securities held to maturity (fair value of $413,247 and $442,469)
 
396,770
 
427,909
 
Investment securities held to maturity (fair value of $396,217 and $442,469)
 
377,097
 
427,909
 
Mortgage loans held for sale
 
15,278
 
17,864
  
27,711
 
17,864
 
Loans, net of allowance for loan losses of $70,143 and $70,898
 
2,727,491
 
2,642,517
 
Loans, net of allowance for loan losses of $69,493 and $70,898
 
2,766,831
 
2,642,517
 
Premises and equipment
 
51,335
 
51,013
  
51,373
 
51,013
 
Federal Reserve and Federal Home Loan Bank stock
 
33,033
 
31,270
  
32,824
 
31,270
 
Interest receivable
 
16,506
 
17,723
  
17,519
 
17,723
 
Core deposit intangibles
 
8,649
 
9,114
  
8,644
 
9,114
 
Goodwill
 
141,357
 
141,357
  
141,375
 
141,357
 
Cash surrender value of life insurance
 
124,018
 
124,329
  
124,702
 
124,329
 
Other real estate owned
 
14,183
 
16,289
  
13,780
 
16,289
 
Tax asset, deferred and receivable
 
32,003
 
36,424
  
29,344
 
36,424
 
Other assets
  
13,996
  
12,613
   
14,998
  
12,613
 
TOTAL ASSETS
 
$
4,232,423
 
$
4,173,076
  
$
4,250,168
 
$
4,173,076
 
LIABILITIES
          
Deposits:
          
Noninterest-bearing
 
$
684,101
 
$
646,508
  
$
679,818
 
$
646,508
 
Interest-bearing
  
2,604,797
  
2,488,147
   
2,514,933
  
2,488,147
 
Total Deposits
 
3,288,898
 
3,134,655
  
3,194,751
 
3,134,655
 
Borrowings:
          
Federal funds purchased
 
652
    
57,024
   
Securities sold under repurchase agreements
 
160,127
 
156,305
  
153,454
 
156,305
 
Federal Home Loan Bank advances
 
96,847
 
138,095
  
145,467
 
138,095
 
Subordinated debentures and term loans
  
115,951
  
194,974
   
112,169
  
194,974
 
Total Borrowings
 
373,577
 
489,374
  
468,114
 
489,374
 
Interest payable
 
2,168
 
2,925
  
1,591
 
2,925
 
Other liabilities
  
32,104
  
31,655
   
38,857
  
31,655
 
Total Liabilities
 
3,696,747
 
3,658,609
  
3,703,313
 
3,658,609
 
COMMITMENTS AND CONTINGENT LIABILITIES
          
STOCKHOLDERS' EQUITY
          
Preferred Stock, no-par value, $1,000 liquidation value:
          
Authorized - 500,000 shares
          
Senior Non-Cumulative Perpetual Preferred Stock, Series B
          
Issued and outstanding - 90,782.94 shares
 
90,783
 
90,783
  
90,783
 
90,783
 
Cumulative Preferred Stock, $1,000 par value, $1,000 liquidation value:
          
Authorized - 600 shares
          
Issued and outstanding - 125 shares
 
125
 
125
  
125
 
125
 
Common Stock, $.125 stated value:
          
Authorized - 50,000,000 shares
          
Issued and outstanding - 28,643,264 and 28,559,707 shares
 
3,580
 
3,570
 
Issued and outstanding - 28,672,177 and 28,559,707 shares
 
3,584
 
3,570
 
Additional paid-in capital
 
255,632
 
254,874
  
256,290
 
254,874
 
Retained earnings
 
188,863
 
168,717
  
198,094
 
168,717
 
Accumulated other comprehensive loss
  
(3,307
)
  
(3,602
)
  
(2,021
)
  
(3,602
)
Total Stockholders' Equity
  
535,676
  
514,467
   
546,855
  
514,467
 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
4,232,423
 
$
4,173,076
  
$
4,250,168
 
$
4,173,076
 
 
See notes to consolidated condensed financial statements.
 
 
3
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
CONSOLIDATED CONDENSED STATEMENTS OF INCOME
(Dollars in thousands, except per share amounts)
(Unaudited) 

 Three Months Ended Six Months Ended  Three Months Ended Nine Months Ended 
 June 30, June 30,  September 30, September 30, 
 2012 2011 2012 2011  2012 2011 2012 2011 
INTEREST INCOME
                  
Loans receivable:
                  
Taxable
 
$
36,652
 
$
37,457
 
$
72,500
 
$
76,195
  
$
38,160
 
$
37,024
 
$
110,660
 
$
113,219
 
Tax exempt
 
123
 
247
 
240
 
349
  
118
 
86
 
358
 
435
 
Investment securities:
                  
Taxable
 
4,468
 
5,040
 
9,042
 
9,587
  
4,176
 
5,078
 
13,218
 
14,665
 
Tax exempt
 
2,551
 
2,535
 
5,113
 
5,088
  
2,532
 
2,529
 
7,645
 
7,617
 
Federal funds sold
   
1
   
3
        
3
 
Deposits with financial institutions
 
28
 
100
 
53
 
183
  
16
 
45
 
69
 
228
 
Federal Reserve and Federal Home Loan Bank stock
  
347
  
341
  
690
  
682
   
345
  
323
  
1,035
  
1,005
 
Total Interest Income
  
44,169
  
45,721
  
87,638
  
92,087
   
45,347
  
45,085
  
132,985
  
137,172
 
INTEREST EXPENSE
                  
Deposits
 
3,939
 
5,864
 
8,049
 
12,730
  
3,517
 
5,046
 
11,566
 
17,776
 
Federal funds purchased
 
12
 
3
 
24
 
6
  
38
 
16
 
62
 
22
 
Securities sold under repurchase agreements
 
197
 
386
 
492
 
764
  
211
 
384
 
703
 
1,148
 
Federal Home Loan Bank advances
 
637
 
977
 
1,631
 
1,978
  
492
 
1,089
 
2,123
 
3,067
 
Subordinated debentures and term loans
  
1,331
  
2,644
  
3,273
  
5,285
   
1,187
  
2,699
  
4,460
  
7,984
 
Total Interest Expense
  
6,116
  
9,874
  
13,469
  
20,763
   
5,445
  
9,234
  
18,914
  
29,997
 
NET INTEREST INCOME
 
38,053
 
35,847
 
74,169
 
71,324
  
39,902
 
35,851
 
114,071
 
107,175
 
Provision for loan losses
  
4,545
  
5,625
  
9,420
  
11,219
   
4,609
  
5,556
  
14,029
  
16,775
 
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
  
33,508
  
30,222
  
64,749
  
60,105
   
35,293
  
30,295
  
100,042
  
90,400
 
OTHER INCOME
                  
Service charges on deposit accounts
 
2,893
 
2,997
 
5,712
 
5,776
  
2,913
 
3,169
 
8,625
 
8,945
 
Fiduciary activities
 
1,938
 
1,929
 
3,921
 
3,965
  
1,986
 
1,881
 
5,907
 
5,846
 
Other customer fees
 
3,150
 
2,634
 
5,736
 
4,869
  
2,740
 
2,583
 
8,476
 
7,452
 
Commission income
 
1,485
 
1,024
 
3,152
 
2,912
  
1,618
 
1,528
 
4,770
 
4,440
 
Earnings on cash surrender value of life insurance
 
662
 
571
 
2,040
 
1,149
  
685
 
644
 
2,725
 
1,793
 
Net gains and fees on sales of loans
 
2,314
 
1,030
 
4,266
 
2,903
  
2,849
 
1,768
 
7,115
 
4,671
 
Net realized gains on sales of available for sale securities
 
502
 
825
 
1,291
 
1,288
  
843
 
861
 
2,134
 
2,149
 
Other-than-temporary impairment on available for sale securities
       
(2,775
)
       
(2,780
)
Portion of loss recognized in other comprehensive income before taxes
           
2,375
            
2,380
 
Net impairment losses recognized in earnings
       
(400
)
       
(400
)
Gain on FDIC modified whole bank transaction
     
9,124
        
9,124
   
Other income
  
221
  
51
  
581
  
457
   
639
  
796
  
1,220
  
1,253
 
Total Other Income
  
13,165
  
11,061
  
35,823
  
22,919
   
14,273
  
13,230
  
50,096
  
36,149
 
OTHER EXPENSES
    ��              
Salaries and employee benefits
 
19,641
 
18,560
 
38,995
 
35,736
  
20,083
 
19,964
 
59,078
 
55,700
 
Net occupancy
 
2,473
 
2,415
 
5,124
 
5,160
  
2,568
 
2,530
 
7,692
 
7,690
 
Equipment
 
1,656
 
1,677
 
3,461
 
3,460
  
1,798
 
1,662
 
5,259
 
5,122
 
Marketing
 
564
 
436
 
1,006
 
818
  
536
 
534
 
1,542
 
1,352
 
Outside data processing fees
 
1,506
 
1,458
 
2,882
 
2,903
  
1,413
 
1,391
 
4,295
 
4,294
 
Printing and office supplies
 
294
 
313
 
561
 
601
  
287
 
301
 
848
 
902
 
Core deposit amortization
 
480
 
1,101
 
949
 
2,202
  
489
 
755
 
1,438
 
2,957
 
FDIC assessments
 
862
 
1,451
 
1,979
 
3,555
  
792
 
1,201
 
2,771
 
4,756
 
Other real estate owned and credit-related expenses
 
2,122
 
2,843
 
4,308
 
6,038
  
2,104
 
2,007
 
6,412
 
8,045
 
Other expenses
  
4,582
  
4,145
  
8,943
  
7,807
   
4,334
  
3,877
  
13,277
  
11,684
 
Total Other Expenses
  
34,180
  
34,399
  
68,208
  
68,280
   
34,404
  
34,222
  
102,612
  
102,502
 
INCOME BEFORE INCOME TAX
 
12,493
 
6,884
 
32,364
 
14,744
  
15,162
 
9,303
 
47,526
 
24,047
 
Income tax expense
  
3,288
  
1,396
  
8,788
  
3,795
   
3,926
  
2,561
  
12,714
  
6,356
 
NET INCOME
 
9,205
 
5,488
 
23,576
 
10,949
  
11,236
 
6,742
 
34,812
 
17,691
 
Loss on retirement of CPP preferred stock
   
(1,401
)
   
(1,401
)
Loss on extinguishment of trust preferred securities
   
(10,857
)
   
(10,857
)
Preferred stock dividends and discount accretion
  
(1,135
)
  
(990
)
  
(2,270
)
  
(1,978
)
  
(1,134
)
  
(868
)
  
(3,404
)
  
(2,846
)
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS
 
$
8,070
 
$
4,498
 
$
21,306
 
$
8,971
 
NET INCOME (LOSS) AVAILABLE TO COMMON STOCKHOLDERS
 
$
10,102
 
$
(6,384
)
 
$
31,408
 
$
2,587
 
Per Share Data:
                  
Basic Net Income Available to Common Stockholders
 
$
0.28
 
$
0.18
 
$
0.74
 
$
0.35
 
Diluted Net Income Available to Common Stockholders
 
$
0.28
 
$
0.18
 
$
0.74
 
$
0.35
 
Basic Net Income (Loss) Available to Common Stockholders
 
$
0.35
 
$
(0.25
)
 
$
1.09
 
$
0.10
 
Diluted Net Income (Loss) Available to Common Stockholders
 
$
0.35
 
$
(0.25
)
 
$
1.09
 
$
0.10
 
Cash Dividends Paid
 
$
0.03
 
$
0.01
 
$
0.04
 
$
0.02
  
$
0.03
 
$
0.01
 
$
0.07
 
$
0.03
 
Average Diluted Shares Outstanding (in thousands)
 
28,815
 
25,783
 
28,782
 
25,773
  
28,888
 
26,367
 
28,819
 
26,019
 

See notes to consolidated condensed financial statements.

 
4
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in thousands)
(Unaudited)

  Three Months Ended  Six Months Ended 
  June 30,  June 30, 
  2012  2011  2012  2011 
Net Income
 
$
9,205
  
$
5,488
  
$
23,576
  
$
10,949
 
Other comprehensive income net of tax:
                
Unrealized holding gain on securities available for sale arising
                
during the period, net of income tax of $664, $1,099, $653, and $3,674
  
1,232
   
2,041
   
1,212
   
6,823
 
Unrealized loss on securities available for sale for which a
                
portion of an other than temporary impairment has been
                
recognized in income, net of tax of  $24, $0, $31, and $844
  
(44
)
      
(58
)
  
(1,568
)
Unrealized loss on cash flow hedges arising during the period,
                
 net of income tax of $567, $217, $404, and $170
  
(1,053
)
  
(403
)
  
(750
)
  
(316
)
Amortization of items previously recorded in accumulated other comprehensive
                
income (loss), net of income tax of $113, $11, $393, and $20
  
209
   
(20
)
  
730
   
(38
)
Reclassification adjustment for gains included in net income
                
net of income tax expense of $176, $289, $452, and $311
  
(326
)
  
(537
)
  
(839
)
  
(577
)
   
18
   
1,081
   
295
   
4,324
 
Comprehensive Income
 
$
9,223
  
$
6,569
  
$
23,871
  
$
15,273
 
  Three Months Ended  Nine Months Ended 
  September 30,  September 30, 
  2012  2011  2012  2011 
Net income
 
$
11,236
  
$
6,742
  
$
34,812
  
$
17,691
 
Other comprehensive income net of tax:
                
Unrealized holding gain on securities available for sale arising during the period,
                
net of income tax of $1,018, $4,553, $1,670, and $8,212
  
1,891
   
8,457
   
3,102
   
15,255
 
Unrealized loss on securities available for sale for which a
                
portion of an other than temporary impairment has been
                
recognized in income, net of tax of  $12, $0, $43, and $831
  
(22
)
      
(80
)
  
(1,546
)
Unrealized loss on cash flow hedges arising during the period,
                
net of income tax of $131, $778, $535, and $949
  
(244
)
  
(1,446
)
  
(994
)
  
(1,762
)
Amortization of items previously recorded in accumulated other
                
comprehensive income (loss), net of income tax of $113, $10, $506, and $29
  
210
   
(18
)
  
940
   
(53
)
Reclassification adjustment for gains included in net income
                
net of income tax expense of $295, $301, $747, and $612
  
(549
)
  
(560
)
  
(1,387
)
  
(1,137
)
   
1,286
   
6,433
   
1,581
   
10,757
 
Comprehensive income
 
$
12,522
  
$
13,175
  
$
36,393
  
$
28,448
 


The components of accumulated other comprehensive loss, net of tax, included in stockholders’ equity, are as follows:

 June 30, 2012 December 31, 2011 
      
September 30,
2012
 
December 31,
2011
 
Net unrealized gain on securities available for sale
 
$
18,617
 
$
18,244
  
$
19,959
 
$
18,244
 
          
Net unrealized loss on securities available for sale for which a portion of an other-
than-temporary impairment has been recognized in income
 
(3,226
)
 
(3,168
)
Net unrealized loss on securities available for sale for which a portion of an other-than-temporary     
impairment has been recognized in income
 
(3,248
)
 
(3,168
)
          
Net unrealized loss on cash flow hedges
 
(2,590
)
 
(1,841
)
 
(2,834
)
 
(1,841
)
          
Defined benefit plans
  
(16,108
)
  
(16,837
)
  
(15,898
)
  
(16,837
)
 
$
(3,307
)
 
$
(3,602
)
 
$
(2,021
)
 
$
(3,602
)

See notes to consolidated condensed financial statements.
 
 
5
 

FIRST MERCHANTS CORPORATION
FORM 10Q
CONSOLIDATED CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY
(Dollars in thousands, except per share data)
(Unaudited)

         Accumulated   
 Preferred Common Stock Additional   Other   
 Preferred Common Stock Additional   Accumulated Other            Paid in Retained Comprehensive   
 Shares Amount Shares Amount 
Paid in
Capital
 Retained Earnings Comprehensive Income (Loss) Total  Shares Amount Shares Amount Capital Earnings Income (Loss) Total 
Balances, December 31, 2011
 
90,908
 
$
90,908
 
28,559,707
 
$
3,570
 
$
254,874
 
$
168,717
 
$
(3,602
)
 
$
514,467
  
90,908
 
$
90,908
 
28,559,707
 
$
3,570
 
$
254,874
 
$
168,717
 
$
(3,602
)
 
$
514,467
 
Comprehensive Income
                                  
Net Income
           
23,576
   
23,576
            
34,812
   
34,812
 
Other Comprehensive Income, net of tax
             
295
 
295
              
1,581
 
1,581
 
Cash Dividends on Common Stock ($.04 per share)
           
(1,160
)
   
(1,160
)
Cash Dividends on Common Stock ($.07 per Share)
           
(2,031
)
   
(2,031
)
Cash Dividends on Preferred Stock under Small
Business Lending Fund
           
(2,270
)
   
(2,270
)
           
(3,404
)
   
(3,404
)
Share-based Compensation
     
73,469
 
9
 
677
     
686
      
79,385
 
10
 
1,091
     
1,101
 
Stock Issued Under Employee Benefit Plans
     
23,495
 
3
 
222
     
225
      
34,352
 
4
 
350
     
354
 
Stock Issued Under Dividend Reinvestment and
Stock Purchase Plan
     
7,625
 
1
 
86
     
87
      
11,475
 
1
 
142
     
143
 
Stock options exercised
     
8,750
 
1
 
66
     
67
 
Stock Redeemed
        
(21,032
)
  
(3
)
  
(227
)
        
(230
)
        
(21,492
)
  
(2
)
  
(233
)
        
(235
)
Balances, June 30, 2012
  
90,908
 
$
90,908
  
28,643,264
 
$
3,580
 
$
255,632
 
$
188,863
 
$
(3,307
)
 
$
535,676
 
Balances, September 30, 2012
  
90,908
 
$
90,908
  
28,672,177
 
$
3,584
 
$
256,290
 
$
198,094
 
$
(2,021
)
 
$
546,855
 


See notes to consolidated condensed financial statements.
 
 
6
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)
 
  September 30, 
  2012  2011 
Cash Flow From Operating Activities:
      
Net income
 
$
34,812
  
$
17,691
 
Adjustments to reconcile net income to net cash provided by operating activities:
        
Provision for loan losses
  
14,029
   
16,775
 
Depreciation and amortization
  
3,432
   
3,998
 
Change in deferred taxes
  
11,239
   
7,211
 
Share-based compensation
  
1,101
   
1,009
 
Mortgage loans originated for sale
  
(314,240
)
  
(185,658
)
Proceeds from sales of mortgage loans
  
304,393
   
194,870
 
Gain on acquisition
  
(9,124
)
    
Gains on sales of securities available for sale
  
(2,134
)
  
(2,149
)
Recognized loss on other-than-temporary-impairment
      
400
 
Change in interest receivable
  
732
   
904
 
Change in interest payable
  
(1,701
)
  
(2,076
)
Other adjustments
  
4,650
   
14,171
 
Net cash provided by operating activities
 
$
47,189
  
$
67,146
 
Cash Flows from Investing Activities:
        
Net change in interest-bearing deposits
 
$
17,527
  
$
49,101
 
Purchases of:
        
Securities available for sale
  
(129,297
)
  
(133,526
)
Securities held to maturity
  
(566
)
  
(77,678
)
Proceeds from sales of securities available for sale
  
43,147
   
54,606
 
Proceeds from maturities of:
        
Securities available for sale
  
77,898
   
37,894
 
Securities held to maturity
  
49,073
   
28,120
 
Change in Federal Reserve and Federal Home Loan Bank stock
  
207
   
2,503
 
Purchase of bank owned life insurance
      
(25,000
)
Net change in loans
  
(52,442
)
  
73,520
 
Net cash received from acquisition
  
29,113
     
Proceeds from the sale of other real estate owned
  
4,295
   
9,916
 
Other adjustments
  
351
   
6,921
 
Net cash provided by investing activities
 
$
39,306
  
$
26,377
 
Cash Flows from Financing Activities:
        
Net change in :
        
Demand and savings deposits
 
$
42,994
  
$
(54,157
)
Certificates of deposit and other time deposits
  
(108,807
)
  
(150,473
)
Borrowings
  
138,127
   
242,323
 
Repayment of borrowings
  
(169,988
)
  
(168,894
)
Cash dividends on common stock
  
(2,031
)
  
(778
)
Cash dividends on preferred stock
  
(3,404
)
  
(2,527
)
Stock issued in private equity placement
      
21,165
 
Stock issued under employee benefit plans
  
354
   
561
 
Stock issued under dividend reinvestment and stock purchase plans
  
143
   
60
 
Stock options exercised
  
67
     
Stock redeemed
  
(235
)
  
(127
)
Cumulative preferred stock issued (SBLF)
      
90,783
 
Cumulative preferred stock redeemed (CPP)
      
(69,600
)
Net cash used in financing activities
 
$
(102,780
)
 
$
(91,664
)
Net Change in Cash and Cash Equivalents
  
(16,285
)
  
1,859
 
Cash and Cash Equivalents, January 1
  
73,312
   
58,307
 
Cash and Cash Equivalents, September 30
 
$
57,027
  
$
60,166
 
 
 
Additional cash flow information:
        
Interest paid
 
$
20,248
  
$
32,073
 
Income tax paid (refunded)
 
$
5,988
  
$
(2,977
)
Loans transferred to other real estate owned
 
$
4,364
  
$
12,646
 
Non-cash investing activities using trade date accounting
 
$
3,043
  
$
2,298
 
  June 30, 
  2012  2011 
Cash Flow From Operating Activities:
      
Net income
 
$
23,576
  
$
10,949
 
Adjustments to reconcile net income to net cash provided by operating activities:
        
Provision for loan losses
  
9,420
   
11,219
 
Depreciation and amortization
  
2,348
   
2,571
 
Change in deferred taxes
  
7,452
   
4,697
 
Share-based compensation
  
686
   
718
 
Mortgage loans originated for sale
  
(177,645
)
  
(106,979
)
Proceeds from sales of mortgage loans
  
180,231
   
123,602
 
Gain on acquisition
  
(9,124
)
    
Gains on sales of securities available for sale
  
(1,291
)
  
(1,288
)
Recognized loss on other-than-temporary-impairment
      
400
 
Change in interest receivable
  
1,745
   
1,673
 
Change in interest payable
  
(1,124
)
  
(661
)
Other adjustments
  
1,297
   
10,553
 
Net cash provided by operating activities
 
$
37,571
  
$
57,454
 
Cash Flows from Investing Activities:
        
Net change in interest-bearing deposits
 
$
23,004
  
$
49,351
 
Purchases of:
        
Securities available for sale
  
(82,459
)
  
(93,887
)
Securities held to maturity
  
(566
)
  
(75,971
)
Proceeds from sales of securities available for sale
  
26,351
   
25,911
 
Proceeds from maturities of:
        
Securities available for sale
  
47,379
   
22,237
 
Securities held to maturity
  
30,131
   
15,362
 
Change in Federal Reserve and Federal Home Loan Bank stock
  
(2
)
  
2,500
 
Purchase of bank owned life insurance
      
(5,000
)
Net change in loans
  
(4,579
)
  
80,883
 
Net cash received from acquisition
  
17,200
     
Proceeds from the sale of other real estate owned
  
3,437
   
5,349
 
Other adjustments
  
(1,216
)
  
7,929
 
Net cash provided by investing activities
 
$
58,680
  
$
34,664
 
Cash Flows from Financing Activities:
        
Net change in :
        
Demand and savings deposits
 
$
93,510
  
$
(12,918
)
Certificates of deposit and other time deposits
  
(65,176
)
  
(113,429
)
Borrowings
  
31,755
   
62,351
 
Repayment of borrowings
  
(157,811
)
  
(33,634
)
Cash dividends on common stock
  
(1,160
)
  
(518
)
Cash dividends on preferred stock
  
(2,270
)
  
(1,740
)
Stock issued under dividend reinvestment and stock purchase plans
  
312
   
461
 
Stock redeemed
  
(230
)
  
(124
)
Net cash used in financing activities
 
$
(101,070
)
 
$
(99,551
)
Net Change in Cash and Cash Equivalents
  
(4,819
)
  
(7,433
)
Cash and Cash Equivalents, January 1
  
73,312
   
58,307
 
Cash and Cash Equivalents, June 30
 
$
68,493
  
$
50,874
 
 
 
Additional cash flow information:
        
Interest paid
 
$
14,226
  
$
21,424
 
Income tax paid
 
$
3,988
  
$
2,977
 
Loans transferred to other real estate owned
 
$
3,199
  
$
3,814
 
Non-cash investing activities using trade date accounting
 
$
757
  
$
1,036
 


See notes to consolidated condensed financial statements.
 
 
7
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 1.  General

Financial Statement Preparation

The significant accounting policies followed by First  Merchants Corporation (the “Corporation”) and its wholly owned subsidiaries for interim financial reporting are consistent with the accounting policies followed for annual financial reporting. All adjustments, which are of a normal recurring nature and are in the opinion of management necessary for a fair statement of the results for the periods reported, have been included in the accompanying consolidated condensed financial statements.

The consolidated condensed balance sheet of the Corporation as of December 31, 2011, has been derived from the audited consolidated balance sheet of the Corporation as of that date. Certain information and note disclosures normally included in the Corporation’s annual financial statements, prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted. These consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Corporation’s Form 10-K annual report filed with the Securities and Exchange Commission. The results of operations for the sixnine months ended JuneSeptember 30, 2012, are not necessarily indicative of the results to be expected for the year.

NOTE 2.  Purchase and Assumption

Effective February 10, 2012, theFirst Merchants Bank, National Association (the “Bank”) assumed substantially all of the deposits and certain other liabilities and acquired certain assets of SCB Bank, a federal savings bank headquartered in Shelbyville, Indiana, from the Federal Deposit Insurance Corporation (“FDIC”), as receiver for SCB Bank (the “Acquisition”), pursuant to the terms of the Purchase and Assumption Agreement – Modified Whole Bank; All Deposits (the “Agreement”), entered into by the Bank, the FDIC as receiver of SCB Bank and the FDIC.

Under the terms of the Agreement, the Bank acquired $147.7 million in assets, including approximately $11.9 million of cash and cash equivalents, $18.9 million of marketable securities, $1.8 million in Federal Home Loan Bank stock, $113.0 million in loans and $2.1 million of premises and other assets.  The Bank assumed approximately $135.7 million of liabilities, including approximately $125.7 million in customer deposits, $9.6 million of other borrowed money and $402,000 in other liabilities. These balances are book balances and do not reflect the fair value adjustments which are shown on the following table. The acquisition did not include any loss sharing agreement with the FDIC.

The bid accepted by the FDIC included no deposit premium. The assets were acquired at a discount of $29.0 million from book value. The FDIC made a payment of $17.2 million to the Bank upon the final closing date balance sheet for SCB Bank that reflected the difference between the purchase price of the assets acquired and the value of the liabilities assumed.

The Bank engaged in this transaction with the expectation that it would be immediately accretive and add a new market area with a demographic profile consistent with many of the current Indiana markets served by the Bank.

 
8
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 2.  Purchase and Assumption continued

The transaction was accounted for under the acquisition method of accounting in accordance with the Business Combination topic of the FASB Accounting Standards Codification (“ASC 310-20 and 310-30”). The statement of net assets and liabilities acquired as of February 10, 2012, are presented below. The assets and liabilities of SCB were recorded at the respective acquisition date provisional fair values, and identifiable intangible assets were recorded at provisional fair value.

Assets
   
Liabilities
   
Cash and due from banks (1)
 
$
29,113
 
Deposits:
   
Investment securities, available for sale
  
18,896
 
Non-interest bearing
 
$
13,715
 
Federal Home Loan Bank stock
  
1,761
 
NOW accounts
  
14,746
 
Loans:
    
Savings and money market
  
25,843
 
Commercial
  
51,042
 
Certificate of deposit
  
71,605
 
Residential mortgage
  
11,181
 
Total Deposits
  
125,909
 
Installment
  
31,570
      
Total Loans
  
93,793
 
Federal Home Loan Bank advances
  
10,286
 
     
Other liabilities
  
804
 
Premises
  
1,516
 
Total Liabilities Assumed
 
$
136,999
 
Core deposit intangible
  
484
      
Other assets
  
560
 
Net Gain on Acquisition
 
$
9,124
 
Total Assets Purchased
 
$
146,123
      

(1)Includes $17,200,000 cash received from the FDIC.

In many cases, the fair values of assets acquired and liabilities assumed were determined by estimating cash flows expected to result from those assets and liabilities and discounting them at appropriate market rates. The most significant category of assets for which this procedure was used was acquired loans. The Bank acquired the $113.0 million loan portfolio at a fair value discount of $19.2 million. The performing portion of the portfolio, $86.3 million, had an estimated fair value of $76.5 million. The excess of expected cash flows above the fair value of the performing portion of loans will be accreted to interest income over the remaining lives of the loans in accordance with ASC 310-20.

Certain loans for which specific credit-related deterioration has occurred since origination are recorded at fair value which is derived from calculating the present value of the amounts expected to be collected. Income recognition on these loans is based on reasonable expectation about the timing and amount of cash flows to be collected. Many of the acquired loans deemed impaired and considered collateral dependent, with the timing of a sale of loan collateral indeterminate, remain on non-accrual status and have no accretable yield.

In accordance with ASC 310-30 (formerly Statement of Position (“SOP”) 03-3 as of February 10, 2012, loans acquired during 2012 for which it was probable at acquisition that all contractually required payments would not be collected are as follows:

Preliminary estimate of contractually required principal and interest at acquisition
 
$
31,143
 
Preliminary estimate of contractual cash flows not expected to be collected (nonaccretable differences)
  
9,688
 
Preliminary estimate of expected cash flows at acquisition
  
21,455
 
Preliminary estimate of interest component of expected cash flows (accretable discount)
  
4,152
 
Preliminary estimate of fair value of acquired loans accounted for under ASC 310-30
 
$
17,303
 


Pro-forma statements were determined to be impracticable due to the nature of the transaction as certain assets were not purchased.

 
9
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 2.  Purchase and Assumption continued

The carrying amount of these loans is included in the balance sheet amounts of loans receivable at JuneSeptember 30, 2012. The amounts of loans at June 30, 2012, are as follows:

 June 30,  September 30, 
 2012  2012 
Commercial and industrial loans
 
$
12,126
  
$
12,494
 
Agricultural production finance and other loans to farmers
 
1,479
  
1,531
 
Real estate loans
      
Construction
 
91
  
92
 
Commercial and farmland
 
29,611
  
23,724
 
Residential
 
34,151
  
32,936
 
Individuals' loans for household and other personal expenditures
 
1,152
  
922
 
Tax exempt
   
Lease financing
   
Other loans
  
1,025
   
987
 
Total
 
$
79,635
  
$
72,686
 


Accretable yield, or income expected to be collected, is as follows:

  June 30, 
  2012 
Beginning balance, February 10, 2012
 
$
9,774
 
Accretions
  
(726
)
Ending balance, June 30, 2012
 
$
9,048
 
  Three Months ended 
  September 30, 2012 
Beginning balance, June 30, 2012
 
$
9,048 
 
Accretions
  
(2,612
) 
Ending balance, September 30, 2012
 
$
6,436
 

At June 30, 2012, specific reserves of $563,000 were included in the allowance for loan losses.
  Nine Months ended 
  September 30, 2012 
Beginning balance, February 10, 2012
 
$
9,774 
 
Accretions
  
(3,338
) 
Ending balance, September 30, 2012
 
$
6,436
 
 
 
10
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 3.  Investment Securities

The amortized cost, gross unrealized gains, gross unrealized losses and approximate fair values of the investment securities at the dates indicated were:

 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
  
Amortized
Cost
 Gross Unrealized Gains Gross Unrealized Losses 
Fair
Value
 
Available for sale at June 30, 2012
         
Available for sale at September 30, 2012
         
U.S. Government-sponsored agency securities
 
$
4,841
 
$
92
   
$
4,933
  
$
4,610
 
$
172
   
$
4,782
 
State and municipal
 
136,011
 
9,614
 
$
28
 
145,597
  
150,281
 
10,761
 
$
25
 
161,017
 
U.S. Government-sponsored mortgage-backed securities
 
371,971
 
11,644
 
53
 
383,562
  
370,800
 
13,142
 
30
 
383,912
 
Corporate obligations
 
16,947
 
419
 
5,737
 
11,629
  
6,008
   
5,806
 
202
 
Equity securities
  
1,830
        
1,830
   
1,706
        
1,706
 
Total available for sale
  
531,600
  
21,769
  
5,818
  
547,551
   
533,405
  
24,075
  
5,861
  
551,619
 
Held to maturity at June 30, 2012
         
Held to maturity at September 30, 2012
         
State and municipal
 
119,222
 
4,250
 
1
 
123,471
  
116,966
 
5,698
   
122,664
 
U.S. Government-sponsored mortgage-backed securities
  
277,548
  
12,228
     
289,776
   
260,131
  
13,422
     
273,553
 
Total held to maturity
  
396,770
  
16,478
  
1
  
413,247
   
377,097
  
19,120
     
396,217
 
Total Investment Securities
 
$
928,370
 
$
38,247
 
$
5,819
 
$
960,798
  
$
910,502
 
$
43,195
 
$
5,861
 
$
947,836
 


 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
  
Amortized
Cost
 Gross Unrealized Gains Gross Unrealized Losses 
Fair
Value
 
Available for sale at December 31, 2011
                  
U.S. Government-sponsored agency securities
 
$
99
 
$
18
   
$
117
  
$
99
 
$
18
   
$
117
 
State and municipal
 
136,857
 
10,496
   
147,353
  
136,857
 
10,496
   
147,353
 
U.S. Government-sponsored mortgage-backed securities
 
358,928
 
10,086
 
$
16
 
368,998
  
358,928
 
10,086
 
$
16
 
368,998
 
Corporate obligations
 
5,765
   
5,572
 
193
  
5,765
   
5,572
 
193
 
Equity securities
  
1,830
        
1,830
   
1,830
        
1,830
 
Total available for sale
  
503,479
  
20,600
  
5,588
  
518,491
   
503,479
  
20,600
  
5,588
  
518,491
 
Held to maturity at December 31, 2011
                  
State and municipal
 
120,171
 
3,785
   
123,956
  
120,171
 
3,785
   
123,956
 
U.S. Government-sponsored mortgage-backed securities
  
307,738
  
10,775
     
318,513
   
307,738
  
10,775
     
318,513
 
Total held to maturity
  
427,909
  
14,560
     
442,469
   
427,909
  
14,560
     
442,469
 
Total Investment Securities
 
$
931,388
 
$
35,160
 
$
5,588
 
$
960,960
  
$
931,388
 
$
35,160
 
$
5,588
 
$
960,960
 


The amortized cost and fair value of available for sale securities and held to maturity securities at JuneSeptember 30, 2012, by contractual maturity, are shown below.  Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

 Available for Sale Held to Maturity  Available for Sale Held to Maturity 
 
Amortized
Cost
 
Fair
 Value
 
Amortized
Cost
 
Fair
Value
  
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
 
Maturity Distribution at June 30, 2012:
         
Maturity Distribution at September 30, 2012:
         
Due in one year or less
 
$
5,513
 
$
5,574
 
$
3,345
 
$
3,345
  
$
4,802
 
$
4,846
 
$
2,425
 
$
2,431
 
Due after one through five years
 
19,028
 
19,909
 
2,953
 
2,979
  
14,559
 
15,277
 
2,208
 
2,233
 
Due after five through ten years
 
29,106
 
30,906
 
51,873
 
53,415
  
48,134
 
51,156
 
55,679
 
57,975
 
Due after ten years
  
104,152
  
105,770
  
61,051
  
63,732
   
93,404
  
94,722
  
56,654
  
60,025
 
 
$
157,799
 
$
162,159
 
$
119,222
 
$
123,471
  
160,899
 
166,001
 
116,966
 
122,664
 
         
U.S. Government-sponsored mortgage-backed securities
 
371,971
 
383,562
 
277,548
 
289,776
  
370,800
 
383,912
 
260,131
 
273,553
 
Equity securities
  
1,830
  
1,830
         
1,706
  
1,706
       
Total Investment Securities
 
$
531,600
 
$
547,551
 
$
396,770
 
$
413,247
  
$
533,405
 
$
551,619
 
$
377,097
 
$
396,217
 


The carrying value of securities pledged as collateral, to secure public deposits and for other purposes, was $363,579,000$348,748,000 at JuneSeptember 30, 2012, and $299,478,000 at December 31, 2011.

The book value of securities sold under agreements to repurchase amounted to $145,705,000$148,486,000 at JuneSeptember 30, 2012, and $129,311,000 at December 31, 2011.

 
11
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 3.  Investment Securities continued

Gross gains and losses on the sales and redemptions of available for sale securities, and other-than-temporary impairment (“OTTI”) losses recognized for the three and sixnine months ended JuneSeptember 30, 2012 and 2011 are shown below.

 Three Months Ended Six Months Ended  Three Months Ended Nine Months Ended 
 June 30, June 30,  September 30, September 30, 
 2012 2011 2012 2011  2012 2011 2012 2011 
Sales and Redemptions of Available for Sale Securities:
                  
Gross gains
 
$
502
 
$
825
 
$
1,291
 
$
1,288
  
$
843
 
$
861
 
$
2,134
 
$
2,149
 
Gross losses
         
Other-than-temporary impairment losses
       
$
400
        
$
400
 


The Corporation’s management has evaluated all securities with unrealized losses for OTTI as of JuneSeptember 30, 2012.  The evaluations are based on the nature of the securities, the extent and duration of the loss and the intent and ability of the Corporation to hold these securities either to maturity or through the expected recovery period.

The current unrealized losses are primarily concentrated within trust preferred securities held by the Corporation.  Such investments have an amortized cost of $5.9$6.0 million and a fair value of $168,000,$171,000, which is less than 1 percent of the Corporation’s entire investment portfolio.  On all but one small pool investment, the Corporation utilized Moody’s to determine their fair value.

In determining the fair value of the trust preferred securities, the Corporation utilizes a third party for portfolio accounting services, including market value input.  The Corporation has obtained an understanding of what inputs are being used by the vendor in pricing the portfolio and how the vendor was classifying these securities based upon these inputs.  From these discussions, the Corporation’s management is comfortable that the classifications are proper.  The Corporation has gained trust in the data for two reasons:  (a) independent spot testing of the data is conducted by the Corporation through obtaining market quotes from various brokers on a periodic basis and (b) actual gains or loss resulting from the sale of certain securities has proven the data to be accurate over time.  

Discount rates used in the OTTI cash flow analysis on these variable rate securities were those margins in effect at the inception of the security added to the appropriate three-month LIBOR spot rate obtained from the forward LIBOR curve used to project future principal and interest payments. These spreads ranged from .85 percent to 1.57 percent spread over LIBOR.

 
12
 

FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 3.  Investment Securities continued

The following table shows the Corporation’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at JuneSeptember 30, 2012, and December 31, 2011:

 Less than 12 Months 12 Months or Longer Total  
Less than
12 Months
 
12 Months or
Longer
 Total 
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
  
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Temporarily Impaired Investment
                          
Securities at June 30, 2012
             
Securities at September 30, 2012
             
State and municipal
 
$
4,545
 
$
(29
)
     
$
4,545
 
$
(29
)
 
$
3,868
 
$
(25
)
     
$
3,868
 
$
(25
)
U.S. Government-sponsored mortgage-backed securities
 
7,817
 
(53
)
     
7,817
 
(53
)
 
6,463
 
(30
)
     
6,463
 
(30
)
Corporate obligations
       
$
168
 
$
(5,737
)
  
168
  
(5,737
)
       
$
171
 
$
(5,806
)
  
171
  
(5,806
)
Total Temporarily Impaired Investment Securities
 
$
12,362
 
$
(82
)
 
$
168
 
$
(5,737
)
 
$
12,530
 
$
(5,819
)
 
$
10,331
 
$
(55
)
 
$
171
 
$
(5,806
)
 
$
10,502
 
$
(5,861
)


 Less than 12 Months 12 Months or Longer Total  
Less than
12 Months
      12 Months or Longer Total 
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
  
Fair
Value
 
Gross
Unrealized Losses
 
Fair
Value
 
Gross
Unrealized Losses
 
Fair
Value
 
Gross
Unrealized Losses
 
Temporarily Impaired Investment
                          
Securities at December 31, 2011
                          
State and municipal
                          
U.S. Government-sponsored mortgage-backed securities
 
$
6,176
 
$
(16
)
     
$
6,176
 
$
(16
)
 
$
6,176
 
$
(16
)
     
$
6,176
 
$
(16
)
Corporate obligations
       
$
163
 
$
(5,572
)
  
163
  
(5,572
)
       
$
163
 
$
(5,572
)
  
163
  
(5,572
)
Total Temporarily Impaired Investment Securities
 
$
6,176
 
$
(16
)
 
$
163
 
$
(5,572
)
 
$
6,339
 
$
(5,588
)
 
$
6,176
 
$
(16
)
 
$
163
 
$
(5,572
)
 
$
6,339
 
$
(5,588
)


Certain investments in debt and equity securities are reported in the financial statements at an amount less than their historical cost as indicated in the table below.

 
June 30,
 2012
 
December 31,
2011
  
September 30,
2012
 
December 31,
2011
 
Investments reported at less than historical cost:
          
Historical cost
 
$
18,349
 
$
11,925
  
$
16,364
 
$
11,925
 
Fair value
 
$
12,530
 
$
6,339
  
$
10,502
 
$
6,339
 
Percent of the Corporation's available for sale and held to maturity portfolio
 
1.3
%
 
0.7
%
 
1.1
%
 
0.7
%


Except as discussed below, management believes the declines in fair value for these securities are temporary.  Should the impairment of any of these securities become other than temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income in the period the OTTI is identified.

U.S. Government-Sponsored Mortgage-Backed Securities

The unrealized losses on the Corporation’s investment in U.S. Government-sponsored mortgage-backed securities were a result of changes in interest rates.  The Corporation expects to recover the amortized cost basis over the term of the securities as the decline in market value is attributable to changes in interest rates and not credit quality. The Corporation does not intend to sell the investment and it is not more likely than not that the Corporation will be required to sell the investment before recovery of its new, lower amortized cost basis, which may be maturity.  The Corporation does not consider the investment securities to be other-than-temporarily impaired at JuneSeptember 30, 2012.

 
13
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 3.  Investment Securities continued

State and Municipal

The unrealized losses on the Corporation’s investments in securities of state and political subdivisions were caused by changes in interest rates.  The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments.  The Corporation does not intend to sell the investment and it is not more likely than not that the Corporation will be required to sell the investment before recovery of its new, lower amortized cost basis, which may be maturity.  The Corporation does not consider the investment securities to be other-than-temporarily impaired at JuneSeptember 30, 2012.

Corporate Obligations

The Corporation’s unrealized losses on Corporate Obligations were due to the decline in value related to the pooled trust preferred securities, and is attributable to temporary illiquidity and the financial crisis affecting these markets, coupled with the potential credit loss resulting from the adverse change in expected cash flows. Due to the illiquidity in the market, it is unlikely that the Corporation would be able to recover its investment in these securities if the Corporation sold the securities at this time. Management has analyzed the cash flow characteristics of the securities and this analysis included utilizing the most recent trustee reports and any other relevant market information, including announcements of deferrals or defaults of trust preferred securities.  The Corporation compared expected discounted cash flows, based on performance indicators of the underlying assets in the security, to the carrying value of the investment to determine if OTTI existed.  The Corporation does not consider the remainder of the investment securities, which are classified as Level 3 inputs in the fair value hierarchy, to be other-than-temporarily impaired at JuneSeptember 30, 2012.  The Corporation does not intend to sell the investment, and it is not more likely than not that the Corporation will be required to sell the investment before recovery of its new, lower amortized cost basis, which may be maturity.

Credit Losses Recognized on Investments

Certain debt securities have experienced fair value deterioration due to credit losses and other market factors. The following table provides information about debt securities for which only a credit loss was recognized in income and other losses were recorded in other comprehensive income.

 
Accumulated
Credit Losses in
2012
 
Accumulated
Credit Losses in
2011
  
Accumulated
Credit Losses in
2012
 
Accumulated
Credit Losses in
2011
 
Credit losses on debt securities held:
          
Balance, January 1
 
$
11,355
 
$
10,955
  
$
11,355
 
$
10,955
 
Additions related to other-than-temporary losses not previously recognized
     
400
      
400
 
Balance, June 30
 
$
11,355
 
$
11,355
 
Balance, September 30
 
$
11,355
 
$
11,355
 
 
 
14
 

FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 4.  Loans and Allowance

The Corporation’s primary lending focus is small business and middle market commercial, residential real estate, auto and small consumer lending, which results in portfolio diversification.  The following tables show the composition in the loan portfolio, loan grades and the allowance for loan losses excluding loans held for sale.  Residential real estate loans held for sale at JuneSeptember 30, 2012, and December 31, 2011, were $15,278,000$27,711,000 and $17,864,000, respectively.

Effective February 10, 2012, the Bank assumed $113.0 million in loans as part of the Purchase and Assumption Agreement discussed in NOTE 2. PURCHASE AND ASSUMPTION included in the Notes to Consolidated Condensed Financial Statements of this Form 10-Q. This loan portfolio was acquired at a fair value discount of $19.2 million.

The following table shows the composition of the corporation’sCorporation’s loan portfolio by loan class for the periods indicated:

 June 30, December 31,  September 30, December 31, 
 2012 2011  2012 2011 
Loans:
          
Commercial and industrial loans
 
$
552,353
 
$
532,523
  
$
592,517
 
$
532,523
 
Agricultural production financing and other loans to farmers
 
106,135
 
104,526
  
107,166
 
104,526
 
Real estate loans:
          
Construction
 
99,588
 
81,780
  
93,610
 
81,780
 
Commercial and farm land
 
1,219,114
 
1,194,230
  
1,241,054
 
1,194,230
 
Residential
 
480,917
 
481,493
  
475,272
 
481,493
 
Home Equity
 
207,250
 
191,631
  
204,888
 
191,631
 
Individual's loans for household and other personal expenditures
 
83,933
 
84,172
  
77,171
 
84,172
 
Lease financing receivables, net of unearned income
 
2,976
 
3,555
  
2,970
 
3,555
 
Other loans
  
45,368
  
39,505
   
41,676
  
39,505
 
 
2,797,634
 
2,713,415
  
2,836,324
 
2,713,415
 
Allowance for loan losses
  
(70,143
)
  
(70,898
)
  
(69,493
)
  
(70,898
)
Total Loans
 
$
2,727,491
 
$
2,642,517
  
$
2,766,831
 
$
2,642,517
 


The Corporation maintains an allowance for loan losses to cover probable credit losses identified during its loan review process. The allowance is increased by the provision for loan losses and decreased by charge offs less recoveries. All charge offs are approved by the Bank’s senior loan officers or loan committees, depending on the amount of the charge off, and are reported to the Bank’s Board of Directors.off. The Bank charges off loans when a determination is made that all or a portion of a loan is uncollectible. The allowance for loan losses is maintained through the provision for loan losses, which is a charge against earnings.

The amount provided for loan losses in a given period may be greater than or less than net loan losses, and is based on management’s judgment as to the appropriate level of the allowance for loan losses. The determination of the provision amount in a given period is based on management’s continuing review and evaluation of the loan portfolio, including an internally administered loan "watch" list and an independent loan review.  The evaluation takes into consideration identified credit problems, the possibility of losses inherent in the loan portfolio that are not specifically identified and management’s judgment as to the impact of current economic conditions on the portfolio.

Management believes that the allowance for loan losses is adequate to cover probable incurred losses inherent in the loan portfolio at JuneSeptember 30, 2012.  The process for determining the adequacy of the allowance for loan losses is critical to the Corporation’s financial results.  It requires management to make difficult, subjective and complex judgments, as estimates aboutto estimate the effect of uncertain matters are needed.matters.  The allowance for loan losses considers current factors, including economic conditions and ongoing internal and external examination processes, and will increase or decrease as deemed necessary to ensure the allowance for loan losses remains adequate.  In addition, the allowance as a percentage of charge offs and nonperforming loans will change at different points in time based on credit performance, loan mix and collateral values.

 
15
 

FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 4.  Loans and Allowance continued

The historical loss allocation for loans not deemed impaired according to ASC 310 is the product of the volume of loans within the non-impaired criticized and non-criticized risk grade classifications, each segmented by call code, and the historical loss factor for each respective classification and call code segment.  The historical loss factors are based upon actual loss experience within each risk and call code classification.  The historical look back period for non-criticized loans looks to the most recent rolling-four-quarter average and aligns with the look back period for non-impaired criticized loans.  Each of the rolling four quarter periods used to obtain the average, include all charge offs for the previous twelve-month period, therefore the historical look back period includes seven quarters. The resulting allocation is reflective of current conditions.  Criticized loans are grouped based on the risk grade assigned to the loan.  Loans with a special mention grade are assigned a loss factor, and loans with a classified grade but not impaired are assigned a separate loss factor.  The loss factor computation for this allocation includes a segmented historical loss migration analysis of criticized risk grades to charge off.

In addition to the specific reserves and historical loss components of the allowance, consideration is given to various environmental factors to help ensure that losses inherent in the portfolio are reflected in the allowance for loan losses.  The environmental component adjusts the historical loss allocations for commercial and consumer loans to reflect relevant current conditions that, in management’s opinion, have an impact on loss recognition.  Environmental factors that management reviews in the analysis include: national and local economic trends and conditions; trends in growth in the loan portfolio and growth in higher risk areas; levels of, and trends in, delinquencies and non-accruals; experience and depth of lending management and staff; adequacy of, and adherence to, lending policies and procedures including those for underwriting; industry concentrations of credit; and adequacy of risk identification systems and controls through the internal loan review and internal audit processes.

The risk characteristics of the Corporation’s material portfolio segments are as follows:

Commercial

Commercial loans are primarily based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate

These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. Management monitors and evaluates commercial real estate loans based on collateral and risk grade criteria. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans.

Residential and Consumer

With respect to residential loans that are secured by 1-4 family residences and are generally owner occupied, the Corporation generally establishes a maximum loan-to-value ratio and requires PMIprivate mortgage insurance if that ratio is exceeded. Home equity loans are typically secured by a subordinate interest in 1-4 family residences, and consumer loans are secured by consumer assets such as automobiles or recreational vehicles. Some consumer loans are unsecured such as small installment loans and certain lines of credit. Repayment of these loans is primarily dependent on the personal income and credit rating of the borrowers, which can be impacted by economic conditions in their market areas such as unemployment levels. Repayment can also be impacted by changes in property values on residential properties. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

 
16
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 4.  Loans and Allowance continued

The following tables summarize changes in the allowance for loan losses by loan segment for the three and sixnine months ended JuneSeptember 30, 2012, and JuneSeptember 30, 2011:

 Three Months Ended June 30, 2012  Three Months Ended September 30, 2012 
 Commercial 
Real Estate
Commercial
 Consumer Residential 
Finance
Leases
 Total  Commercial Real Estate Commercial Consumer Residential 
Finance
Leases
 Total 
Allowance for loan losses:
                          
Balances, April 1
 
$
15,574
 
$
37,907
 
$
2,805
 
$
14,083
   
$
70,369
 
Balances, July 1
 
$
17,791
 
$
35,133
 
$
2,431
 
$
14,788
   
$
70,143
 
Provision for losses
 
4,325
 
(750
)
 
(177
)
 
1,147
   
4,545
  
5,431
 
(879
)
 
147
 
(90
)
   
4,609
 
Recoveries on loans
 
519
 
1,636
 
168
 
481
   
2,804
  
526
 
1,598
 
219
 
174
   
2,517
 
Loans charged off
  
(2,627
)
  
(3,660
)
  
(365
)
  
(923
)
     
(7,575
)
  
(1,424
)
  
(4,439
)
  
(168
)
  
(1,745
)
    
(7,776
)
Balances, June 30, 2012
 
$
17,791
 
$
35,133
 
$
2,431
 
$
14,788
    
$
70,143
 
Balances, September 30, 2012
 
$
22,324
 
$
31,413
 
$
2,629
 
$
13,127
   
$
69,493
 


 Six Months Ended June 30, 2012  Nine Months Ended September 30, 2012 
 Commercial 
Real Estate
Commercial
 Consumer Residential 
Finance
Leases
 Total  Commercial Real Estate Commercial Consumer Residential 
Finance
Leases
 Total 
Allowance for loan losses:
                          
Balances, January 1
 
$
17,731
 
$
37,919
 
$
2,902
 
$
12,343
 
$
3
 
$
70,898
  
$
17,731
 
$
37,919
 
$
2,902
 
$
12,343
 
$
3
 
$
70,898
 
Provision for losses
 
4,902
 
1,028
 
(161
)
 
3,655
 
(4
)
 
9,420
  
10,333
 
149
 
(14
)
 
3,565
 
(4
)
 
14,029
 
Recoveries on loans
 
667
 
1,864
 
376
 
794
 
1
 
3,702
  
1,193
 
3,462
 
595
 
968
 
1
 
6,219
 
Loans charged off
  
(5,509
)
  
(5,678
)
  
(686
)
  
(2,004
)
     
(13,877
)
  
(6,933
)
  
(10,117
)
  
(854
)
  
(3,749
)
     
(21,653
)
Balances, June 30, 2012
 
$
17,791
 
$
35,133
 
$
2,431
 
$
14,788
    
$
70,143
 
Balances, September 30, 2012
 
$
22,324
 
$
31,413
 
$
2,629
 
$
13,127
    
$
69,493
 


 Three Months Ended June 30, 2011  Three Months Ended September 30, 2011 
 Commercial 
Real Estate
Commercial
 Consumer Residential 
Finance
Leases
 Total  Commercial Real Estate Commercial Consumer Residential 
Finance
Leases
 Total 
Allowance for loan losses:
                          
Balances, April 1
 
$
30,206
 
$
37,240
 
$
3,098
 
$
10,371
 
$
21
 
$
80,936
  
$
23,715
 
$
38,668
 
$
2,859
 
$
11,877
 
$
14
 
$
77,133
 
Provision for losses
 
(11,993
)
 
14,264
 
(253
)
 
3,617
 
(10
)
 
5,625
  
(903
)
 
3,042
 
281
 
3,142
 
(6
)
 
5,556
 
Recoveries on loans
 
6,351
 
545
 
332
 
225
 
3
 
7,456
  
1,176
 
378
 
163
 
237
 
1
 
1,955
 
Loans charged off
  
(849
)
  
(13,381
)
  
(318
)
  
(2,336
)
     
(16,884
)
  
(4,344
)
  
(5,003
)
  
(266
)
  
(1,957
)
     
(11,570
)
Balances, June 30, 2011
 
$
23,715
 
$
38,668
 
$
2,859
 
$
11,877
 
$
14
 
$
77,133
 
Balances, September 30, 2011
 
$
19,644
 
$
37,085
 
$
3,037
 
$
13,299
 
$
9
 
$
73,074
 


  Six Months Ended June 30, 2011 
  Commercial  
Real Estate
Commercial
  Consumer  Residential  
Finance
Leases
  Total 
Allowance for loan losses:
                  
Balances, January 1
 
$
32,508
  
$
36,341
  
$
3,622
  
$
10,408
  
$
98
  
$
82,977
 
Provision for losses
  
(13,875
)
  
21,190
   
(468
)
  
4,459
   
(87
)
  
11,219
 
Recoveries on loans
  
6,998
   
866
   
618
   
697
   
3
   
9,182
 
Loans charged off
  
(1,916
)
  
(19,729
)
  
(913
)
  
(3,687
)
      
(26,245
)
Balances, June 30, 2011
 
$
23,715
  
$
38,668
  
$
2,859
  
$
11,877
  
$
14
  
$
77,133
 

  Nine Months Ended September 30, 2011 
  Commercial  Real Estate Commercial  Consumer  Residential  
Finance
Leases
  Total 
Allowance for loan losses:
                  
Balances, January 1
 
$
32,508
  
$
36,341
  
$
3,622
  
$
10,408
  
$
98
  
$
82,977
 
Provision for losses
  
(14,778
)
  
24,232
   
(187
)
  
7,601
   
(93
)
  
16,775
 
Recoveries on loans
  
8,174
   
1,244
   
781
   
934
   
4
   
11,137
 
Loans charged off
  
(6,260
)
  
(24,732
)
  
(1,179
)
  
(5,644
)
      
(37,815
)
Balances, September 30, 2011
 
$
19,644
  
$
37,085
  
$
3,037
  
$
13,299
  
$
9
  
$
73,074
 

 
17
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 4.  Loans and Allowance continued

The following table shows the Corporation’s allowance for credit losses and loan portfolio by loan segment for the periods indicated:

 June 30, 2012  September 30, 2012 
 Commercial 
Commercial
Real Estate
 Consumer Residential 
Finance
Leases
 Total  Commercial 
Commercial
Real Estate
 Consumer Residential 
Finance
Leases
 Total 
Allowance Balances:
                          
Individually evaluated for impairment
 
$
2,447
 
$
2,202
   
$
1,427
   
$
6,076
  
$
1,775
 
$
4,157
   
$
319
   
$
6,251
 
Collectively evaluated for impairment
  
15,344
  
32,931
 
$ 
2,431
  
13,361
     
64,067
   
20,549
  
27,256
 
$
2,629
  
12,808
     
63,242
 
Total Allowance for Loan Losses
 
$
17,791
 
$
35,133
 
$
2,431
 
$
14,788
    
$
70,143
  
$
22,324
 
$
31,413
 
$
2,629
 
$
13,127
    
$
69,493
 
                          
Loan Balances:
                          
Individually evaluated for impairment
 
$
16,596
 
$
56,343
 
$
139
 
$
15,204
   
$
88,282
  
$
16,286
 
$
54,773
   
$
8,906
   
$
79,965
 
Collectively evaluated for impairment
  
687,260
  
1,262,359
  
83,794
  
672,963
 
$ 
2,976
  
2,709,352
   
725,073
  
1,279,891
 
$ 
77,171
  
671,254
 
$ 
2,970
  
2,756,359
 
Total Loans
 
$
703,856
 
$
1,318,702
 
$
83,933
 
$
688,167
 
$
2,976
 
$
2,797,634
 
�� Total Loans
 
$
741,359
 
$
1,334,664
 
$
77,171
 
$
680,160
 
$
2,970
 
$
2,836,324
 


  December 31, 2011 
  Commercial  
Commercial
Real Estate
  Consumer  Residential  
Finance
Leases
  Total 
Allowance Balances:
                  
        Individually evaluated for impairment
 
$
4,701
  
$
2,504
     
$
733
     
$
7,938
 
        Collectively evaluated for impairment
  
13,030
   
35,415
  
$
2,902
   
11,610
  
$
3
   
62,960
 
                Total Allowance for Loan Losses
 
$
17,731
  
$
37,919
  
$
2,902
  
$
12,343
  
$
3
  
$
70,898
 
                         
Loan Balances:
                        
        Individually evaluated for impairment
 
$
18,793
  
$
51,980
      
$
12,546
      
$
83,319
 
        Collectively evaluated for impairment
  
657,760
   
1,224,031
  
$
84,172
   
660,578
  
$
3,555
   
2,630,096
 
                Total Loans
 
$
676,553
  
$
1,276,011
  
$
84,172
  
$
673,124
  
$
3,555
  
$
2,713,415
 


Loans are reclassified to a non-accruing status when, in management’s judgment, the collateral value and financial condition of the borrower do not justify accruing interest. Interest previously recorded, but not deemed collectible, is reversed and charged against current income. Payments subsequently received on nonaccrual loans are applied to principal. A loan is returned to accrual status when principal and interest are no longer past due and collectability is probable, typically after a minimum of six consecutive months of performance.  Payments received on impaired accruing or delinquent loans are applied to interest income as accrued.

The following table summarizes the Corporation’s non-accrual loans by loan class for the periods indicated:

  September 30,  December 31, 
  2012  2011 
Commercial and Industrial
 
$
12,507
  
$
12,246
 
Real Estate Loans:
        
       Construction
  
5,440
   
8,990
 
       Commercial and farm land
  
24,501
   
31,093
 
       Residential
  
12,444
   
14,805
 
       Home Equity
  
1,761
   
1,896
 
Individuals loans for household and other personal expenditures
  
3
   
1
 
Lease financing receivables, net of unearned income
  
337
     
Other Loans
  
6
   
561
 
             Total
 
$
56,999
  
$
69,592
 

  June 30,  December 31, 
  2012  2011 
Commercial and Industrial
 
$
13,723
  
$
12,246
 
Agriculture production financing and other loans
        
Real Estate Loans:
        
       Construction
  
7,630
   
8,990
 
       Commercial and farm land
  
26,838
   
31,093
 
       Residential
  
12,583
   
14,805
 
       Home Equity
  
1,855
   
1,896
 
Individuals loans for household and other personal expenditures
  
146
   
1
 
Lease financing receivables, net of unearned income
  
345
     
Other Loans
  
7
   
561
 
             Total
 
$
63,127
  
$
69,592
 

ImpairedCommercial impaired loans include all non-accrual loans, loans accounted for under SOP-03-3 and renegotiated loans, as well as substandard, doubtful and loss grade loans that were still accruing but deemed impaired according to guidance set forth in ASC 310.  Also included in impaired loans are accruing loans that are contractually past due 90 days or more. A loan is deemed impaired when, based on current information or events, it is probable that all amounts due of principal and interest according to the contractual terms of the loan agreement will not be collected.

 
18
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 4.  Loans and Allowance continued

Impaired loans are measured by the present value of expected future cash flows or the fair value of the collateral of the loans, if collateral dependent. The fair value for impaired loans is measured based on the value of the collateral securing those loans and is determined using several methods.  The fair value of real estate is generally based on appraisals by qualified licensed appraisers.  The appraisers typically determine the value of the real estate by utilizing an income or market valuation approach.  If an appraisal is not available, the fair value may be determined by using a cash flow analysis.  Fair value on other collateral, such as business assets, is typically valued by using financial information such as financial statements and aging reports provided by the borrower and is discounted as considered appropriate.

The following table shows the composition of the Corporation’s commercial impaired loans by loan class as of JuneSeptember 30, 2012:

       Three Months Ended Six Months Ended        Three Months Ended Nine Months Ended 
 June 30, 2012 June 30, 2012 June 30, 2012  September 30, 2012 September 30, 2012 September 30, 2012 
 
Unpaid
Principal
Balance
 
Recorded
Investment
 
Related
Allowance
 
Average
Recorded
Investment
 
Interest
Income
Recognized
 
Average
Recorded
Investment
 
Interest
Income
Recognized
  
Unpaid
Principal
Balance
 
Recorded
Investment
 
Related
Allowance
 
Average
Recorded
Investment
 
Interest
Income
Recognized
 
Average
Recorded
Investment
 
Interest
Income
Recognized
 
Impaired loans with no related allowance:
                              
Commercial and industrial
 
$
26,307
 
$
10,487
   
$
11,411
 
$
39
 
$
12,418
 
$
64
  
$
27,363
 
$
10,743
   
$
9,994
 
$
26
 
$
11,615
 
$
68
 
Agriculture production financing
               
and other loans to farmers
 
300
 
300
   
300
   
300
   
Real Estate Loans:
                              
Construction
 
12,309
 
7,197
   
8,040
 
16
 
8,581
 
29
  
10,743
 
6,378
   
6,658
 
17
 
7,665
 
47
 
Commercial and farm land
 
57,740
 
38,884
   
41,084
 
315
 
42,615
 
575
  
52,953
 
35,606
   
31,081
 
250
 
33,459
 
706
 
Residential
 
8,372
 
5,589
   
5,815
 
15
 
6,072
 
26
  
9,307
 
6,716
   
6,936
 
20
 
7,342
 
54
 
Home equity
 
3,754
 
567
   
570
 
3
 
585
 
6
  
3,901
 
711
   
713
 
3
 
727
 
10
 
Individuals loans for household and
       
139
   
139
   
other personal expenditures
 
283
 
139
           
Other loans
  
91
  
18
     
18
     
19
      
87
  
16
     
17
     
18
  
1
 
Total
 
$
108,856
 
$
62,881
    
$
67,077
 
$
388
 
$
70,429
 
$
700
  
$
104,654
 
$
60,470
    
$
55,699
 
$
316
 
$
61,126
 
$
886
 
                              
Impaired loans with related allowance:
                              
Commercial and industrial
 
$
6,523
 
$
6,091
 
$
2,447
 
$
6,111
 
$
11
 
$
6,136
 
$
21
  
$
5,570
 
$
5,227
 
$
1,775
 
$
5,244
 
$
11
 
$
5,307
 
$
32
 
Real Estate Loans:
                              
Construction
 
2,176
 
1,931
 
235
 
1,931
   
1,936
    
725
 
480
 
51
 
510
   
541
   
Commercial and farm land
 
9,671
 
8,330
 
1,967
 
8,369
 
45
 
8,505
 
89
  
13,021
 
12,309
 
4,106
 
12,326
 
32
 
12,371
 
95
 
Residential
 
2,115
 
2,008
 
552
 
2,012
 
19
 
1,993
 
38
   
1,578
  
1,479
  
319
  
1,485
  
19
  
1,485
  
56
 
Home equity
               
Individuals loans for household and
               
other personal expenditures
               
Other loans
                      
Total
 
$
20,485
 
$
18,360
 
$
5,201
 
$
18,423
 
$
75
 
$
18,570
 
$
148
  
$
20,894
 
$
19,495
 
$
6,251
 
$
19,565
 
$
62
 
$
19,704
 
$
183
 
Total Impaired Loans
 
$
129,341
 
$
81,241
 
$
5,201
 
$
85,500
 
$
463
 
$
88,999
 
$
848
  
$
125,548
 
$
79,965
 
$
6,251
 
$
75,264
 
$
378
 
$
80,830
 
$
1,069
 
 
 
19
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 4.  Loans and Allowance continued

The following table shows the composition of the Corporation’s commercial impaired loans by loan class as of December 31, 2011:

 December 31,2011  December 31, 2011 
 
Unpaid
Principal
Balance
 
Recorded
Investment
 
Related
Allowance
 
Average
Recorded
Investment
 
Interest
Income
Recognized
  
Unpaid
Principal
Balance
 
Recorded
Investment
 
Related
Allowance
 
Average
Recorded
Investment
 
Interest
Income
Recognized
 
Impaired loans with no related allowance:
                      
Commercial and industrial
 
$
23,364
 
$
10,116
   
$
13,399
 
$
615
  
$
23,364
 
$
10,116
   
$
13,399
 
$
615
 
Real Estate Loans:
              
Construction
 
14,301
 
7,701
   
8,836
    
14,301
 
7,701
   
8,836
 
Commercial and farm land
 
49,242
 
34,571
   
39,032
 
591
  
49,242
 
34,571
   
39,032
 
591
 
Residential
 
7,491
 
6,185
   
6,539
 
20
  
7,491
 
6,185
   
6,539
 
20
 
Home equity
 
4,425
 
1,241
   
1,500
 
15
  
4,425
 
1,241
   
1,500
 
15
 
Individuals loans for household and
           
other personal expenditures
           
Other loans
 
99
 
21
   
24
     
99
  
21
     
24
    
Total
 
$
98,922
 
$
59,835
   
$
69,330
 
$
1,241
  
$
98,922
 
$
59,835
    
$
69,330
 
$
1,241
 
                      
Impaired loans with related allowance:
                      
Commercial and industrial
 
$
8,691
 
$
8,104
 
$
4,142
 
$
8,196
 
$
174
  
$
8,691
 
$
8,104
 
$
4,142
 
$
8,196
 
$
174
 
Real Estate Loans:
                      
Construction
 
961
 
961
 
321
 
961
    
961
 
961
 
321
 
961
   
Commercial and farm land
 
12,115
 
8,748
 
2,183
 
10,028
 
140
  
12,115
 
8,748
 
2,183
 
10,028
 
140
 
Residential
 
1,888
 
1,575
 
391
 
1,687
 
7
  
1,888
 
1,575
 
391
 
1,687
 
7
 
Home equity
           
Individuals loans for household and
           
other personal expenditures
           
Other loans
 
579
 
552
 
559
 
590
     
579
  
552
  
559
  
590
    
Total
 
$
24,234
 
$
19,940
 
$
7,596
 
$
21,462
 
$
321
  
$
24,234
 
$
19,940
 
$
7,596
 
$
21,462
 
$
321
 
Total Impaired Loans
 
$
123,156
 
$
79,775
 
$
7,596
 
$
90,792
 
$
1,562
  
$
123,156
 
$
79,775
 
$
7,596
 
$
90,792
 
$
1,562
 

In addition to the impaired loans outlined above, the Corporation has identified $7,040,000 in non-accrual residential mortgage loans which have been deemed impaired in accordance with ASC 310.  Specific reserves totaling $875,000 have been set on 40 of these loans with a total principal balance of $2,954,000.

As part of the ongoing monitoring of the credit quality of the Corporation’s loan portfolio, management tracks certain credit quality indicators including trends related to: (i) the level of criticized commercial loans, (ii) net charge offs, (iii) non-performing loans and (iv) the general national and local economic conditions.

The Corporation utilizes a risk grading of pass, special mention, substandard, doubtful and loss to assess the overall credit quality of large commercial loans. All large commercial credit grades are reviewed at a minimum of once a year for pass grade loans.  Loans with grades below pass are reviewed more frequently depending on the grade.  A description of the general characteristics of these grades is as follows:

·●Pass – Loans that are considered to be of acceptable credit quality.
·●Special Mention – Loans which possess some credit deficiency or potential weakness, which deserves close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Corporation’s credit position at some future date.  Special mention assets are not adversely classified and do not expose the Corporation to sufficient risk to warrant adverse classification.  Such loans pose an unwarranted financial risk that, if not corrected, could weaken the loan adversely impacting the future repayment ability of the borrower.  The key distinctions of this category’s classification are that it is indicative of an unwarranted level of risk; and weaknesses are considered “potential”, not “defined”, impairments to the primary source of repayment. Examples include businesses that may be suffering from inadequate management, loss of key personnel or significant customer or litigation.
 
 
20
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 4.  Loans and Allowance continued

·
●
Substandard – A substandard loan is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any.  Assets so classified have a well-defined weakness that jeopardizes the liquidation of the debt.  They are characterized by the distinct possibility that the Corporation will sustain some loss if the deficiencies are not corrected.  Other characteristics may include:
othe likelihood that a loan will be paid from the primary source of repayment is uncertain or financial deterioration is underway and very close attention is warranted to ensure that the loan is collected without loss,
othe primary source of repayment is gone, and the Corporation is forced to rely on a secondary source of repayment, such as collateral liquidation or guarantees,
oloans have a distinct possibility that the Corporation will sustain some loss if deficiencies are not corrected,
ounusual courses of action are needed to maintain a high probability of repayment,
othe borrower is not generating enough cash flow to repay loan principal; however, it continues to make interest payments,
othe Corporation is forced into a subordinated or unsecured position due to flaws in documentation,
oloans have been restructured so that payment schedules, terms and collateral represent concessions to the borrower when compared to the normal loan terms,
othe Corporation is seriously contemplating foreclosure or legal action due to the apparent deterioration of the loan, and
othere is significant deterioration in market conditions to which the borrower is highly vulnerable.
·●Doubtful – Loans that have all of the weaknesses of those classified as Substandard. However, based on currently existing facts, conditions and values, these weaknesses make full collection of principal highly questionable and improbable. Other credit characteristics may include the primary source of repayment is gone or there is considerable doubt as to the quality of the secondary sources of repayment. The possibility of loss is high, but because of certain important pending factors that may strengthen the loan, loss classification is deferred until the exact status of repayment is known.
·●Loss – Loans that are considered uncollectible and of such little value that continuing to carry them as an asset is not warranted. Loans will be classified as Loss when it is neither practical not desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future.

 
21
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 4.  Loans and Allowance continued

The following table summarizes the credit quality of the Corporation’s loan portfolio, by loan class for the periods indicated.  Consumer Non-Performing loans include accruing consumer loans 90 plus days delinquent and consumer non-accrual loans.  The entire balance of a loan is considered delinquent if the minimum payment contractually required to be made is not received by the specified date.

 June 30, 2012  September 30, 2012 
 
Commercial
Pass
 
Commercial
Special
Mention
 
Commercial
Substandard
 
Commercial
Doubtful
 
Consumer
Performing
 
Consumer
Non-
Performing
 
Total
Loans
  
Commercial
Pass
 
Commercial
Special
Mention
 Commercial Substandard 
Commercial
Doubtful
 Consumer Performing 
Consumer
Non-Performing
 Total Loans 
Commercial and industrial
 
$
485,220
 
$
37,086
 
$
25,293
 
$
4,754
     
$
552,353
  
$
524,180
 
$
25,143
 
$
36,564
 
$
6,630
     
$
592,517
 
Agriculture production financing and other loans
 
105,269
 
352
 
514
       
106,135
  
106,775
 
230
 
161
       
107,166
 
Real Estate Loans:
                              
Construction
 
76,112
 
2,116
 
21,246
     
$
114
 
99,588
  
78,655
 
1,639
 
13,140
     
$
176
 
93,610
 
Commercial and farm land
 
1,079,776
 
45,377
 
93,101
 
802
   
58
 
1,219,114
  
1,105,407
 
48,344
 
86,500
 
475
   
328
 
1,241,054
 
Residential
 
132,361
 
9,552
 
16,885
 
459
 
$
314,191
 
7,469
 
480,917
  
142,394
 
4,909
 
14,709
 
1,360
 
$
304,255
 
7,645
 
475,272
 
Home equity
 
14,543
 
1,298
 
1,778
   
188,108
 
1,523
 
207,250
  
11,036
 
1,344
 
1,021
   
189,938
 
1,549
 
204,888
 
Individuals loans for household and other
personal expenditures
         
83,925
 
8
 
83,933
          
77,168
 
3
 
77,171
 
Lease financing receivables, net of unearned income
         
2,976
   
2,976
          
2,633
 
337
 
2,970
 
Other loans
  
45,314
  
11
  
43
           
45,368
   
41,640
     
36
           
41,676
 
Total
 
$
1,938,595
 
$
95,792
 
$
158,860
 
$
6,015
 
$
589,200
 
$
9,172
 
$
2,797,634
  
$
2,010,087
 
$
81,609
 
$
152,131
 
$
8,465
 
$
573,994
 
$
10,038
 
$
2,836,324
 


 December 31, 2011  December 31, 2011 
 
Commercial
Pass
 
Commercial
Special
Mention
 
Commercial
Substandard
 
Commercial
Doubtful
 
Consumer
Performing
 
Consumer
Non
Performing
 
Total
Loans
  
Commercial
Pass
 
Commercial
Special
Mention
 Commercial Substandard 
Commercial
Doubtful
 Consumer Performing 
Consumer
Non Performing
 Total Loans 
Commercial and industrial
 
$
478,885
 
$
22,405
 
$
28,025
 
$
3,208
     
$
532,523
  
$
478,885
 
$
22,405
 
$
28,025
 
$
3,208
     
$
532,523
 
Agriculture production financing and other loans
 
101,289
 
1,582
 
1,655
       
104,526
  
101,289
 
1,582
 
1,655
       
104,526
 
Real Estate Loans:
                              
Construction
 
47,611
 
3,672
 
22,376
   
$
7,762
 
$
359
 
81,780
  
47,611
 
3,672
 
22,376
   
$
7,762
 
$
359
 
81,780
 
Commercial and farm land
 
1,033,397
 
54,697
 
103,330
 
1,724
 
1,035
 
47
 
1,194,230
  
1,033,397
 
54,697
 
103,330
 
1,724
 
1,035
 
47
 
1,194,230
 
Residential
 
139,237
 
9,175
 
16,699
 
500
 
308,306
 
7,576
 
481,493
  
139,237
 
9,175
 
16,699
 
500
 
308,306
 
7,576
 
481,493
 
Home equity
 
15,912
 
499
 
3,317
   
170,776
 
1,127
 
191,631
  
15,912
 
499
 
3,317
   
170,776
 
1,127
 
191,631
 
Individuals loans for household and other
personal expenditures
         
84,121
 
51
 
84,172
          
84,121
 
51
 
84,172
 
Lease financing receivables, net of unearned income
         
3,555
   
3,555
          
3,555
   
3,555
 
Other loans
  
38,917
  
15
  
21
  
552
        
39,505
   
38,917
  
15
  
21
  
552
        
39,505
 
Total
 
$
1,855,248
 
$
92,045
 
$
175,423
 
$
5,984
 
$
575,555
 
$
9,160
 
$
2,713,415
  
$
1,855,248
 
$
92,045
 
$
175,423
 
$
5,984
 
$
575,555
 
$
9,160
 
$
2,713,415
 

 
22
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 4.  Loans and Allowance continued

The following table shows a past due aging of the Corporation’s loan portfolio, by loan class for JuneSeptember 30, 2012, and December 31, 2011:

 June 30, 2012  September 30, 2012 
 Current 
30-59
Days
Past Due
 
60-89
Days
Past Due
 
Loans > 90
Days And
Accruing
 
Non-
Accrual
 
Total Past
Due & Non-
Accrual
 Total Loans  Current 
30-59 Days
Past Due
 
60-89 Days
Past Due
 
Loans > 90 Days
And Accruing
 Non-Accrual 
Total Past Due
& Non-Accrual
 Total Loans 
Commercial and industrial
 
$
535,910
 
$
2,086
 
$
506
 
$
128
 
$
13,723
 
$
16,443
 
$
552,353
  
$
574,730
 
$
4,800
 
$
434
 
$
46
 
$
12,507
 
$
17,787
 
$
592,517
 
Agriculture production financing and other loans
 
106,135
           
106,135
  
106,782
 
74
 
10
 
300
   
384
 
107,166
 
Real Estate Loans:
                              
Construction
 
91,751
 
202
   
5
 
7,630
 
7,837
 
99,588
  
87,829
 
341
     
5,440
 
5,781
 
93,610
 
Commercial and farm land
 
1,184,882
 
5,095
 
2,122
 
177
 
26,838
 
34,232
 
1,219,114
  
1,209,194
 
6,931
 
65
 
363
 
24,501
 
31,860
 
1,241,054
 
Residential
 
459,104
 
6,967
 
1,936
 
327
 
12,583
 
21,813
 
480,917
  
453,234
 
5,835
 
2,788
 
971
 
12,444
 
22,038
 
475,272
 
Home equity
 
203,794
 
904
 
669
 
28
 
1,855
 
3,456
 
207,250
  
200,402
 
1,532
 
899
 
294
 
1,761
 
4,486
 
204,888
 
Individuals loans for household and other
personal expenditures
 
83,065
 
649
 
73
   
146
 
868
 
83,933
  
76,053
 
720
 
395
   
3
 
1,118
 
77,171
 
Lease financing receivables, net of unearned income
 
2,631
       
345
 
345
 
2,976
  
2,633
       
337
 
337
 
2,970
 
Other loans
  
45,361
           
7
  
7
  
45,368
   
41,670
           
6
  
6
  
41,676
 
Total
 
$
2,712,633
 
$
15,903
 
$
5,306
 
$
665
 
$
63,127
 
$
85,001
 
$
2,797,634
  
$
2,752,527
 
$
20,233
 
$
4,591
 
$
1,974
 
$
56,999
 
$
83,797
 
$
2,836,324
 


 December 31, 2011  December 31, 2011 
 Current 
30-59
Days
Past Due
 
60-89
Days
Past Due
 
Loans > 90
Days And
Accruing
 
Non-
Accrual
 
Total Past
Due & Non-
Accrual
 Total Loans  Current 
30-59 Days
Past Due
 
60-89 Days
Past Due
 
Loans > 90 Days
And Accruing
 Non-Accrual 
Total Past Due
& Non-Accrual
 Total Loans 
Commercial and industrial
 
$
518,764
 
$
1,332
 
$
135
 
$
46
 
$
12,246
 
$
13,759
 
$
532,523
  
$
518,764
 
$
1,332
 
$
135
 
$
46
 
$
12,246
 
$
13,759
 
$
532,523
 
Agriculture production financing and other loans
 
104,464
 
62
       
62
 
104,526
  
104,464
 
62
       
62
 
104,526
 
Real Estate Loans:
                              
Construction
 
69,305
 
328
 
3,126
 
31
 
8,990
 
12,475
 
81,780
  
69,305
 
328
 
3,126
 
31
 
8,990
 
12,475
 
81,780
 
Commercial and farm land
 
1,140,897
 
16,457
 
5,783
   
31,093
 
53,333
 
1,194,230
  
1,140,897
 
16,457
 
5,783
   
31,093
 
53,333
 
1,194,230
 
Residential
 
458,925
 
5,485
 
2,087
 
191
 
14,805
 
22,568
 
481,493
  
458,925
 
5,485
 
2,087
 
191
 
14,805
 
22,568
 
481,493
 
Home equity
 
187,788
 
1,096
 
590
 
261
 
1,896
 
3,843
 
191,631
  
187,788
 
1,096
 
590
 
261
 
1,896
 
3,843
 
191,631
 
Individuals loans for household and other
personal expenditures
 
82,837
 
1,075
 
208
 
51
 
1
 
1,335
 
84,172
  
82,837
 
1,075
 
208
 
51
 
1
 
1,335
 
84,172
 
Lease financing receivables, net of unearned income
 
3,555
           
3,555
  
3,555
           
3,555
 
Other loans
  
38,944
           
561
  
561
  
39,505
   
38,944
           
561
  
561
  
39,505
 
Total
 
$
2,605,479
 
$
25,835
 
$
11,929
 
$
580
 
$
69,592
 
$
107,936
 
$
2,713,415
  
$
2,605,479
 
$
25,835
 
$
11,929
 
$
580
 
$
69,592
 
$
107,936
 
$
2,713,415
 


See the information regarding the analysis of loan loss experience in the Loan Quality/Provision for Loan Losses section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included as ITEM 2 of this Form 10-Q.

Given recent economic conditions, borrowers of all types are experiencinghave experienced declines in income and cash flow.  As a result, borrowers are occasionally seeking to reduce contractual cash outlays including debt payments.  Concurrently, in an effort to preserve and protect its earning assets, specifically troubled loans, the Corporation is working to maintain its relationship with certain customers who are experiencing financial difficulty by contractually modifying the borrower’s debt agreement with the Corporation.  In certain loan restructuring situations, the Corporation may grant a concession to a debtor experiencing financial difficulty, resulting in a trouble debt restructuring.  A concession is deemed to be granted when, as a result of the restructuring, the Corporation does not expect to collect all amounts due, including interest accrued at the original contract rate.  If the payment of principal at original maturity is primarily dependent on the value of collateral, the current value of the collateral is considered in determining whether the principal will be paid.

 
23
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 4.  Loans and Allowance continued

The following tables summarize troubled debt restructurings that occurred during the periods indicated:

 Three Months Ended Six Months Ended  Three Months Ended Nine Months Ended 
 June 30, 2012 June 30, 2012  September 30, 2012 September 30, 2012 
                          
 Pre-Modification Post-Modification   Pre-Modification Post-Modification    Pre-Modification Post-Modification Number Pre-Modification Post-Modification Number 
 
Recorded
Balance
 
Recorded
Balance
 
Number
of Loans
 
Recorded
Balance
 
Recorded
Balance
 
Number
of Loans
  
Recorded
Balance
 
Recorded
Balance
 
of
Loans
 
Recorded
Balance
 
Recorded
Balance
 
of
Loans
 
Commercial and industrial
 
$
166
 
$
166
 
2
 
$
405
 
$
405
 
4
  
$
875
 
$
1,048
 
3
 
$
1,155
 
$
1,327
 
6
 
Real Estate Loans:
                          
Construction
 
491
 
350
 
1
 
491
 
350
 
1
  
303
 
303
 
1
 
794
 
653
 
2
 
Commercial and farm land
 
730
 
735
 
4
 
2,508
 
2,369
 
6
  
875
 
875
 
2
 
2,967
 
2,828
 
7
 
Residential
  
1,733
  
1,598
  
11
  
1,957
  
1,822
  
15
  
239
 
241
 
4
 
2,196
 
2,063
 
19
 
Individuals loans for household and other
personal expenditures
  
90
  
117
  
4
  
90
  
117
  
 
4
 
Total
 
$
3,120
 
$
2,849
  
18
 
$
5,361
 
$
4,946
  
26
  
$
2,382
 
$
2,584
  
14
 
$
7,202
 
$
6,988
  
38
 


  Three Months Ended  Nine Months Ended 
  September 30, 2011  September 30, 2011 
                   
  Pre-Modification  Post-Modification  Number  Pre-Modification  Post-Modification  Number 
  
Recorded
Balance
  
Recorded
Balance
  
of
Loans
  
Recorded
Balance
  
Recorded
Balance
  
of
Loans
 
Commercial and Industrial
 
$
535
  
$
552
   
5
  
$
1,636
  
$
1,651
   
10
 
Real Estate Loans:
                        
       Construction
  
40
   
41
   
1
   
175
   
184
   
3
 
       Commercial and farm land
  
379
   
379
   
1
   
4,357
   
4,346
   
6
 
       Residential
  
1,034
   
1,407
   
10
   
2,690
   
3,115
   
30
 
       Home Equity
              
82
   
87
   
8
 
             Total
 
$
1,988
  
$
2,379
   
17
  
$
8,940
  
$
9,383
   
57
 
24
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 4.  Loans and Allowance continued

The following table shows the recorded investment, as of JuneSeptember 30, 2012, of troubled debt restructurings that occurred during the periods indicated:

 Three Months Ended  Three Months Ended 
   June 30, 2012    September 30, 2012 
 Term Rate   Total  Term Rate   Total 
 Modification Modification Combination Modification  Modification Modification Combination Modification 
Commercial and industrial
     
$
31
 
$
31
      
$
1,048
 
$
1,048
 
Real Estate Loans:
              
Construction
     
346
 
346
      
299
 
299
 
Commercial and farm land
 
$
82
   
599
 
681
    
$ 
680
 
195
 
875
 
Residential
  
531
 
$
258
  
720
  
1,509
      
167
 
167
 
Individuals loans for household and other personal expenditures
    
7
  
109
  
116
 
Total
 
$
613
 
$
258
 
$
1,696
 
$
2,567
    
$
687
 
$
1,818
 
$
2,505
 


 Six Months Ended  Nine Months Ended 
   June 30, 2012    September 30, 2012 
 Term Rate   Total  Term Rate   Total 
 Modification Modification Combination Modification  Modification Modification Combination Modification 
Commercial and industrial
 
$
238
   
$
31
 
$
269
  
$
230
   
$
1,072
 
$
1,302
 
Real Estate Loans:
            
Construction
   
346
 
346
      
639
 
639
 
Commercial and farm land
 
1,717
   
599
 
2,316
  
1,693
 
$ 
680
 
385
 
2,758
 
Residential
  
531
 
$
258
  
944
  
1,733
  
528
 
252
 
1,100
 
1,880
 
Individuals loans for household and other personal expenditures
     
7
  
109
  
116
 
Total
 
$
2,486
 
$
258
 
$
1,920
 
$
4,664
  
$
2,451
 
$
939
 
$
3,305
 
$
6,695
 


Residential real estate loans account for 6129 percent and 5848 percent of the troubled debt restructured loans made in the three and sixnine months ended JuneSeptember 30, 2012, respectively.  SevenThree and teneleven troubled debt restructured loans made during the three and sixnine months ended JuneSeptember 30, 2012, respectively, are in non accrual status.

The following table summarizes troubled debt restructures that occurred between July 1, 2011, and June 30, 2012, subsequently defaulted during the period indicated:

  Three Months Ended  Six Months Ended 
  June 30, 2012  June 30, 2012 
  
Number of
Loans
  
Recorded
Balance
  
Number of
Loans
  
Recorded
Balance
 
Commercial and Industrial
        
1
  
$
46
 
Real Estate Loans:
              
       Construction
              
       Commercial and farm land
  
2
  
$
445
   
3
   
1,203
 
       Residential
  
5
   
2,283
   
 5
   
 2,283
 
             Total
  
7
  
$
2,728
   
9
  
$
3,532
 
 
2425
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 4.  Loans and Allowance continued

The following tables summarize troubled debt restructures that occurred during the twelve months ended September 30, 2012, and September 30, 2011, that subsequently defaulted during the period indicated:

  Three Months Ended  Nine Months Ended 
  September 30, 2012  September 30, 2012 
             
  
Number of
Loans
  
Recorded
Balance
  
Number of
Loans
  
Recorded
Balance
 
Commercial and Industrial
  
3
  
$
1,415
   
3
  
$
1,415
 
Real Estate Loans:
                
       Commercial and farm land
  
1
   
23
   
1
   
23
 
       Residential
  
7
   
371
   
11
   
2,494
 
             Total
  
11
  
$
1,809
   
15
  
$
3,932
 


  Three Months Ended  Nine Months Ended 
  September 30, 2011  September 30, 2011 
             
  
Number of
Loans
  
Recorded
Balance
  
Number of
Loans
  
Recorded
Balance
 
Commercial and Industrial
  
1
  
$
66
   
2
  
$
553
 
Real Estate Loans:
                
       Commercial and farm land
          
1
     
       Residential
  
3
   
271
   
3
   
657
 
       Home Equity
  
1
   
11
   
1
   
11
 
             Total
  
5
  
$
348
   
7
  
$
1,221
 


For potential consumer loan restructures, impairment evaluation occurs prior to modification.  Any subsequent impairment is typically addressed through the charge off process, or may be addressed through a specific reserve.  Consumer troubled debt restructurings are generally included in the general historical allowance for loan loss at the post modification balance.  Consumer non-accrual and delinquent troubled debt restructurings are also considered in the calculation of the non-accrual and delinquency trend environmental allowance allocation.  Commercial troubled debt restructured loans risk graded special mention, substandard, doubtful and loss are individually evaluated for impairment under ASC 310.  Any resulting specific reserves are included in the allowance for loan losses. Commercial 30 – 89 day delinquent troubled debt restructurings are included in the calculation of the delinquency trend environmental allowance allocation. All commercial non-impaired loans, including non-accrual and 90+ day delinquents, are included in the ASC 450 loss migration analysis.

26

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 5.  Derivative Financial Instruments

Risk Management Objective of Using Derivatives

The Corporation is exposed to certain risks arising from both its business operations and economic conditions.  The Corporation principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Corporation manages economic risks, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities and through the use of derivative financial instruments.  Specifically, the Corporation enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates.  The Corporation’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Corporation’s known or expected cash payments principally related to certain variable-rate liabilities.  The Corporation also has derivatives that are a result of a service the Corporation provides to certain qualifying customers, and, therefore, are not used to manage interest rate risk in the Corporation’s assets or liabilities.

Cash Flow Hedges of Interest Rate Risk

The Corporation’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish these objectives, the Corporation primarily uses interest rate swaps and interest rate caps as part of its interest rate risk management strategy.  Interest rate swaps designated as cash flow hedges involve the payment of fixed amounts to a counterparty in exchange for the Corporation receiving variable payments over the life of the agreements without exchange of the underlying notional amount. Interest rate caps designated as cash flow hedges involve the receipt of variable amounts from a counterparty if interest rates rise above the strike rate on the contract in exchange for an up-front premium.  As of JuneSeptember 30, 2012, the Corporation had two interest rate swaps with a notional amount of $26.0 million and one interest rate cap with a notional amount of $13.0 million that were designated as cash flow hedges.   As of JuneSeptember 30, 2011, the Corporation had one interest rate swap with a notional amount of $13.0 million and one interest rate cap with a notional amount of $13.0 million that were designated as cash flow hedges.

Cash Flow Hedges of Interest Rate Risk continued

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During 2012, such derivatives were used to hedge the forecasted LIBOR-based outflows associated with existing trust preferred securities when the outflows convertconverted from a fixed rate to variable rate in September of 2012.  The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. During the three and sixnine months ended JuneSeptember 30, 2012, and 2011, the Corporation did not recognize any ineffectiveness.

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on the Corporation’s variable-rate liabilities.  During the next twelve months, the Corporation does not expect to reclassify any amounts from accumulated other comprehensive income to interest expense.

The Corporation does not use derivatives for trading or speculative purposes.  Derivatives not designated as hedges are not speculative and result from a service the Corporation provides to certain customers. The Corporation executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies.  Those interest rate swaps are simultaneously hedged by offsetting interest rate swaps that the Corporation executes with a third party, such that the Corporation minimizes its net risk exposure resulting from such transactions.  As the interest rate swaps associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings.  As of September 30, 2012, the notional amount of customer-facing swaps was approximately $152,667,000.  This amount is offset with third party counterparties, as described above.

 
2527
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 5.  Derivative Financial Instruments continued

Non-designated Hedges

The Corporation does not use derivatives for trading or speculative purposes.  Derivatives not designated as hedges are not speculative and result from a service the Corporation provides to certain customers. The Corporation executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies.  Those interest rate swaps are simultaneously hedged by offsetting interest rate swaps that the Corporation executes with a third party, such that the Corporation minimizes its net risk exposure resulting from such transactions.  As the interest rate swaps associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings.  As of June 30, 2012, the notional amount of customer-facing swaps was approximately $121,710,000.  This amount is offset with third party counterparties, as described above.

Fair Values of Derivative Instruments on the Balance Sheet

The table below presents the fair value of the Corporation’s derivative financial instruments, as well as their classification on the Balance Sheet, as of JuneSeptember 30, 2012, and December 31, 2011.

 Asset Derivatives Liability Derivatives 
 September 30, 2012 December 31, 2011 September 30, 2012 December 31, 2011 
 
Balance
Sheet
Location
 
Fair
Value
 
Balance
Sheet
Location
 
Fair
Value
 
Balance
Sheet
Location
 
Fair
Value
 
Balance
Sheet
Location
 
Fair
Value
 
Derivatives designated as hedging instruments:
                
Interest rate contracts
Other Assets
 
$
206
 
Other Assets
 
$
424
 
Other Liabilities
 
$
3,617
 
Other Liabilities
 
$
2,305
 
                     
Derivatives not designated as hedging instruments:
                    
Interest rate contracts
Other Assets
 
$
6,412
 
Other Assets
 
$
5,241
 
Other Liabilities
 
$
6,789
 
Other Liabilities
 
$
5,492
 

 Asset Derivatives Liability Derivatives 
 June 30, 2012 December 31, 2011 June 30, 2012 December 31, 2011 
 
Balance Sheet
Location
 
Fair
Value
 
Balance Sheet
Location
 
Fair
Value
 
Balance Sheet
Location
 
Fair
Value
 
Balance Sheet
Location
 
Fair
Value
 
Derivatives designated as hedging instruments:
                
Interest rate contracts
Other Assets
 
$
243
 
Other Assets
 
$
424
 
Other Liabilities
 
$
3,277
 
Other Liabilities
 
$
2,305
 
                     
Derivatives not designated as hedging instruments:
                    
Interest rate contracts
Other Assets
 
$
5,552
 
Other Assets
 
$
5,241
 
Other Liabilities
 
$
5,859
 
Other Liabilities
 
$
5,492
 

Effect of Derivative Instruments on the Income Statement

The tables below present the effect of the Corporation’s derivative financial instruments on the Income Statement for the three and sixnine months ended JuneSeptember 30, 2012, and 2011.

Derivatives Not Designated as
Hedging Instruments under
ASC 815-10
Location of Gain (Loss)
Recognized Income on
Derivative
 
Amount of Gain (Loss)
Recognized Income on
Derivative
 
Amount of Gain (Loss)
Recognized Income on
Derivative
 
Location of Gain (Loss)
Recognized Income on
Derivative
 
Amount of Gain (Loss)
Recognized Income on
Derivative
 
Amount of Gain (Loss)
Recognized Income on
Derivative
 
  
Three Months Ended
June 30, 2012
 
Six Months Ended
 June 30, 2011
   
Three Months Ended
September 30, 2012
 
Nine Months Ended
 September 30, 2012
 
Interest rate contracts
Other income
 
$
(58
)
 
$
(55
)
Other income
 
$
(70
)
 
$
(125
)
            
Derivatives Not Designated as
Hedging Instruments under
ASC 815-10
Location of Gain (Loss)
Recognized Income on
Derivative
 
Amount of Gain (Loss)
Recognized Income on
Derivative
 
Amount of Gain (Loss)
Recognized Income on
Derivative
 
Location of Gain (Loss)
Recognized Income on
Derivative
 
Amount of Gain (Loss)
Recognized Income on
Derivative
 
Amount of Gain (Loss)
Recognized Income on
Derivative
 
  
Three Months Ended
June 30, 2011
 
Six Months Ended
June 30, 2011
   
Three Months Ended
September 30, 2011
 
Nine Months Ended
September 30, 2011
 
Interest rate contracts
Other income
 
$
(21
)
 
$
2
 
Other income
 
$
(95
)
 
$
(93
) 


The Corporation’s exposure to credit risk occurs because of nonperformance by its counterparties.  The counterparties approved by the Corporation are usually financial institutions, which are well capitalized and have credit ratings through Moody’s and/or Standard & Poor’s, at or above investment grade.  The Corporation’s control of such risk is through quarterly financial reviews, comparing mark-to-mark values with policy limitations, credit ratings and collateral pledging.
26
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)
NOTE 5.  Derivative Financial Instruments continued


Credit-risk-related Contingent Features

The Corporation also has agreements with certain of its derivative counterparties that contain a provision where if the Corporation fails to maintain its status as a well or adequate capitalized institution, then the Corporation could be required to terminate or fully collateralize all outstanding derivative contracts.

The Corporation has agreements with certain of its derivative counterparties that contain a provision where if the Corporation defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, the Corporation could also be declared in default on its derivative obligations.

As of JuneSeptember 30, 2012, the termination value of derivatives in a net liability position related to these agreements was $9,285,000.$10,567,000. As of JuneSeptember 30, 2012, the Corporation had minimum collateral posting thresholds with certain of its derivative counterparties and had posted collateral of $8,312,000.$9,337,000. If the Corporation had breached any of these provisions at JuneSeptember 30, 2012, it could have been required to settle its obligations under the agreements at their termination value.

28
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

Note 6.  Disclosures About Fair Value of Assets and Liabilities

The Corporation has adopted fair value accounting guidance that defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  This guidance defines fair value 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. This guidance also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1 Quoted prices in active markets for identical assets or liabilities

Level 2 Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in active markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities

Level 3 Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities

Recurring Measurements

The following table presents the fair value measurements of assets and liabilities recognized in the Consolidated Condensed Balance Sheets measured at fair value on a recurring basis and the level within the fair value hierarchy in which the fair value measurements fall at September 30, 2012, and December 31, 2011.

    Fair Value Measurements Using 
September 30, 2012 Fair Value 
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
 
Significant Other Observable
Inputs
(Level 2)
  
Significant
Unobservable
Inputs
(Level 3)
 
Available for sale securities:
          
U.S. Government-sponsored agency securities
 
$
4,782
   
$
4,782
    
State and municipal
  
161,017
    
142,798
  
$
18,219
 
U.S. Government-sponsored mortgage-backed securities
  
383,912
    
383,912
     
Corporate obligations
  
202
        
202
 
Equity securities
  
1,706
    
1,702
   
4
 
Interest rate swap asset
  
6,412
    
6,412
     
Interest rate cap
  
206
    
206
     
Interest rate swap liability
  
(10,406
)
   
(10,406
)
    
              

    Fair Value Measurements Using 
December 31, 2011 Fair Value 
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
 
Significant Other Observable
Inputs
(Level 2)
  
Significant
Unobservable
Inputs
(Level 3)
 
Available for sale securities:
          
U.S. Government-sponsored agency securities
 
$
117
   
$
117
    
State and municipal
  
147,353
    
126,712
  
$
20,641
 
U.S. Government-sponsored mortgage-backed securities
  
368,998
    
368,998
     
Corporate obligations
  
193
        
193
 
Equity securities
  
1,830
    
1,826
   
4
 
Interest rate swap asset
  
5,241
        
5,241
 
Interest rate cap
  
424
        
424
 
Interest rate swap liability
  
(7,797
)
       
(7,797
)
 
 
2729
 

FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

Note 6. Disclosures About Fair Value of Assets and Liabilities continued

Recurring Measurements

The following table presents the fair value measurements of assets and liabilities recognized in the Consolidated Condensed Balance Sheets measured at fair value on a recurring basis and the level within the fair value hierarchy in which the fair value measurements fall at June 30, 2012, and December 31, 2011.

     Fair Value Measurements Using 
June 30, 2012 
Fair
Value
  
Quoted Prices in Active
Markets for Identical
Assets (Level 1)
  
Significant Other
Observable
Inputs (Level 2)
  
Significant
Unobservable
Inputs (Level 3)
 
Available for sale securities:
            
U.S. Government-sponsored agency securities
 $4,933      $4,933    
State and municipal
  145,597       126,059  $19,538 
U.S. Government-sponsored mortgage-backed securities
  383,562       383,562     
Corporate obligations
  11,629       11,431   198 
Marketable equity securities
  1,830       1,826   4 
Interest rate swap asset
  5,552       5,552     
Interest rate cap
  243       243     
Interest rate swap liability
  (9,136)       (9,136     


     Fair Value Measurements Using 
December 31, 2011 
Fair
Value
  
Quoted Prices in Active
Markets for Identical
Assets (Level 1)
  
Significant Other
Observable
Inputs (Level 2)
  
Significant
Unobservable
Inputs (Level 3)
 
Available for sale securities:
            
U.S. Government-sponsored agency securities
 $17      $17    
State and municipal
  147,353       126,712  $20,641 
U.S. Government-sponsored mortgage-backed securities
  368,998       368,998     
Corporate obligations
  193           193 
Marketable equity securities
  1,830       1,826   4 
Interest rate swap asset
  5,241           5,241 
Interest rate cap
  424           424 
Interest rate swap liability
  (7,797)          (7,797)
28
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)
Note 6.  Disclosures About Fair Value of Assets and Liabilities continued

Following is a description of the valuation methodologies and inputs used for instruments measured at fair value on a recurring basis and recognized in the accompanying Consolidated Condensed Balance Sheets, as well as the general classification of such instruments pursuant to the valuation hierarchy.  There have been no significant changes in the valuation techniques during the sixnine months ended JuneSeptember 30, 2012.

Available for Sale Investment Securities

Where quoted, market prices are available in an active market and securities are classified within Level 1 of the valuation hierarchy. There are no securities classified within Level 1 of the hierarchy. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows. Level 2 securities include agencies, mortgage backs, state and municipal, corporate obligations and equity securities. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy. Level 3 fair value, including corporate obligations, state and municipal and equity securities, was determined using a discounted cash flow model that incorporated market estimates of interest rates and volatility in markets that have not been active.

Third party vendors compile prices from various sources and may apply such techniques as matrix pricing to determine the value of identical or similar investment securities classified within Level 2. Matrix pricing is a mathematical technique widely used in the banking industry to value investment securities without relying exclusively on quoted prices for specific investment securities but rather relying on the investment securities’ relationship to other benchmark quoted investment securities. Any investment security not valued based upon the methods above are considered Level 3.

Pooled Trust Preferred Securities

Pooled trust preferred securities in the portfolio amount to $5.9$6 million in amortized cost, with a fair value of $168,000;$171,000; all of which are classified as Level 3 inputs in the fair value hierarchy. These securities were rated A or better at inception, but at JuneSeptember 30, 2012, Moody’s ratings on these securities ranged from Ca to C. The issuers in these securities are primarily banks, but some of the pools do include a limited number of insurance companies. On a quarterly basis, the Corporation uses an other-than-temporary impairment (“OTTI”) evaluation process to compare the present value of expected cash flows to determine whether an adverse change in cash flows has occurred. The OTTI evaluation process considers the structure and term of the collateralized debt obligation (“CDO”), interest rates, principal balances of note classes and underlying issuers, the timing and amount of interest and principal payments of the underlying issuers, and the allocation of the payments to the note classes.  The current estimate of expected cash flows is based on the most recent trustee reports and any other relevant market information including announcements of interest payment deferrals or defaults of underlying trust preferred securities. Assumptions used in the evaluation process include expected future default rates and prepayments as well as recovery assumptions on defaults and deferrals. In addition, the process is used to “stress” each CDO, or make assumptions more severe than expected activity, to determine the degree to which assumptions could deteriorate before the CDO could no longer fully support repayment of the Corporation’s note class. Upon completion of the JuneSeptember 30, 2012, quarterly evaluation process, the conclusion was no additional OTTI impairment for the three and sixnine months ending JuneSeptember 30, 2012. The Corporation did not recognize any OTTI impairment for the three months ended JuneSeptember 30, 2011, but did recognize $400,000 of OTTI impairment for the sixnine months ended JuneSeptember 30, 2011.

 
2930
 

FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 6.  Disclosures About Fair Value of Assets and Liabilities continued

Level 3 Reconciliation

The following is a reconciliation of the beginning and ending balances of recurring fair value measurements recognized in the Consolidated Condensed Balance Sheets using significant unobservable (Level 3) inputs for the three and sixnine months ended JuneSeptember 30, 2012, and 2011.

 Three Months Ended June 30, 2012  Six Months Ended June 30, 2012  Three Months Ended September 30, 2012 Nine Months Ended September 30, 2012 
 
Available
for Sale
Securities
  
Interest
Rate Swap
Asset
  
Interest
Rate Cap
  
Interest
Rate Swap
Liability
  
Available
for Sale
Securities
  
Interest
Rate Swap
Asset
  
Interest
Rate Cap
  
Interest
Rate Swap
Liability
  
Available for
Sale
Securities
 
Interest
Rate Swap
Asset
 
Interest
Rate
Cap
 
Interest Rate
Swap
Liability
 
Available
for Sale
Securities
 
Interest
Rate Swap
Asset
 
Interest
Rate
Cap
 
Interest
Rate Swap
Liability
 
Balance at beginning of the period
 $19,878              $20,838  $5,241  $424  $(7,797) 
$
19,740
       
$
20,838
 
$
5,241
 
$
424
 
$
(7,797
)
Total realized and unrealized gains and losses:
                                                 
Included in net income (loss)
                      (860)      863            
(860
)
   
863
 
Included in other comprehensive income
  (238)              (761)  481   (15)     
(183
)
       
(944
)
 
481
 
(15
)
   
Purchases, issuances and settlements
                                                 
Transfers in/(out) of Level 3
                      (4,862)  (409)  6,934            
(4,862
)
 
(409
)
 
6,934
 
Principal payments/additions
  100               (337)              
(1,132
)
        
(1,469
)
          
Ending balance at June 30, 2012
 $19,740              $19,740             
Ending balance at September 30, 2012
 
$
18,425
       
$
18,425
          


 Three Months Ended June 30, 2011 Six Months Ended June 30, 2011  Three Months Ended September 30, 2011 Nine Months Ended September 30, 2011 
 
Available
for Sale
Securities
 
Interest
Rate Swap
Asset
 
Interest
Rate Cap
 
Interest
Rate Swap
Liability
 
Available
for Sale
Securities
 
Interest
Rate Swap
Asset
 
Interest
Rate Cap
 
Interest
Rate Swap
Liability
  
Available for
Sale
Securities
 
Interest
Rate Swap
Asset
 
Interest
Rate
Cap
 
Interest Rate Swap
Liability
 
Available
for Sale Securities
 
Interest
Rate Swap
Asset
 
Interest
Rate
Cap
 
Interest
Rate Swap Liability
 
Balance at beginning of the period
 
$
173
 
$
3,647
 
$
1,124
 
$
(3,379
)
 
$
186
 
$
4,002
 
$
1,109
 
$
(3,876
)
 
$
180
 
$
3,783
 
$
954
 
$
(3,986
)
 
$
186
 
$
4,002
 
$
1,109
 
$
(3,876
)
Total realized and unrealized gains and losses:
                                  
Included in net income (loss)
   
586
   
(607
)
 
(400
)
 
112
   
(110
)
   
3,251
   
(3,345
)
 
(400
)
 
3,363
   
(3,455
)
Included in other comprehensive income
 
(82
)
 
 
(450
)
 
 
(170
)
   
240
 
 
(331
)
 
 
(155
)
    
(45
)
 
(1,726
)
 
(498
)
   
195
 
(2,057
)
 
(653
)
   
Purchases, issuances and settlements
                                  
Transfers in/(out) of Level 3
                  
18,711
       
18,711
       
Principal payments
  
89
           
154
            
65
           
219
          
Ending balance at June 30, 2011
 
$
180
 
$
3,783
 
$
954
 
$
(3,986
)
 
$
180
 
$
3,783
 
$
954
 
$
(3,986
)
Ending balance at September 30, 2011
 
$
18,911
 
$
5,308
 
$
456
 
$
(7,331
)
 
$
18,911
 
$
5,308
 
$
456
 
$
(7,331
)


There were no gains or losses for the period included in earnings that were attributable to the changes in unrealized gains or losses related to assets or liabilities held at JuneSeptember 30, 2012 or December 31, 2011.

Transfers Between Levels

Transfer between Levels 1, 2 and 3 and the reasons for those transfers are as follows:

 
Quoted Prices in
Active Markets
for Identical
Assets
 (Level 1)
  
Significant
Other
Observable
Inputs
(Level 2)
  
Significant Unobservable
Inputs
 (Level 3)
 Reason for Transfer
Transfers from Level:
         
Interest rate swap asset
      
$
4,862
 
The interest rate swap and cap instruments were transferred from Level 3 to Level 2 as of March 31, 2012 due to the Corporation's additional analysis of valuation methodologies.  These instruments are valued using widely accepted valuation techniques including discounted cash flow analysis using observable inputs such as contractual terms and Libor-based rate curves.
Interest rate cap
       
409
 
Interest rate swap liability
        
6,934
 
Total Transfers from Level
       
$
12,205
  
            
Transfers to Level:
           
Interest rate swap asset
   
$
4,862
     
The interest rate swap and cap instruments were transferred from Level 3 to Level 2 as of March 31, 2012 due to the Corporation's additional analysis of valuation methodologies.  These instruments are valued using widely accepted valuation techniques including discounted cash flow analysis using observable inputs such as contractual terms and Libor-based rate curves.
Interest rate cap
    
409
     
Interest rate swap liability
    
6,934
     
Total Transfers to Level
   
$
12,205
      
  
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
  
Significant
Other
Observable
Inputs
(Level 2)
  
Significant
Unobservable
Inputs
(Level 3)
  
Transfers from Level:
          
Interest rate swap asset
         $4,862 The interest rate swap and cap instruments were transferred
Interest rate cap
          409 
from Level 3 to Level 2 as of March 31, 2012 due to the
Corporation's additional analysis of valuation methodologies.
These instruments are valued using widely accepted valuation
techniques including discounted cash flow analysis using
observable inputs such as contractual terms and Libor-based
rate curves.
Interest rate swap liability
          6,934  
Total Transfers from Level
         $12,205  
              
Transfers to Level:
             
Interest rate swap asset
     $4,862     The interest rate swap and cap instruments were transferred
Interest rate cap
      409     
from Level 3 to Level 2 as of March 31, 2012 due to the
Corporation's additional analysis of valuation methodologies.
These instruments are valued using widely accepted valuation
techniques including discounted cash flow analysis using
observable inputs such as contractual terms and Libor-based
rate curves.
Interest rate swap liability
      6,934      
Total Transfers to Level
     $12,205      

 
3031
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 6.  Disclosures About Fair Value of Assets and Liabilities continued

Nonrecurring Measurements

The following table presents the fair value measurement of assets and liabilities measured at fair value on a nonrecurring basis and the level within the fair value hierarchy in which the fair value measurements fall at JuneSeptember 30, 2012, and December 31, 2011.

    Fair Value Measurements Using    Fair Value Measurements Using 
June 30, 2012 Fair Value  
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
  
Significant Other
Observable
Inputs (Level 2)
  
Significant
Unobservable
Inputs (Level 3)
 
September 30, 2012 Fair Value 
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable
Inputs
(Level 2)
 
Significant Unobservable
Inputs
(Level 3)
 
Impaired loans
 $20,780          $20,780  
$
25,853
     
$
25,853
 
Other real estate owned (collateral dependent)
 $6,563          $6,563  
$
5,132
     
$
5,132
 


     Fair Value Measurements Using 
December 31, 2011 Fair Value  
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
  
Significant Other
Observable
Inputs (Level 2)
  
Significant
Unobservable
Inputs (Level 3)
 
Impaired loans
 $22,885          $22,885 
Other real estate owned (collateral dependent)
 $7,882          $7,882 
    Fair Value Measurements Using 
December 31, 2011 Fair Value 
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable
 Inputs
(Level 2)
 
Significant Unobservable
Inputs
(Level 3)
 
Impaired loans
 
$
22,885
     
$
22,885
 
Other real estate owned (collateral dependent)
 
$
7,882
     
$
7,882
 


Following is a description of valuation methodologies used for instruments measured at fair value on a nonrecurring basis and recognized in the Consolidated Condensed Balance Sheets, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Nonrecurring Measurements continued

Impaired Loans (collateral dependent) and Other Real Estate Owned

Loan impairment is reported when substantial doubt about the collectability of scheduled payments exists. Impaired loans are carried at the present value of estimated future cash flows using the loan’s existing rate, or the fair value of collateral if the loan is collateral dependent. A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance. If these allocations cause the allowance for loan losses to increase, such increase is reported as a component of the provision for loan losses. Loan losses are charged against the allowance when management believes the uncollectability of the loan is confirmed. During the first sixnine months of 2012, certain impaired loans were partially charged-off or re-evaluated. The valuation would be considered Level 3, consisting of appraisals of underlying collateral and discounted cash flow analysis.

The fair value for impaired loans and other real estate owned is measured based on the value of the collateral securing those loans or real estate and is determined using several methods. The fair value of real estate is generally determined based on appraisals by qualified licensed appraisers. The appraisers typically determine the value of the real estate by utilizing an income or market valuation approach. If an appraisal is not available, the fair value may be determined by using a cash flow analysis. Fair value on other collateral such as business assets is typically calculated by using financial information such as financial statements and aging reports provided by the borrower and is discounted as considered appropriate.

 
3132
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 6.  Disclosures About Fair Value of Assets and Liabilities continued

Unobservable (Level 3) Inputs

The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements, other than goodwill, at JuneSeptember 30, 2012.

 
Fair
Value
 Valuation Technique Unobservable Inputs Range  Fair Value Valuation TechniqueUnobservable Inputs Range 
                 
State and municipal securities
 $19,538 
Discounted cash flow
 
Maturity/Call date
 
1 month to 11 yrs
  
$
18,219
 
Discounted cash flow
Maturity/Call date
 
1 month to 11 yrs
 
      
Blend of US Muni BQ curve
 
A- to BBB-
     
Blend of US Muni BQ curve
 
A- to BBB-
 
      
Discount rate
 1% - 4%    
Discount rate
 
1% - 4
%
                  
Corporate obligations/ Marketable equity securities
 $202 
Discounted cash flow
 
                               Risk free rate
 
3 month libor
 
Corporate obligations/Equity securities
 
$
206
 
Discounted cash flow
                               Risk free rate
 
3 month libor
 
      
 plus Premium for illiquidity
 
plus 200bps
     
 plus Premium for illiquidity
 
plus 200bps
 
                  
Impaired loans (collateral dependent)
 $20,780 
Collateral based
 measurements
 
Discount to reflect current market
conditions and ultimate collectabilty
 0% - 50% 
$
25,853
 
Collateral based
Discount to reflect current market
 
0% - 50
%
             measurementsconditions and ultimate collectability   
        
Other real estate owned
 $6,563 
Appraisals
 
Discount to reflect current market conditions
 0% - 20% 
$
5,132
 
Appraisals
Discount to reflect current market
 
0% - 20
%
    conditions   

Sensitivity of Significant Unobservable Inputs

The following is a discussion of the sensitivity of significant unobservable inputs, the interrelationships between those inputs and other unobservable inputs used in recurring fair value measurement and of how those inputs might magnify or mitigate the effect of changes in the unobservable inputs on the fair value measurement.

State and Municipal Securities

The significant unobservable inputs used in the fair value measurement of the Corporation’s state and municipal securities are premiums for unrated securities and marketability discounts.  Significant increases or decreases in either of those inputs in isolation would result in a significantly lower or higher fair value measurement.  Generally, changes in either of those inputs will not affect the other input.

Corporate Obligations/Equity Securities

The significant unobservable inputs used in the fair value measurement of the Corporation’s corporate obligations/equity securities are premiums for unrated securities and marketability discounts.  Significant increases or decreases in either of those inputs in isolation would result in a significantly lower or higher fair value measurement.  Generally, changes in either of those inputs will not affect the other input.

 
3233
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 6.  Disclosures About Fair Value of Assets and Liabilities continued

Fair Value of Financial Instruments

The following table presents estimated fair values of the Corporation’s financial instruments and the level within the fair value hierarchy in which the fair value measurements fall at JuneSeptember 30, 2012, and December 31, 2011.

  September 30, 2012 
  (unaudited) 
  
Carrying
Amount
  
Quoted Prices in Active Markets
for Identical
Assets
  
Significant
Other
Observable
Inputs
  
Significant Unobservable
Inputs
 
  (Level 1)  (Level 2)  (Level 3) 
Assets:
            
Cash and due from banks
 
$
57,027
  
$
57,027
       
Interest-bearing time deposits
  
35,324
   
35,324
       
Investment securities available for sale
  
551,619
      
$
533,194
  
$
18,425
 
Investment securities held to maturity
  
377,097
       
385,155
   
11,062
 
Mortgage loans held for sale
  
27,711
       
27,711
     
Loans
  
2,766,831
           
2,793,212
 
Federal Reserve Bank and Federal Home Loan Bank stock
  
32,824
       
32,824
     
Interest rate swap asset
  
6,618
       
6,618
     
Interest receivable
  
17,519
       
17,519
     
Liabilities:
                
Deposits
 
$
3,194,751
  
$
2,292,977
  
$
902,678
     
Borrowings:
                
Federal funds purchased
  
57,024
       
57,024
     
Securities sold under repurchase agreements
  
153,454
       
154,017
     
Federal Home Loan Bank advances
  
145,467
       
148,985
     
Subordinated debentures, revolving credit lines and term loans
  
112,169
       
67,837
     
Interest rate swap liability
  
10,406
       
10,405
     
Interest payable
  
1,591
       
1,591
     

 June 30, 2012  December 31, 2011 
 (unaudited)  (unaudited) 
 
Carrying
Amount
  
Quoted Prices in Active Markets
for Identical
Assets
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
  
Carrying
Amount
  
Quoted Prices in Active Markets
for Identical
Assets
 
Significant
Other
Observable
Inputs
 
Significant Unobservable
Inputs
 
 (Level 1) (Level 2) (Level 3)  (Level 1) (Level 2) (Level 3) 
Assets:
                  
Cash and due from banks
 
$
68,493
 
$
68,493
      
$
73,312
 
$
73,312
     
Interest-bearing time deposits
 
41,760
 
41,760
      
52,851
 
52,851
     
Investment securities available for sale
 
547,551
   
$
527,811
 
$
19,740
  
518,491
   
$
497,653
 
$
20,838
 
Investment securities held to maturity
 
396,770
   
400,173
 
13,074
  
427,909
   
428,737
 
13,732
 
Mortgage loans held for sale
 
15,278
   
15,278
    
17,864
   
17,864
   
Loans
 
2,727,491
     
2,756,565
  
2,642,517
     
2,658,227
 
Federal Reserve Bank and Federal Home Loan Bank stock
 
33,033
   
33,033
    
31,270
   
31,270
   
Interest rate swap asset
 
5,795
   
5,795
    
5,665
     
5,665
 
Interest receivable
 
16,506
   
16,506
    
17,723
   
17,723
   
Liabilities:
                  
Deposits
 
$
3,288,898
 
$
2,343,492
 
$
946,039
    
$
3,134,655
 
$
2,195,679
 
$
944,078
   
Borrowings:
                  
Federal funds purchased
 
652
   
652
   
Securities sold under repurchase agreements
 
160,127
   
160,728
    
156,305
   
157,342
   
Federal Home Loan Bank advances
 
96,847
   
100,031
    
138,095
   
141,693
   
Subordinated debentures, revolving credit lines and term loans
 
115,951
   
68,852
    
194,974
   
142,632
   
Interest rate swap liability
 
9,136
   
9,136
    
7,797
     
$ 
7,797
 
Interest payable
 
2,168
   
2,168
    
2,925
   
2,925
   
  December 31, 2011 
  (unaudited) 
  
Carrying
Amount
  
Quoted Prices in
Active Markets
for Identical
Assets
  
Significant
Other
Observable
Inputs
  
Significant
Unobservable
Inputs
 
  (Level 1)  (Level 2)  (Level 3) 
Assets:
            
Cash and due from banks
 
$
73,312
  
$
73,312
       
Interest-bearing time deposits
  
52,851
   
52,851
       
Investment securities available for sale
  
518,491
      
$
497,653
  
$
20,838
 
Investment securities held to maturity
  
427,909
       
428,737
   
13,732
 
Mortgage loans held for sale
  
17,864
       
17,864
     
Loans
  
2,642,517
           
2,658,227
 
Federal Reserve Bank and Federal Home Loan Bank stock
  
31,270
       
31,270
     
Interest rate swap asset
  
5,665
           
5,665
 
Interest receivable
  
17,723
       
17,723
     
Liabilities:
                
Deposits
 
$
3,134,655
  
$
2,195,679
  
$
944,078
     
Borrowings:
                
Securities sold under repurchase agreements
  
156,305
       
157,342
     
Federal Home Loan Bank advances
  
138,095
       
141,693
     
Subordinated debentures, revolving credit lines and term loans
  
194,974
       
142,632
     
Interest rate swap liability
  
7,797
           
7,797
 
Interest payable
  
2,925
       
2,925
     


The following methods were used to estimate the fair value of all other financial instruments recognized in the Consolidated Condensed Balance Sheets at amounts other than fair value.

Cash and due from banks:  The fair value of cash and cash equivalents approximates carrying value.
33
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)
NOTE 6. Disclosures About Fair Value of Assets and Liabilities continued

Interest-bearing time deposits:  The fair value of interest-bearing time deposits approximates carrying value.

Investment securities:  Fair value is based on quoted market prices, if available.  If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Mortgage Loans Held For Sale:  The carrying amount approximates fair value due to the insignificant time between origination and date of sale.

34
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 6.  Disclosures About Fair Value of Assets and Liabilities continued

Loans:  The fair value for loans is estimated using discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.  See Impaired Loans above.

Federal Reserve and Federal Home Loan Bank stock:  The fair value of Federal Reserve Bank and Federal Home Loan Bank stock is based on the price which it may be resold to the Federal Reserve and Federal Home Loan Bank.

Derivative instruments:  The fair value of the derivatives reflects the estimated amounts that would have been received to terminate these contracts at the reporting date based upon pricing or valuation models applied to current market information.  Interest rate caps are valued using the market standard methodology of discounting the future expected cash receipts that would occur if variable interest rates rose above the strike rate of the caps.  The projected cash receipts on the caps are based on an expectation of future interest rates derived from observed market interest rate curves and volatilities.

Interest Receivable and Interest Payable:  The carrying amount approximates fair value.

Deposits:  The fair values of noninterest-bearing and interest-bearing demand accounts and savings deposits are equal to the amount payable on demand at the balance sheet date. The carrying amounts for variable rate, fixed-term certificates of deposit approximate their fair values at the balance sheet date. Fair values for fixed-rate certificates of deposit and other time deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered to a schedule of aggregated expected monthly maturities on such time deposits.

Federal funds purchased:  The carrying amount approximates fair value.

Borrowings:  The fair value of borrowings is estimated using a discounted cash flow calculation, based on current rates for similar debt.


NOTE 7.  Share-Based Compensation

Stock options and restricted stock awards ("RSAs") have been issued to directors, officers and other management employees under the Corporation's 1999 Long-term Equity Incentive Plan and the 2009 Long-term Equity Incentive Plan.  The stock options, which have a ten-year life, become 100 percent vested ranging from threesix months to two years and are fully exercisable when vested. Option exercise prices equal the Corporation's common stock closing price on NASDAQ on the date of grant.  RSAs provide for the issuance of shares of the Corporation's common stock at no cost to the holder and generally vest after three years.  The RSAs vest only if the employee is actively employed by the Corporation on the vesting date and, therefore, any unvested shares are forfeited.  Deferred stock units ("DSUs") can be credited to non-employee directors who have elected to defer payment of compensation under the Corporation's 2008 Equity Compensation Plan for Non-employee Directors.  DSUs credited are equal to the restricted shares that the non-employee director would have received under the plan.  As of JuneSeptember 30, 2012, there were no outstanding DSUs.

The Corporation’s 2009 Employee Stock Purchase Plan (“ESPP”) provides eligible employees of the Corporation and its subsidiaries an opportunity to purchase shares of common stock of the Corporation through quarterly offerings financed by payroll deductions. The price of the stock to be paid by the employees shall be equal to 85 percent of the average of the closing price of the Corporation’s common stock on each trading day during the offering period. However, in no event shall such purchase price be less than the lesser of an amount equal to 85 percent of the market price of the Corporation’s stock on the offering date or an amount equal to 85 percent of the market value on the date of purchase. Common stock purchases are made quarterly and are paid through advance payroll deductions up to a calendar year maximum of $25,000.

 
3435
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)

NOTE 7.  Share-Based Compensation continued

The Corporation’s 2009 Employee Stock Purchase Plan (“ESPP”) provides eligible employees of the Corporation and its subsidiaries an opportunity to purchase shares of common stock of the Corporation through quarterly offerings financed by payroll deductions. The price of the stock to be paid by the employees shall be equal to 85 percent of the average of the closing price of the Corporation’s common stock on each trading day during the offering period. However, in no event shall such purchase price be less than the lesser of an amount equal to 85 percent of the market price of the Corporation’s stock on the offering date or an amount equal to 85 percent of the market value on the date of purchase. Common stock purchases are made quarterly and are paid through advance payroll deductions up to a calendar year maximum of $25,000.

Compensation expense related to unvested share-based awards is recorded by recognizing the unamortized grant date fair value of these awards over the remaining service periods of those awards, with no change in historical reported fair values and earnings. Awards are valued at fair value in accordance with provisions of share-based compensation guidance and are recognized on a straight-line basis over the service periods of each award. To complete the exercise of vested stock options, RSA’s and ESPP options, the Corporation generally issues new shares from its authorized but unissued share pool. Share-based compensation for the three months and sixnine months ended JuneSeptember 30, 2012, was $360,000$415,000 and $686,000,$1,101,000, respectively compared to $350,000$290,000 and $718,000$1,009,000 for the three months and sixnine months ended JuneSeptember 30, 2011. Share-based compensation has been recognized as a component of salaries and benefits expense in the accompanying CONSOLIDATED CONDENSED STATEMENTS OF INCOME.

The estimated fair value of the stock options granted during 2012 and in prior years was calculated using a Black Scholes option pricing model.  The following summarizes the assumptions used in the 2012 Black Scholes model:

Risk-free interest rate
1.36%
1.36%
Expected price volatility
46.22%
46.22%
Dividend yield
3.29%
3.29%
Forfeiture rate
4.77%
4.77%
Weighted-average expected life, until exercise
7.2 years
years


The Black Scholes model incorporates assumptions to value share-based awards. The risk-free rate of interest, for periods equal to the expected life of the option, is based on a U.S. government instrument over a similar contractual term of the equity instrument. Expected price volatility is based on historical volatility of the Corporation’s common stock.  In addition, the Corporation generally uses historical information to determine the dividend yield and weighted-average expected life of the options until exercise. Separate groups of employees that have similar historical exercise behavior with regard to option exercise timing and forfeiture rates are considered separately for valuation and attribution purposes.

Share-based compensation expense recognized in the CONSOLIDATED CONDENSED STATEMENTS OF INCOME is based on awards ultimately expected to vest and is reduced for estimated forfeitures. Share-based compensation guidance requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods, if actual forfeitures differ from those estimates. Pre-vesting forfeitures were estimated to be approximately 4.8 percent for the sixnine months ended JuneSeptember 30, 2012, based on historical experience.
35
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)
NOTE 7. Share-Based Compensation continued

The following table summarizes the components of the Corporation's share-based compensation awards recorded as expense:

 Three Months Ended Six Months Ended  Three Months Ended Nine Months Ended 
 June 30, June 30,  September 30, September 30, 
 2012 2011 2012 2011  2012 2011 2012 2011 
Stock and ESPP Options
                  
Pre-tax compensation expense
 
$
80
 
$
38
 
$
126
 
$ 
109
  
$
71
 
$
56
 
$
197
 
$ 
165
 
Income tax benefit
  
(2
)
     
(2
)
  
(1
) 
  
(11
)
  
(7
)
  
(13
)
  
(8
)
Stock and ESPP option expense, net of income taxes
 
$
78
 
$
38
 
$
124
 
$
108
  
$
60
 
$
49
 
$
184
 
$
157
 
Restricted Stock Awards
                  
Pre-tax compensation expense
 
$
280
 
$
312
 
$
560
 
 $
609
  
$
344
 
$
234
 
$
904
 
$
844
 
Income tax benefit
  
(112
)
  
(111
)
  
(218
)
  
(213
) 
  
(104
)
  
(76
)
  
(322
)
  
(289
)
Restricted stock awards expense, net of income taxes
 
$
168
 
$
201
 
$
342
 
$
396
  
$
240
 
$
158
 
$
582
 
$
555
 
Total Share-Based Compensation:
                  
Pre-tax compensation expense
 
$
360
 
$
350
 
$
686
 
$
718
  
$
415
 
$
290
 
$
1,101
 
$
1,009
 
Income tax benefit
  
(114
)
  
(111
)
  
(220
)
  
(214
)
  
(115
)
  
(83
)
  
(335
)
  
(297
)
Total share-based compensation expense, net of income taxes
 
$
246
 
$
239
 
$
466
 
$
504
  
$
300
 
$
207
 
$
766
 
$
712
 

36
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands, except per share amounts)
(Unaudited)

NOTE 7.  Share-Based Compensation continued

As of JuneSeptember 30, 2012, unrecognized compensation expense related to stock options and RSAs totaling $133,000$132,000 and $2,182,000,$2,053,000, respectively, is expected to be recognized over weighted-average periods of 1.14.84 and 1.651.52 years, respectively.

Stock option activity under the Corporation's stock option plans as of JuneSeptember 30, 2012 and changes during the sixnine months ended JuneSeptember 30, 2012, were as follows:

 
Number of
Shares
 
Weighted-
Average
Exercise Price
 
Weighted Average
Remaining Contractual
Term (in Years)
 
Aggregate
Intrinsic
Value
  
Number of
Shares
 Weighted-Average Exercise Price 
Weighted Average Remaining
Contractual Term
(in Years)
 
Aggregate
Intrinsic
Value
 
Outstanding at January 1, 2012
 
1,035,871
 
$
22.57
      
1,035,871
 
$
22.57
     
Granted/ Converted
 
33,301
 
$
11.38
      
46,801
 
$
11.69
     
Exercised
 
(8,750
)
 
$
7.69
     
Cancelled
  
(2,768
)
 
$
19.00
       
(165,536
)
 
$
25.87
     
Outstanding June 30, 2012
  
1,066,404
 
$
22.23
  
4.53
  
609,772
 
Vested and Expected to Vest at June 30, 2012
 
1,066,404
 
$
22.23
 
4.05
 
609,772
 
Exercisable at June 30, 2012
 
999,104
 
$
23.04
 
4.18
 
462,023
 
Outstanding September 30, 2012
  
908,386
 
$
21.55
  
4.33
  
1,097,884
 
Vested and Expected to Vest at September 30, 2012
 
908,386
 
$
21.55
 
4.33
 
1,097,884
 
Exercisable at September 30, 2012
 
830,336
 
$
22.58
 
3.89
 
760,073
 


The weighted-average grant date fair value was $3.86$3.97 for stock options granted during the sixnine months ended JuneSeptember 30, 2012.

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Corporation's closing stock price on the last trading day of the first sixnine months of 2012 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 stock options on JuneSeptember 30, 2012.  The amount of aggregate intrinsic value will change based on the fair market value of the Corporation's common stock.    There were noThe aggregate intrinsic value of stock options exercised during the first sixnine months of 2012.2012 was $46,000. Cash receipts of stock options exercised during this same period were $67,000.

The following table summarizes information on unvested RSAs outstanding as of JuneSeptember 30, 2012:

 
Number of
Shares
 
Weighted-Average
Grant Date Fair Value
  
Number of
Shares
 
Weighted-Average
Grant Date Fair Value
 
Unvested RSAs at January 1, 2012
 
338,087
 
$
8.65
  
338,087
 
$
8.65
 
Granted
 
140,733
 
$
11.43
  
156,473
 
$
11.79
 
Forfeited
 
(2,350
)
 
$
7.73
  
(8,800
)
 
$
9.63
 
Vested
  
(73,470
)
 
$
12.30
   
(79,386
)
 
$
11.90
 
Unvested RSAs at June 30, 2012
  
403,000
 
$
8.94
 
Unvested RSAs at September 30, 2012
  
406,374
 
$
9.18
 
36
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)
NOTE 7. Share-Based Compensation continued

The grant date fair value of ESPP options was estimated at the beginning of the AprilJuly 1, 2012 quarterly offering period of approximately $45,400.$22,000. The ESPP options vested during the three months ending JuneSeptember 30, 2012, leaving no unrecognized compensation expense related to unvested ESPP options at JuneSeptember 30, 2012.

37
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands, except per share amounts)
(Unaudited)

NOTE 8.  Income Tax

 Three Months Ended Six Months Ended  Three Months Ended Nine Months Ended 
 June 30, June 30,  September 30, September 30, 
 2012 2011 2012 2011  2012 2011 2012 2011 
Income Tax Expense :
                  
Currently Payable:
                  
Federal
 
$
518
 
$
(450
)
 
$
1,336
 
$
(902
)
 
$
139
 
$
47
 
$
1,475
 
$
(855
)
State
                  
Deferred:
                  
Federal
 
2,770
 
1,846
 
7,452
 
4,697
  
3,787
 
2,514
 
11,239
 
7,211
 
State
                          
Total Income Tax Expense
 
$
3,288
 
$
1,396
 
$
8,788
 
$
3,795
  
$
3,926
 
$
2,561
 
$
12,714
 
$
6,356
 
                  
Reconciliation of Federal Statutory to Actual Tax Expense:
                  
Federal statutory income tax at 35%
 
$
4,372
 
$
2,409
 
$
11,327
 
$
5,160
  
$
5,307
 
$
3,256
 
$
16,634
 
$
8,416
 
Tax-exempt interest income
 
(930
)
 
(961
)
 
(1,861
)
 
(1,877
)
 
(927
)
 
(916
)
 
(2,788
)
 
(2,793
)
Non-deductible interest expense
   
210
   
419
    
230
   
649
 
Stock compensation
 
26
 
13
 
42
 
37
  
14
 
19
 
56
 
56
 
Earnings on life insurance
 
(231
)
 
(200
)
 
(714
)
 
(402
)
 
(240
)
 
(208
)
 
(954
)
 
(610
)
Tax credits
 
(18
)
 
(13
)
 
(36
)
 
(26
)
 
(19
)
 
(29
)
 
(55
)
 
(55
)
Other
  
69
  
(62
)
  
30
  
484
   
(209
)
  
209
  
(179
)
  
693
 
Actual Tax Expense
 
$
3,288
 
$
1,396
 
$
8,788
 
$
3,795
  
$
3,926
 
$
2,561
 
$
12,714
 
$
6,356
 


NOTE 9.  Net Income Per Share

Basic net income per share is computed by dividing net income by the weighted-average shares outstanding during the reporting period. Diluted net income per share is computed by dividing net income by the combination of all dilutive common share equivalents, comprised of shares issuable under the Corporation’s share-based compensation plans, and the weighted-average shares outstanding during the reporting period.

Dilutive common share equivalents include the dilutive effect of in-the-money share-based awards, which are calculated based on the average share price for each period using the treasury stock method. Under the treasury stock method, the exercise price of share-based awards, the amount of compensation expense, if any, for future service that the Corporation has not yet recognized, and the amount of estimated tax benefits that would be recorded in additional paid-in capital when share-based awards are exercised, are assumed to be used to repurchase common stock in the current period.

  Three Months Ended June 30, 
  2012  2011 
  
Net
Income
  
Weighted-
Average
Shares
  
Per
Share
Amount
  
Net
Income
  
Weighted-
Average
Shares
  
Per
Share
Amount
 
Basic net income per share:
 
$
9,205
        
$
5,488
       
Preferred Stock dividends and discount accretion
  
(1,135
) 
        
(990
) 
      
Net income available to common stockholders
 
$
8,070
   
28,624,609
  
$
0.28
  
$
4,498
   
25,656,826
  
$
0.18
 
Effect of dilutive stock options and warrants
      
190,410
           
125,973
     
Diluted net income (loss) per share:
                        
Net income available to common stockholders
 
$
8,070
   
28,815,019
  
$
0.28
  
$
4,498
   
25,782,799
  
$
0.18
 
  Three Months Ended September 30, 
  2012  2011 
  Net Income  Weighted-Average Shares  
Per Share
Amount
  
Net Income
(Loss)
  Weighted-Average Shares  
Per Share
Amount
 
Basic net income (loss) per share:
 
$
11,236
        
$
6,742
       
Loss on extinguishment of trust preferred securities
            
(10,857
)
      
Loss on CPP unamortized discount
            
(1,401
)
      
Less: Preferred Stock dividends and discount accretion
  
(1,134
)
        
(868
)
      
Net income (loss) available to common stockholders
  
10,102
   
28,649,996
  
$
0.35
   
(6,384
)
  
26,367,067
  
$
(0.25
)
Effect of dilutive stock options and warrants
      
238,080
                 
Diluted net income (loss) per share:
                        
Net income (loss) available to common stockholders
 
$
10,102
   
28,888,076
  
$
0.35
  
$
(6,384
)
  
26,367,067
  
$
(0.25
)

 
3738
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)thousands, except per share amounts)
(Unaudited)

NOTE 9.  Net Income Per Share continued

Stock options to purchase 890,642770,001 and 1,033,5461,008,957 shares for the three months ended JuneSeptember 30, 2012, and 2011, respectively, were not included in the earnings per share calculation because the exercise price exceeded the average market price.

 Six Months Ended June 30,  Nine Months Ended September 30, 
 2012 2011  2012 2011 
 
Net
Income
 
Weighted-
Average
Shares
 
Per
Share
Amount
 
Net
Income
 
Weighted-
Average
Shares
 
Per
Share
Amount
  Net Income Weighted-Average Shares 
Per Share
Amount
 Net Income Weighted-Average Shares 
Per Share
Amount
 
Basic net income per share:
 
$
23,576
     
$
10,949
      
$
34,812
     
$
17,691
     
Preferred Stock dividends and discount accretion
  
2,270
      
1,978
     
Loss on extinguishment of trust preferred securities
     
(10,857
)
     
Loss on CPP unamortized discount
     
(1,401
)
     
Less: Preferred Stock dividends and discount accretion
  
(3,404
)
      
(2,846
)
     
Net income available to common stockholders
 
$
21,306
  
28,603,612
 
$
0.74
 
$
8,971
  
25,631,340
 
$
0.35
   
31,408
  
28,619,186
 
$
1.09
  
2,587
  
25,879,277
 
$
0.10
 
Effect of dilutive stock options and warrants
     
178,430
        
141,523
         
200,097
        
139,659
    
Diluted net income (loss) per share:
                          
Net income available to common stockholders
 
$
21,306
  
28,782,042
 
$
0.74
 
$
8,971
  
25,772,863
 
$
0.35
  
$
31,408
  
28,819,283
 
$
1.09
 
$
2,587
  
26,018,936
 
$
0.10
 


Stock options to purchase 881,661846,499 and 1,026,1771,024,775 shares for the sixnine months ended JuneSeptember 30, 2012, and 2011, respectively, were not included in the earnings per share calculation because the exercise price exceeded the average market price.


NoteNOTE 10.  Impact of Accounting Changes

ASU No. 2011-03, “Transfers and Servicing (Topic 860) – Reconsideration of Effective Control for Repurchase Agreements.” ASU 2011-03 is intended to improve financial reporting of repurchase agreements and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. ASU 2011-03 removes from the assessment of effective control (i) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (ii) the collateral maintenance guidance related to that criterion. ASU 2011-03 became effective for the Corporation on January 1, 2012 and did not have a significant impact on the Corporation’s financial statements.
ASU 2011-04, “Fair Value Measurement (Topic 820) – Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRSs.”  ASU 2011-04 amends Topic 820, “Fair Value Measurements and Disclosures,” to converge the fair value measurement guidance in U.S. generally accepted accounting principles and International Financial Reporting Standards. ASU 2011-04 clarifies the application of existing fair value measurement requirements, changes certain principles in Topic 820 and requires additional fair value disclosures. ASU 2011-04 became effective for the Corporation on January 1, 2012 and, aside from new disclosures included in Note 6 – Disclosures About Fair Value of Assets and Liabilities, did not have a significant impact on the Corporation’s financial statements.
ASU 2011-05, “Comprehensive Income (Topic 220) – Presentation of Comprehensive Income.” ASU 2011-05 amends Topic 220, “Comprehensive Income,” to require that all non-owner changes in stockholders’ equity be presented in either a single continuous statement of comprehensive income or in two separate but consecutive statements. Additionally, ASU 2011-05 requires entities to present, on the face of the financial statements, reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement or statements where the components of net income and the components of other comprehensive income are presented. The option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity was eliminated. ASU 2011-05 became effective for the Corporation on January 1, 2012; however, certain provisions related to the presentation of reclassification adjustments have been deferred by ASU 2011-12 “Comprehensive Income (Topic 220)  –  Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05,” as further discussed below. In connection with the application of ASU 2011-05, the Corporation’s financial statements now include separate statements of comprehensive income.
38
FIRST MERCHANTS CORPORATION
FORM 10Q
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Table dollars in thousands)
(Unaudited)
Note 10.  Impact of Accounting Changes continued

ASU 2011-08, “Intangibles – Goodwill and Other (Topic 350) – Testing Goodwill for Impairment.” ASU 2011-08 amends Topic 350, “Intangibles – Goodwill and Other,” to give entities the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if an entity concludes otherwise, then it is required to perform the first step of the two-step impairment test by calculating the fair value of the reporting unit and comparing the fair value with the carrying amount of the reporting unit. ASU 2011-08 became effective for the Corporation on January 1, 2012 and did not have a significant impact on the Corporation’s financial statements.
ASU 2011-11, “Balance Sheet (Topic 210) – “Disclosures about Offsetting Assets and Liabilities.” ASU 2011-11 amends Topic 210, “Balance Sheet,” to require an entity to disclose both gross and net information about financial instruments, such as sales and repurchase agreements and reverse sale and repurchase agreements and securities borrowing/lending arrangements, and derivative instruments that are eligible for offset in the statement of financial position and/or subject to a master netting arrangement or similar agreement. ASU 2011-11 is effective for annual and interim periods beginning on January 1, 2013, and is not expected to have a significant impact on the Corporation’s financial statements.
ASU 2011-12, “Comprehensive“Comprehensive Income (Topic 220) – Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.”  In December 2011 the FASB issued Accounting Standards Update 2011-12, Comprehensive Income (Topic 220):  Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.  This ASU 2011-12 defers the changes in ASU No.Update 2011-05 that relate to the presentation of reclassification adjustments to allow the FASB time to redeliberate whether to require presentation of such adjustments on the face of the financial statements to show the effects of reclassifications out of accumulated other comprehensive income on the components of net incomeincome. This ASU is effective for public entities for fiscal years, and other comprehensive income.interim periods within those years, beginning after December 15, 2011.  For nonpublic entities this ASU 2011-12 allows entities to continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before ASU No. 2011-05. All other requirements in ASU No. 2011-05 are not affected by ASU No. 2011-12.is effective for fiscal years ending after December 15, 2012. ASU 2011-12 became effective for the Corporation on January 1, 2012 and did not have a significant impact on the Corporation’s financial statements.

ASU 2012-02, “Intangibles – Goodwill and Other (Topic 350).”  In July 2012, the FASB issued Accounting Standards Update 2012-02, Intangibles – Goodwill and Other:  Testing Indefinite-Lived Intangible Assets for Impairment.  The amendments in this ASU allow an entity to first assess qualitative factors to determine whether it is necessary to perform a quantitative impairment test.  An entity would not be required to calculate the fair value of an indefinite-live intangible asset unless the entity determines, bases on qualitative assessment, that it is more likely than not, the indefinite-lived intangible asset is impaired.  This ASU is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, and is not expected to have a significant impact on the Corporation’s financial statements.  Early adoption is permitted.

ASU 2012-04, “Technical Corrections and Improvements.”  In October 2012, the FASB issued Accounting Standards Update 2012-04, Technical Corrections and Improvements.  The amendments in this ASU make technical corrections, clarifications and limited-scope improvements to various Topics throughout the Codification.  This ASU is effective for public entities for fiscal periods beginning after December 15, 2012 and is not expected to have a significant impact on the Corporation’s financial statements.

 
39
 
 
FIRST MERCHANTS CORPORATIONNOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FORM 10Q
(Table dollars in thousands)
(Unaudited)

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

From time to time, we include forward-looking statements in our oral and written communication. We may include forward-looking statements in filings with the Securities and Exchange Commission, such as this Form 10-Q, in other written materials and in oral statements made by senior management to analysts, investors, representatives of the media and others. We intend these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and we are including this statement for purposes of these safe harbor provisions. Forward-looking statements can often be identified by the use of words like “believe”, “continue”, “pattern”, “estimate”, “project”, “intend”, “anticipate”,  “expect” and similar expressions or future or conditional verbs such as “will”, “would”,  “should”,  “could”,  “might”, “can”, “may”, or similar expressions. These forward-looking statements include:

statements of our goals, intentions and expectations;

statements regarding our business plan and growth strategies;

statements regarding the asset quality of our loan and investment portfolios; and

estimates of our risks and future costs and benefits.

These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, the following important factors which could affect the actual outcome of future events:

fluctuations in market rates of interest and loan and deposit pricing, which could negatively affect our net interest margin, asset valuations and expense expectations;

adverse changes in the economy, which might affect our business prospects and could cause credit-related losses and expenses;

adverse developments in our loan and investment portfolios;

competitive factors in the banking industry, such as the trend towards consolidation in our market;

changes in the banking legislation or the regulatory requirements of federal and state agencies applicable to bank holding companies and banks like our affiliate banks;

acquisitions of other businesses by us and integration of such acquired businesses;

changes in market, economic, operational, liquidity, credit and interest rate risks associated with our business; and

the continued availability of earnings and excess capital sufficient for the lawful and prudent declaration and payment of cash dividends.

Because of these and other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements. In addition, our past results of operations do not necessarily indicate our anticipated future results.

 
40
 

FIRST MERCHANTS CORPORATION
FORM 10Q
ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CRITICAL ACCOUNTING POLICIES

Generally accepted accounting principles are complex and require us to apply significant judgments to various accounting, reporting and disclosure matters. We must use assumptions and estimates to apply these principles where actual measurement is not possible or practical. For a complete discussion of our significant accounting policies, see “Notes to the Consolidated Financial Statements” in our Annual Report on Form 10-K for the year ended December 31, 2011. Certain policies are considered critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements. We have reviewed the application of these policies with the Audit Committee of our Board of Directors.

We believe there have been no significant changes during the sixnine months ended JuneSeptember 30, 2012, to the items that we disclosed as our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2011.


BUSINESS SUMMARY

First Merchants Corporation (the “Corporation”) is a financial holding company headquartered in Muncie, Indiana and was organized in September 1982. The Corporation’s Common Stock is traded on NASDAQ’s Global Select Market System under the symbol FRME. The Corporation has one full-service bank charter, First Merchants Bank, National Association (the “Bank”), which opened for business in Muncie, Indiana, in March 1893. The Bank also operates Lafayette Bank and Trust, Commerce National Bank and First Merchants Trust Company as divisions of First Merchants Bank, N.A.  The Bank includes seventy-nine banking locations in twenty-four Indiana and two Ohio counties. In addition to its branch network, the Corporation’s delivery channels include ATMs, check cards, remote deposit capture, interactive voice response systems and internet technology. The Corporation’s business activities are currently limited to one significant business segment, which is community banking.

Through the Bank, the Corporation offers a broad range of financial services, including accepting time deposits, savings and demand deposits; making consumer, commercial, agri-business and real estate mortgage loans; renting safe deposit facilities; providing personal and corporate trust services; providing full-service brokerage; and providing other corporate services, letters of credit and repurchase agreements.

The Corporation also operates First Merchants Insurance Services, Inc., operating as First Merchants Insurance Group, a full-service property, casualty, personal lines, and employee benefit insurance agency headquartered in Muncie, Indiana.

 
41
 

FIRST MERCHANTS CORPORATION
FORM 10Q
ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

RESULTS OF OPERATIONS

Executive Summary

First Merchants Corporation reported net income available to common stockholders of $8.1$10.1 million, or $0.28$0.35 per fully diluted common share for the quarter ended JuneSeptember 30, 2012, an increase of $3.6$16.5 million, compared to a net incomeloss available to common stockholders of $4.5$6.4 million, or $0.18$(0.25) per common share for the quarter ended JuneSeptember 30, 2011.

Net income available to common stockholders for the sixnine months ended JuneSeptember 30, 2012 was $21.3$31.4 million, or $0.74$1.09 per fully diluted common share, compared to net income available to common stockholders of $9.0$2.6 million, or $0.35$0.10 per fully diluted common share for the sixnine months ended JuneSeptember 30, 2011.

In the third quarter of 2011, an after-tax loss of $12.3 million, or $.47 per share, was recorded due to the accounting treatment for the extinguishment of trust preferred securities.  The extinguishment of the trust preferred securities was done in conjunction with the redemption of 69,600 shares of the Corporation’s fixed rate cumulative perpetual preferred stock, under the Capital Purchase Program, for $69.6 million, the issuance of 90,783 shares of the Corporation’s senior non-cumulative perpetual preferred stock, through the Small Business Lending Fund, for $90.8 million, and the issuance of 2.8 million of the Corporation’s common stock for $20.8 million.

On February 10, 2012, the Bank assumed substantially all the deposits and certain other liabilities and acquired certain assets of SCB Bank, from the FDIC as the receiver of SCB Bank. This transaction generated a pre-tax gain of $9.1 million, or $0.21 per common share after tax.  Details of this transaction are included in NOTE 2.  PURCHASE AND ASSUMPTION, included within the Notes to Consolidated Condensed Financial Statements of this Form 10-Q.

As of JuneSeptember 30, 2012, total assets equaled $4.2$4.3 billion, an increase of $59.3$77.1 million from December 31, 2011.  The three most significant assets acquired through the SCB transaction were cash and due from banks of $29.1 million, loans of $93.8 million and securities of approximately $18.9 million.

The Corporation’s allowance for loan losses totaled $70.1$69.5 million as of JuneSeptember 30, 2012.  The allowance provides 111.1121.9 percent coverage of all non-accrual loans and 2.492.43 percent of total loans.  Provision expense totaled $4.5$4.6 million for the three months ended JuneSeptember 30, 2012, compared to $5.6 million in the three months ended JuneSeptember 30, 2011.  Net charge-offs totaled $4.8$5.3 million for the secondthird quarter of 2012, down from $9.4$9.6 million for the secondthird quarter of 2011.  The decline in the provision expense for the three months ended JuneSeptember 30, 2012 compared to the same period in 2011 was directionally consistent with the improvements in non-performing and adversely classified loans.  Additional details are discussed within the “PROVISION/ALLOWANCE FOR LOAN LOSSES” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-Q.

Taxes, both current and deferred, decreased from December 31, 2011 by $4.4$7.1 million, mainly due to the temporary difference related to the $9.1 million gain on the FDIC modified whole bank transaction.transaction and a lower deferred tax asset associated with the reduction in the allowance for loan losses.

Deposits increased from December 31, 2011 by $154.2$60.1 million.  As part of the SCB transaction, the Bank assumed deposits of $125.9 million.  Excess liquidity was used to pay off maturing FHLB Advances of $41.2 million.  In addition, The Bank also completed repayment of $79$79.0 million of Senior Notes (the “Notes”) that matured on March 30, 2012.  The Notes were originally issued by the Bank on March 31, 2009 and were guaranteed by the FDIC under its Temporary Liquidity Guarantee Program.  Additionally, on August 22, 2012 the Corporation exercised its option to redeem the $4,124,000 subordinated debenture associated with the CNBC Statutory Trust I.  The redemption price premium was 104.59.  The debenture had carried a fixed interest rate of 10.2 percent.

The Corporation was able to maintain all regulatory capital ratios in excess of the regulatory definition of “well-capitalized” as discussed in the “CAPITAL” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-Q.

NET INTEREST INCOME

Net interest income is the primary source of the Corporation’s earnings.  Net interest margin is a function of net interest income and the level of average earning assets. Net interest income and net interest margin are presented in the following table on a fully taxable equivalent basis (“FTE”), which adjusts tax-exempt or nontaxable interest income to an amount that would be comparable to interest subject to income taxes using the federal statutory tax rate of 35 percent in effect for all periods.  Net interest margin increased 1230 basis pointpoints from 3.994.02 percent in the secondthird quarter of 2011 to 4.114.32 percent in the secondthird quarter of 2012, while earning assets increased by $86.5$114.7 million.

42
ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

NET INTEREST INCOME continued

The increased net interest income during the three months ended JuneSeptember 30, 2012 compared with the same period in 2011 was driven by two primary factors.  The first factor is a higher level of earning assets and interest income resulting from the assumption of SCB loans moreand related fair value accretion recognized in interest income.  Additional details of which can be found in NOTE 2.  PURCHASE AND ASSUMPTION, included within the Notes to Consolidated condensed Financial Statements of this Form 10-Q.  The second factor contributing to the improvement in the net interest margin, expressed as a percentage of earning assets, was largely the result of the Corporation’s ability to lower its cost of funds and in particular its cost of deposits.  Also, contributingdeposits, due to the improvement was  the growth of the Corporation’s non-interest bearing demand deposits and interest-bearing non-maturity deposits.
42
FIRST MERCHANTS CORPORATION
FORM 10Q
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
NET INTEREST INCOME continued

During the sixnine months ended JuneSeptember 30, 2012, asset yields decreased 3226 basis points FTE and interest costs decreased 4041 basis points, resulting in an 8a 15 basis point FTE increase in net interest income as compared to the same period in 2011.  The following table presents the Corporation’s interest income, interest expense, and net interest income as a percent of average earning assets for the three and sixnine months ended JuneSeptember 30, 2012, and 2011.

 Three Months Ended Six Months Ended  Three Months Ended Nine Months Ended 
 June 30, June 30,  September 30, September 30, 
(Dollars in Thousands) 2012 2011 2012 2011  2012 2011 2012 2011 
Annualized net interest income
 
$
152,210
 
$
143,389
 
$
148,337
 
$
142,649
  
$
159,611
 
$
143,402
 
$
152,095
 
$
142,900
 
Annualized FTE adjustment
 
$
5,758
 
$
5,993
 
$
5,765
 
$
5,856
  
$
5,707
 
$
5,633
 
$
5,746
 
$
5,781
 
Annualized net interest income on a fully taxable equivalent basis
 
$
157,968
 
$
149,382
 
$
154,102
 
$
148,505
  
$
165,318
 
$
149,035
 
$
157,841
 
$
148,681
 
Average earning assets
 
$
3,837,738
 
$
3,751,241
 
$
3,813,587
 
$
3,747,738
  
$
3,829,127
 
$
3,714,401
 
$
3,818,805
 
$
3,736,503
 
Interest income (FTE) as a percent of average earning assets
 
4.75
%
 
5.04
%
 
4.75
%
 
5.07
%
 
4.89
%
 
5.01
%
 
4.79
%
 
5.05
%
Interest expense as a percent of average earning assets
 
0.64
%
 
1.05
%
 
0.71
%
 
1.11
%
 
0.57
%
 
0.99
%
 
0.66
%
 
1.07
%
Net interest income (FTE) as a percent of average earning assets
 
4.11
%
 
3.99
%
 
4.04
%
 
3.96
%
 
4.32
%
 
4.02
%
 
4.13
%
 
3.98
%


Average earning assets include the average balance of securities classified as available for sale, computed based on the average of the historical amortized cost balances without the effects of the fair value adjustment.  Annualized amounts are computed utilizing a 30/360 day basis.

NON-INTEREST INCOME

Non-interest income increased $2.1$1.0 million or 19.07.9 percent in the secondthird quarter of 2012, compared to the secondthird quarter of 2011.  The largest increasesprimary reason for the increase during the secondthird quarter of 2012 werewas increased mortgage origination volume which resulted in an increase in the gains on the sale of mortgage loans insurance commissions and interchange income from electronic card transactions totaling $1,284,000, $461,000 and $459,000$1.1 million more than the secondthird quarter of 2011 respectively.  The increases in gains on the sale of mortgage loans and electronic card transactions were volume driven while the increase in insurance commissions resulted from second quarter 2011 reflecting a one-time negative adjustment.2011.

During the first sixnine months of 2012, non-interest income increased $12.9$13.9 million or 56.338.6 percent over the same period onin 2011.  The largest item contributing to the increase was a gross purchase gain of $9.1 million recognized from the purchase of certain assets and assumption of certain liabilities of SCB Bank.  See NOTE 2. PURCHASE AND ASSUMPTION in the Notes to Consolidated Condensed Financial Statements included of this Form 10-Q for additional discussion of this transaction.

Additionally, $1,363,000 more gains on the sale of mortgage loans and $689,000 more interchange income from electronic card transactions was realizedincreased $2.4 million due to increased mortgage origination volume in the first six months of 2012 than in the same period of 2011.  The increase in gains on the sale of mortgage loans resulted from a higher volume of mortgage originations over the same period in 2011.  The interchange income from electronic card transactions was due to increased customer volumes from prior periods.  Also,In 2012, $576,000 was received in the first sixnine months of 2012 from a Bank Owned Life Insurance death benefit, while none was received in the first sixnine months of 2011.
Also, an increase of $740,000 from more interchange income from electronic card transactions was realized in the first nine months of 2012 than the same period of 2011 due to increased customer volumes.

NON-INTEREST EXPENSE

Non-interest expenses decreased $219,000increased $182,000 or 0.60.5 percent in the secondthird quarter of 2012, compared to the secondthird quarter of 2011.  Salaries and employee benefits increased by $1.1 million or 5.8 percent$119,000 over the same period in 2011.  Base salaries were up $49,000 or 0.4 percent,$351,000 less than the same period in 2011, while commissions and incentives increased $489,000 and temporary employee expense increased $254,000$1.1 million over the same quarter last year.  Employee health insurance and retirement plan expenses increased $301,000 and $178,000, respectively,decreased $1.0 million when compared to the secondthird quarter of 2011.  TheIncreases were also noted in equipment and other expenses of $136,000 and $457,000, respectively, mainly due to expenses associated with the integration of the Shelbyville acquisition into our core business platform.  A portion of the increase in salaries and benefitsother expenses was offset by declines in core deposit intangible amortizationalso due to a prepayment penalty of $621,000, FDIC expenses of $589,000 and credit$184,000 related expenses of $721,000, from the second quarter of 2011 to the second quarterearly payoff of 2012.$4.1 million in subordinated debentures.  See the “LIQUIDITY” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-Q for additional information related to this reduction in borrowings.

 
43
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

NON-INTEREST EXPENSE continued

The increases mentioned above were offset by declines in core deposit intangible amortization of $266,000 and FDIC expenses of $409,000, from the third quarter of 2011 to the third quarter of 2012.

During the first sixnine months of 2012, non-interest expense decreased $72,000 or 0.1 percent$110,000 when compared to the first sixnine months of 2011.  Salaries and employee benefits increased by $3.3$3.4 million or 9.16.1 percent over the same period in 2011.  Base salaries were up $343,000 or 1.4 percent,down $7,000, while commissions and incentives increased $1,178,000$2.3 million and temporary employee expenseexpenses associated with the Shelbyville acquisition increased $456,000$567,000 over the same period last year.  Employee health insurance and retirement plan expenses also increased $1,107,000 and $495,000, respectively,$743,000 when compared to the first sixnine months of 2011.

Additionally, other expenses were $1.6 million higher than the same period in 2011 due to expenses associated with the integration of the Shelbyville acquisition into our core business platform.  A portion of the increase in other expenses was also due to a prepayment penalty of $184,000 related to the early payoff of $4.1 million in subordinated debentures.  See the “LIQUIDITY” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-Q for additional information related to this reduction in borrowings.

The increase in salaries and benefits and other expenses was offset by declines in core deposit intangible amortization of $1,253,000,$1.5 million, FDIC expenses of $1,576,000$2.0 million and credit related expenses of $1,730,000,$1.6 million, from the first sixnine months of 2011 to the first sixnine months of 2012.

INCOME TAX

The income tax expense for the sixnine months ended JuneSeptember 30, 2012, was $8,788,000$12,714,000 on pre-tax net income of $32,364,000.$47,526,000.  For the same period in 2011, the income tax expense was $3,795,000$6,356,000 on pre-tax net income of $14,744,000.$24,047,000.   Additional details are discussed within the “Results of Operations” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-Q.

CAPITAL

Capital adequacy is an important indicator of financial stability and performance.  The Corporation maintained a strong capital position as tangible common equity to tangible assets was 7.277.51 percent at JuneSeptember 30, 2012, and 6.84 percent at December 31, 2011.

The Corporation and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies and are assigned to a capital category.  The assigned capital category is largely determined by three ratios that are calculated according to the regulations: total risk-based capital, Tier 1 capital, and Tier 1 leverage ratios. The ratios are intended to measure capital relative to assets and credit risk associated with those assets and off-balance sheet exposures of the entity.  The capital category assigned to an entity can also be affected by qualitative judgments made by regulatory agencies about the risk inherent in the entity's activities that are not part of the calculated ratios.  At JuneSeptember 30, 2012, the management of the Corporation believes that it meets all capital adequacy requirements to which it is subject. The most recent notifications from the regulatory agencies categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.

There are five capital categories defined in the regulations, ranging from well capitalized to critically undercapitalized. Classification of a bank in any of the undercapitalized categories can result in actions by regulators that could have a material effect on a bank's operations.

To be considered well capitalized, a bank must have a total risk-based capital ratio of at least 10 percent, a Tier I capital ratio of at least 6 percent, a Tier 1 leverage ratio of at least 5 percent, and must not be subject to any order or directive requiring the bank to improve its capital level.  An adequately capitalized bank has a total risk-based capital ratio of a least 8 percent, a Tier I capital ratio of at least 4 percent and a Tier 1 leverage ratio of at least 4 percent.  Banks with lower capital levels are deemed to be undercapitalized, significantly undercapitalized or critically undercapitalized, depending on their actual levels.  The appropriate federal regulatory agency may also downgrade a bank to the next lower capital category upon a determination that the bank is in an unsafe or unsound practice.  Banks are required to monitor closely their capital levels and to notify their appropriate regulatory agency of any basis for a change in capital category.

 
44
 

FIRST MERCHANTS CORPORATION
FORM 10Q
ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAPITAL continued

As of JuneSeptember 30, 2012, the Corporation, on a consolidated basis, as well as the Bank, exceeded the minimum capital levels of the well capitalized category.

 June 30, 2012 December 31, 2011  September 30, 2012 December 31, 2011 
(Dollars in Thousands) Amount Ratio Amount Ratio  Amount Ratio Amount Ratio 
Consolidated
                  
Total risk-based capital (to risk-weighted assets)
 
$
507,202
 
16.75
%
 
$
487,393
 
16.54
%
 
$
517,552
 
16.62
%
 
$
487,393
 
16.54
%
Tier 1 capital (to risk-weighted assets)
 
438,947
 
14.49
%
 
410,132
 
13.92
%
 
448,239
 
14.39
%
 
410,132
 
13.92
%
Tier 1 capital (to average assets)
 
438,947
 
10.73
%
 
410,132
 
10.17
%
 
448,239
 
10.98
%
 
410,132
 
10.17
%
                  
First Merchants Bank
                  
Total risk-based capital (to risk-weighted assets)
 
$
492,117
 
16.28
%
 
$
477,805
 
16.26
%
 
$
507,609
 
16.31
%
 
$
477,805
 
16.26
%
Tier 1 capital (to risk-weighted assets)
 
454,148
 
15.02
%
 
440,909
 
15.00
%
 
468,311
 
15.04
%
 
440,909
 
15.00
%
Tier 1 capital (to average assets)
 
454,148
 
11.11
%
 
440,909
 
10.96
%
 
468,311
 
11.49
%
 
440,909
 
10.96
%


Tier I regulatory capital consists primarily of total stockholders’ equity and subordinated debentures issued to business trusts categorized as qualifying borrowings, less non-qualifying intangible assets and unrealized net securities gains or losses.

Management believes that all of the above capital ratios are meaningful measurements for evaluating the safety and soundness of the Corporation. Additionally, management believes the following table is also meaningful when considering performance measures of the Corporation. The table details and reconciles tangible earnings per share, return on tangible capital and tangible assets to traditional GAAP measures.

 June 30, December 31,  September 30, December 31, 
(Dollars in Thousands, Except Per Share Amounts) 2012 2011  2012 2011 
Average goodwill
 
$
141,357
 
$
141,357
  
$
141,357
 
$
141,357
 
Average core deposit intangible (CDI)
 
8,877
 
10,655
  
8,826
 
10,655
 
Average deferred tax on CDI
  
(2,212
)
  
(2,458
)
  
(2,200
)
  
(2,458
)
Intangible adjustment
 
$
148,022
 
$
149,554
  
$
147,983
 
$
149,554
 
Average stockholders' equity (GAAP capital)
 
$
524,693
 
$
478,440
  
$
530,165
 
$
478,440
 
Average cumulative preferred stock
 
(125
)
 
(125
)
 
(125
)
 
(125
)
Average non-cumulative preferred stock issued under the Small Business Lending Fund Program
 
(90,783
)
 
(74,181
)
 
(90,783
)
 
(74,181
)
Intangible adjustment
  
(148,022
)
  
(149,554
)
  
(147,983
)
  
(149,554
)
Average tangible capital
 
$
285,763
 
$
254,580
  
$
291,274
 
$
254,580
 
Average assets
 
$
4,226,432
 
$
4,143,850
  
$
4,230,009
 
$
4,143,850
 
Intangible adjustment
  
(148,022
)
  
(149,554
)
  
(147,983
)
  
(149,554
)
Average tangible assets
 
$
4,078,410
 
$
3,994,296
  
$
4,082,026
 
$
3,994,296
 
Net income available to common stockholders
 
$
21,306
 
$
9,013
  
$
31,408
 
$
9,013
 
CDI amortization, net of tax
  
537
  
2,112
   
809
  
2,112
 
Tangible net income available to common stockholders
 
$
21,843
 
$
11,125
  
$
32,217
 
$
11,125
 
          
Per Share Data:
          
Diluted net income available to common stockholders
 
$
0.74
 
$
0.34
  
$
1.09
 
$
0.34
 
Diluted tangible net income available to common stockholders
 
$
0.76
 
$
0.42
  
$
1.12
 
$
0.42
 
          
Ratios:
          
Return on average GAAP capital (ROE)
 
8.12
%
 
1.88
%
 
7.90
%
 
1.88
%
Return on average tangible capital
 
15.29
%
 
4.37
%
 
14.75
%
 
4.37
%
Return on average assets (ROA)
 
1.01
%
 
0.22
%
 
0.99
%
 
0.22
%
Return on average tangible assets
 
1.07
%
 
0.28
%
 
1.05
%
 
0.28
%


Return on average tangible capital is tangible net income available to common stockholders (annualized) expressed as a percentage of average tangible capital.  Return on average tangible assets is tangible net income available to common stockholders (annualized) expressed as a percentage of average tangible assets.

 
45
 

FIRST MERCHANTS CORPORATION
FORM 10Q
ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

LOAN QUALITY/PROVISION FOR LOAN LOSSES

The Corporation’s primary business focus is small business and middle market commercial, residential real estate, auto and small consumer lending, which results in portfolio diversification.  Commercial loans are individually underwritten and judgmentally risk rated.  They are periodically monitored and prompt corrective actions are taken on deteriorating loans.  Retail loans are typically underwritten with statistical decision-making tools and are managed throughout their life cycle on a portfolio basis.

The allowance for loan losses is maintained through the provision for loan losses, which is a charge against earnings. The amount provided for loan losses and the determination of the adequacy of the allowance are based on a continuous review of the loan portfolio, including an internally administered loan “watch” list and an ongoing loan review. The evaluation takes into consideration identified credit problems, as well as the possibility of losses inherent in the loan portfolio that are not specifically identified.

Non-performing loansloan balances will change as a result of routine problem loan recognition and resolution through collections, sales or charge offs. The performance of any loan can be affected by external factors such as economic conditions, or factors particular to a borrower, such as actions of a borrower’s management.

Non-accrual loans decreased by $6,465,000$12,593,000 during the sixnine months ended JuneSeptember 30, 2012, from $69,592,000 at December 31, 2011 to the JuneSeptember 30, 2012, balance of 63,127,000..$56,999,000. In addition, other real estate owned declined $2,106,000$2,509,000 during the same period.  For other real estate owned, current appraisals are obtained to determine value as management continues to aggressively market these real estate assets. Accruing loans delinquent 90 or more days were $665,000$1,974,000 at JuneSeptember 30, 2012, up slightly from $580,000 at December 31, 2011.

 June 30, December 31,  September 30, December 31, 
(Dollars in Thousands) 2012 2011  2012 2011 
Non-Performing Assets:
          
Non-accrual loans
 
$
63,127
 
$
69,592
  
$
56,999
 
$
69,592
 
Renegotiated loans
  
3,921
  
14,308
   
6,871
  
14,308
 
Non-performing loans (NPL)
 
67,048
 
83,900
  
63,870
 
83,900
 
Other real estate owned
  
14,183
  
16,289
   
13,780
  
16,289
 
Non-performing assets (NPA)
 
81,231
 
100,189
  
77,650
 
100,189
 
90+ days delinquent and still accruing
 
665
 
580
   
1,974
  
580
 
NPAs & 90+ days delinquent
 
$
81,896
 
$
100,769
  
$
79,624
 
$
100,769
 
Impaired Loans
 
$
81,241
 
$
79,775
  
$
79,965
 
$
79,775
 


Commercial Impaired loans include all non-accrual loans, loans accounted for under SOP-03-3 and renegotiated loans as well as substandard, doubtful and loss grade loans that were still accruing but deemed impaired according to guidance set forth in ASC 310.  Also included in impaired loans are accruing loans that are contractually past due 90 days or more. A loan is deemed impaired when, based on current information or events, it is probable that all amounts due of principal and interest according to the contractual terms of the loan agreement will not be collected.

A loan is deemed impaired when, based on current information or events, it is probable that all amounts due of principal and interest according to the contractual terms of the loan agreement will not be collected substantially within the contractual terms of the note.  At JuneSeptember 30, 2012, commercial impaired loans totaled $81,241,000,$79,965,000, a decrease of $13,149,000$1,276,000 from the March 31,June 30, 2012, balance of $94,390,000, but$81,241,000, and up slightly from the December 31, 2011 balance of $79,775,000.  The primary driver of the increase from December 31, 2011 is$79,775,000 despite the addition of the purchased loans discussed in NOTE 2. PURCHASE AND ASSUMPTION included in the Notes to Consolidated Condensed Financial Statements of this Form 10-Q. At JuneSeptember 30, 2012, an allowance for losses was not deemed necessary for commercial impaired loans totaling $62,880,000$60,470,000 as there was no identified loss on these credits. An allowance of $5,201,000$6,251,000 was recorded for the remaining balance of these impaired loans totaling $18,361,000$19,495,000 and is included in the corporation’s allowance for loan losses.

 
46
 

FIRST MERCHANTS CORPORATION
FORM 10Q
ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

LOAN QUALITY/PROVISION FOR LOAN LOSSES continued

The composition of non-performing assets plus 90-days delinquent is reflected in the following table.

 June 30, December 31,  September 30, December 31, 
(Dollars in Thousands) 2012 2011  2012 2011 
Non Performing Assets and 90+ Days Delinquent:
          
Commercial and industrial loans
 
$
14,086
 
$
13,725
  
$
13,731
 
$
13,725
 
Agricultural production financing and other loans to farmers
      
300
   
Real estate loans:
          
Construction
 
14,921
 
17,784
  
12,377
 
17,784
 
Commercial and farm land
 
32,982
 
46,985
  
31,564
 
46,985
 
Residential
 
17,171
 
18,398
  
18,731
 
18,398
 
Home Equity
 
2,238
 
3,142
  
2,460
 
3,142
 
Individual's loans for household and other personal expenditures
 
146
 
162
  
119
 
162
 
Other loans
  
352
  
573
   
342
  
573
 
Non performing assets plus 90+ days delinquent
 
$
81,896
 
$
100,769
  
$
79,624
 
$
100,769
 


At JuneSeptember 30, 2012, the allowance for loan losses was $70,143,000,$69,493,000, a decrease of $226,000$650,000 from March 31,June 30, 2012. As a percent of loans, the allowance was 2.43 percent at September 30, 2012, 2.49 percent at June 30, 2012, 2.50 percent at March 31, 2012 and 2.60 percent at December 31, 2011. The provision for loan losses for the three months ended JuneSeptember 30, 2012 was $4,545,000,$4,609,000, a decrease of $1,080,000$947,000 from $5,625,000$5,556,000 for the same period in 2011. The continued improvement in credit quality, primarily the declines in loans graded substandard, doubtful and loss, contributed to the decrease in provision expense.  Specific reserves, on impaired loans including residential mortgage, increased $181,000$175,000 from $5,895,000$6,076,000 at March 31,June 30, 2012, to $6,076,000$6,251,000 at JuneSeptember 30, 2012.

Net charge offs for the three months ended JuneSeptember 30, 2012, were $4,771,000,$5,259,000, a decrease of $4,657,000$4,356,000 from the same period in 2011.  Of this amount, $1,839,000, or 38.5a single charge off, totaling 9.8 percent of net charge offs, was made up of two customer charge offs of moregreater than $500,000.   The distribution of the net charge offs for the three and nine months ended JuneSeptember 30, 2012 and JuneSeptember 30, 2011 is reflected in the following table:

 Three Months Ended Six Months Ended  Three Months Ended Nine Months Ended 
 June 30, June 30,  September 30, September 30, 
(Dollars in Thousands) 2012 2011 2012 2011  2012 2011 2012 2011 
Net Charge Offs (Recoveries):
                  
Commercial and industrial loans
 
$
2,137
 
$
(5,428
)
 
$
4,343
 
$
(4,920
)
 
$
923
 
$
3,238
 
$
5,266
 
$
(1,682
)
Agricultural production financing and other loans to farmers
 
(6
)
 
(75
)
 
(20
)
 
(156
)
 
(3
)
 
(68
)
 
(23
)
 
(224
)
Real estate loans:
                  
Construction
 
(471
)
 
2,602
 
(328
)
 
5,190
  
433
 
640
 
105
 
5,830
 
Commercial and farm land
 
2,495
 
10,234
 
4,142
 
13,673
  
2,408
 
3,985
 
6,550
 
17,658
 
Residential
 
442
 
2,111
 
1,210
 
2,990
  
1,571
 
1,720
 
2,781
 
4,710
 
Individual's loans for household and other personal expenditures
 
197
 
(14
)
 
310
 
295
  
(51
)
 
103
 
259
 
398
 
Lease financing receivables, net of unearned income
   
(2
)
 
(1
)
 
(3
)
   
(1
)
 
(1
)
 
(4
)
Other Loans
  
(23
)
     
519
  
(6
)
  
(22
)
  
(2
)
  
497
  
(8
)
Total Net Charge Offs
 
$
4,771
 
$
9,428
 
$
10,175
 
$
17,063
  
$
5,259
 
$
9,615
 
$
15,434
 
$
26,678
 


The declines in the value of commercial and residential real estate in our market over the last couple of years has had a negative impact on the underlying collateral value in our commercial, residential, land development and construction loans. Management continually evaluates commercial borrowers by including consideration of specific borrower cash flow analysis and estimated collateral values, types and amounts on non-performing loans, past and anticipated loan loss experience, changes in the composition of the loan portfolio, and the current condition and amount of loans outstanding. The determination of the provision in any period is based on management’s continuing review and evaluation of the loan portfolio, and its judgment as to the impact of current economic conditions on the portfolio.

 
47
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

LIQUIDITY

Liquidity management is the process by which we ensure that adequate liquid funds are available for the holding company and its subsidiaries.  These funds are necessary in order to meet financial commitments on a timely basis.  These commitments include withdrawals by depositors, funding credit obligations to borrowers, paying dividends to stockholders, paying operating expenses, funding capital expenditures, and maintaining deposit reserve requirements.  Liquidity is monitored and closely managed by the asset/liability committee.
 
The Corporation’s liquidity is dependent upon our receipt of dividends from the Bank, which is subject to certain regulatory limitations and access to other funding sources.  Liquidity of the Bank is derived primarily from core deposit growth, principal payments received on loans, the sale and maturity of investment securities, net cash provided by operating activities, and access to other funding sources.

The most stable source of liability-funded liquidity for both the long-term and short-term is deposit growth and retention in the core deposit base.  In addition, Federal Home Loan Bank (“FHLB”) advances are utilized as funding sources.  At JuneSeptember 30, 2012, total borrowings from the FHLB were $96,847,000.$145,467,000.  The Bank has pledged certain mortgage loans and investments to the FHLB.  The total available remaining borrowing capacity from the FHLB at JuneSeptember 30, 2012, was $227,319,000.$168,223,000.

On March 30, 2012, the Bank completed repayment of $79,000,000 of Senior Notes (the “Notes”) that had matured.  The Notes, which were originally issued by the Bank on March 31, 2009, were guaranteed by the FDIC under its Temporary Liquidity Guarantee Program (“TLGP”).

On August 22, 2012, the Corporation exercised its option to redeem the $4,124,000 subordinated debenture associated with the CNBC Statutory Trust I.  The redemption price premium was 104.59.  The debenture had carried a fixed interest rate of 10.2 percent.

The principal source of asset-funded liquidity is investment securities classified as available for sale, the market values of which totaled $547,551,000$551,619,000 at JuneSeptember 30, 2012, an increase of $29,060,000,$33,128,000, or 5.66.4 percent, from December 31, 2011.  Securities classified as held to maturity that are maturing within a short period of time can also be a source of liquidity.  Securities classified as held to maturity that are maturing in one year or less, totaled $3,345,000$2,425,000 at JuneSeptember 30, 2012.  In addition, other types of assets such as cash and due from banks, federal funds sold, and securities purchased under agreements to resell, loans and interest-bearing deposits with other banks maturing within one year are sources of liquidity.

The Corporation currently has a $55.0 million credit facility with Bank of America, N.A., comprised of (a) a term loan in the principal amount of $5.0 million (the “Term Loan”) and (b) a subordinated debenture in the principal amount of $50.0 million (the “Subordinated Debt”).  Pursuant to the terms of the underlying Loan Agreement (the “Loan Agreement”), the Term Loan and the Subordinated Debt each mature on February 15, 2015.  The Term Loan is secured by a pledge of all of the issued and outstanding shares of the Bank.

The Loan Agreement contains certain customary representations and warranties and financial and negative covenants.   A breach of any of these covenants could result in a default under the Loan Agreement.   As of JuneSeptember 30, 2012, the Corporation was in compliance with these financial covenants.

As of December 31, 2011, the Corporation failed to meet the minimum return on average total assets covenant of at least 0.75 percent.  The Loan Agreement provides that upon an event of default as the result of the Corporation’s failure to comply with a financial covenant, Bank of America may (a) declare the $5.0 million outstanding principal amount of the Term Loan immediately due and payable, (b) exercise all of its rights and remedies at law, in equity and/or pursuant to any or all collateral documents, including foreclosing on the collateral if payment of the Term Loan is not made in full, and (c) add a default rate of 3 percent per annum to the Term Loan.  Because the Subordinated Debt is treated as Tier 2 capital for regulatory capital purposes, the Loan Agreement does not provide Bank of America with any right of acceleration or other remedies with regard to the Subordinated Debt upon an event of default caused by the Corporation’s breach of a financial covenant. Bank of America chose to apply the default rate through March 31, 2012, but not to accelerate the Term Loan based on the Corporation’s failure to meet these financial covenants.  As of March 31, 2012, the Corporation was no longer in default due to breach of a financial covenant; therefore, the default rate of 3 percent per annum was notno longer applied to the Term Loan for the three months ended June 30, 2012.Loan.

In the normal course of business, the Bank is a party to a number of other off-balance sheet activities that contain credit, market and operational risk that are not reflected in whole or in part in our consolidated financial statements.  Such activities include traditional off-balance sheet credit-related financial instruments, commitments under operating leases and long-term debt.

 
48
 

FIRST MERCHANTS CORPORATION
FORM 10Q
ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

LIQUIDITY continued

The Bank provides customers with off-balance sheet credit support through loan commitments and standby and commercial letters of credit. Summarized credit-related financial instruments at JuneSeptember 30, 2012, are as follows:

 June 30,  September 30, 
(Dollars in Thousands) 2012  2012 
Amounts of commitments:
      
Loan commitments to extend credit
 
$
873,834
  
$
883,783
 
Standby and commercial letters of credit
  
22,208
   
22,006
 
 
$
896,042
  
$
905,789
 


Since many of the commitments are expected to expire unused or be only partially used, the total amount of unused commitments in the preceding table does not necessarily represent future cash requirements.

In addition to owned banking facilities, the Corporation has entered into a number of long-term leasing arrangements to support ongoing activities.  The required payments under such commitments and borrowings at JuneSeptember 30, 2012, are as follows:

(Dollars in Thousands) 
Remaining
2012
 2013 2014 2015 2016 2017 
2018 and
after
 Total  
Remaining
2012
 2013 2014 2015 2016 2017 
2018 and
after
 Total 
Operating leases
 
$
1,262
 
$
2,258
 
$
1,995
 
$
1,790
 
$
1,424
 
$
849
 
$
1,429
 
$
11,007
  
$
630
 
$
2,239
 
$
1,980
 
$
1,790
 
$
1,424
 
$
849
 
$
1,428
 
$
10,340
 
Federal funds purchased
 
652
             
652
  
57,024
             
57,024
 
Securities sold under repurchase agreements
 
150,127
   
10,000
         
160,127
  
143,454
   
10,000
         
153,454
 
Federal Home Loan Bank advances
 
2,238
 
1,624
 
26,506
 
31,066
 
29,025
 
2,826
 
3,562
 
96,847
  
51,124
 
1,621
 
26,506
 
30,993
 
29,025
 
2,734
 
3,464
 
145,467
 
Subordinated debentures and term loans
  
125
        
55,000
        
60,826
  
115,951
   
467
        
55,000
        
56,702
  
112,169
 
Total
 
$
154,404
 
$
3,882
 
$
38,501
 
$
87,856
 
$
30,449
 
$
3,675
 
$
65,817
 
$
384,584
  
$
252,699
 
$
3,860
 
$
38,486
 
$
87,783
 
$
30,449
 
$
3,583
 
$
61,594
 
$
478,454
 


INTEREST SENSITIVITY AND DISCLOSURE ABOUT MARKET RISK

Asset/Liability Management has been an important factor in the Corporation's ability to record consistent earnings growth through periods of interest rate volatility and product deregulation. Management and the Board of Directors monitor the Corporation's liquidity and interest sensitivity positions at regular meetings to review how changes in interest rates may affect earnings.  Decisions regarding investment and the pricing of loan and deposit products are made after analysis of reports designed to measure liquidity, rate sensitivity, the Corporation’s exposure to changes in net interest income given various rate scenarios and the economic and competitive environments.

It is the objective of the Corporation to monitor and manage risk exposure to net interest income caused by changes in interest rates.  It is the goal of the Corporation’s Asset/Liability function to provide optimum and stable net interest income. To accomplish this, management uses two asset liability tools. GAP/Interest Rate Sensitivity Reports and Net Interest Income Simulation Modeling are constructed, presented and monitored quarterly.

Net interest income simulation modeling, or earnings-at-risk, measures the sensitivity of net interest income to various interest rate movements. The Corporation's asset liability process monitors simulated net interest income under three separate interest rate scenarios; base, rising and falling. Estimated net interest income for each scenario is calculated over a 12-month horizon. The immediate and parallel changes to the base case scenario used in the model are presented below. The interest rate scenarios are used for analytical purposes and do not necessarily represent management's view of future market movements. Rather, these are intended to provide a measure of the degree of volatility interest rate movements may introduce into the earnings of the Corporation.

The base scenario is highly dependent on numerous assumptions embedded in the model, including assumptions related to future interest rates. While the base sensitivity analysis incorporates management's best estimate of interest rate and balance sheet dynamics under various market rate movements, the actual behavior and resulting earnings impact will likely differ from that projected. For certain assets, the base simulation model captures the expected prepayment behavior under changing interest rate environments. Assumptions and methodologies regarding the interest rate or balance behavior of indeterminate maturity products, such as savings, money market, NOW and demand deposits, reflect management's best estimate of expected future behavior.

 
49
 

FIRST MERCHANTS CORPORATION
FORM 10Q
ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

INTEREST SENSITIVITY AND DISCLOSURE ABOUT MARKET RISK continued

The comparative rising 200 basis points and falling 100 basis points scenarios below, as of  JuneSeptember 30, 2012, assume further interest rate changes in addition to the base simulation discussed above. These changes are immediate and parallel changes to the base case scenario. In the current rate environment, many driver rates are at or near historical lows, thus total rate movements (beginning point minus ending point) to each of the various driver rates utilized by management have the following results:

 At June 30, 2012 At September 30, 2012
 RISING  FALLING RISINGFALLING
Driver Rates (200 Basis Points)  (100 Basis Points) (200 Basis Points)(100 Basis Points)
Prime
  200   0 
200
0
Federal funds
  200   0 
200
0
One-year CMT
  200   (13)
200
                                           (8)
Three-year CMT
  200   (8)
200
                                            (1)
Five-year CMT
  200   (10)
200
(2)
CD's
  200   (29)
200
                                        (27)
FHLB advances
  200   (2)
200
(2)


Results for the base, rising 200 basis points, and falling 100 basis points interest rate scenarios are listed below based upon the Corporation’s rate sensitive assets and liabilities at JuneSeptember 30, 2012. The net interest income shown represents cumulative net interest income over a 12-month time horizon. Balance sheet assumptions used for the base scenario are the same for the rising and falling simulations.

 At June 30, 2012  At September 30, 2012 
   RISING FALLING    RISING FALLING 
Driver Rates Base (200 Basis Points) (100 Basis Points)  Base (200 Basis Points) (100 Basis Points) 
Net interest income
 
$
147,855
 
$
153,807
 
$
145,787
  
$
144,718
 
$
149,758
 
$
143,203
 
Variance from base
   
$
5,952
 
$
(2,068
)
   
$
5,040
 
$
(1,515
)
Percent of change from base
   
4.03
%
 
-1.40
%
   
3.48
%
 
-1.05
%
Policy limit
       


The comparative rising 200 basis points and falling 100 basis points scenarios below, as of December 31, 2011, assume further interest rate changes in addition to the base simulation discussed above. These changes are immediate and parallel changes to the base case scenario. In addition, total rate movements (beginning point minus ending point) to each of the various driver rates utilized by management in the base simulation are as follows:

 At December 31, 2011 At December 31, 2011
 RISING  FALLING RISINGFALLING
Driver Rates (200 Basis Points)  (100 Basis Points) (200 Basis Points)(100 Basis Points)
Prime
  200   0 
200
0
Federal funds
  200   0 
200
0
One-year CMT
  200   (2)
200
                                 (2)
Three-year CMT
  200   (6)
200
                                 (6)
Five-year CMT
  200   0 
200
0
CD's
  200   (42)
200
                              (42)
FHLB advances
  200   0 
200
0


Results for the base, rising 200 basis points, and falling 100 basis points interest rate scenarios are listed below. The net interest income shown represents cumulative net interest income over a 12-month time horizon. Balance sheet assumptions used for the base scenario are the same for the rising and falling simulations.

  At December 31, 2011 
     RISING  FALLING 
Driver Rates Base  (200 Basis Points)  (100 Basis Points) 
Net interest income
 
$
142,706
  
$
146,352
  
$
140,332
 
Variance from base
     
$
3,646
  
$
(2,374
)
Percent of change from base
      
2.55
%
  
-1.66
%


 
50
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

EARNING ASSETS

The following table presents the earning asset mix as of JuneSeptember 30, 2012, and December 31, 2011. Earning assets increased by $70,226,000$99,099,000 in the sixnine months ended JuneSeptember 30, 2012.  Interest-bearing time deposits decreased $11,091,000.$17,527,000.  Investments decreased by approximately $2,079,000,$17,684,000, while loans and loans held for sale increased by $81,633,000.$132,756,000.   The four largest loan classes that increased from December 31, 2011 were commercial and farm land,industrial, commercial and industrial,farm land, construction and home equity.

Effective February 10, 2012, the Bank assumed substantially all the deposits and certain other liabilities and acquired certain assets of SCB Bank, from the FDIC as the receiver of SCB Bank.  The two most significant earning assets acquired were loans of $93.8 million$93,800,000 and securities of approximately $18,900,000.  Details of this transaction are included in NOTE 2.  PURCHASE AND ASSUMPTION, included within the Notes to Consolidated Condensed Financial Statements of this Form 10-Q.

 June 30, December 31,  September 30, December 31, 
(Dollars in Thousands) 2012 2011  2012 2011 
Interest-bearing time deposits
 
$ 
41,760
 
$
52,851
  
$ 
35,324
 
$
52,851
 
Investment securities available for sale
 
547,551
 
518,491
  
551,619
 
518,491
 
Investment securities held to maturity
 
396,770
 
427,909
  
377,097
 
427,909
 
Mortgage loans held for sale
 
15,278
 
17,864
  
27,711
 
17,864
 
Loans
 
2,797,634
 
2,713,415
  
2,836,324
 
2,713,415
 
Federal Reserve and Federal Home Loan Bank stock
  
33,033
  
31,270
   
32,824
  
31,270
 
Total
 
$
3,832,026
 
$
3,761,800
  
$
3,860,899
 
$
3,761,800
 


OTHER

The Securities and Exchange Commission maintains a Web site that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Commission, including us, and that address is (http://www.sec.gov).


ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information required under this item is included as part of Management’s Discussion and Analysis of Financial Condition and Results of Operations, under the headings “LIQUIDITY” and “INTEREST SENSITIVITY AND DISCLOSURE ABOUT MARKET RISK”.


ITEM 4.  CONTROLS AND PROCEDURES

At the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 are recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

There have been no changes in the Corporation’s internal control over financial reporting identified in connection with the evaluation discussed above that occurred during the Corporation’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

 
51
 

FIRST MERCHANTS CORPORATION
FORM 10Q
PART II.  OTHER INFORMATION


ITEM 1.  LEGAL PROCEEDINGS

          None


ITEM 1.A.  RISK FACTORS

There have been no material changes to the risk factors previously disclosed in the Corporation’s December 31, 2011, Annual Report on Form 10-K.


ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

          a. None

          b. None

          c. Issuer Purchases of Equity Securities

The following table presents information relating to our purchases of equity securities during the quarter ended JuneSeptember 30, 2012, as follows:

Period 
Total Number
of Shares
Purchased
  
Average
Price Paid
per Share
  
Total Number of Shares
Purchased as part of
Publicly announced
Plans or Programs
  
Maximum Number of
Shares that may yet be
Purchased Under the
Plans or Programs
 
April, 2012
  
306
  
$
11.74
   
0
   
0
 
May, 2012
          
0
   
0
 
June, 2012
          
0
   
0
 
Period 
Total Number
of Shares
Purchased
  
Average
Price Paid
per Share
  
Total Number of Shares
Purchased as part of Publicly announced Plans or Programs
  
Maximum Number of Shares
that may yet be Purchased
Under the Plans or Programs
 
July, 2012
  
460
  
$
12.79
   
0
   
0
 
August, 2012
          
0
   
0
 
September, 2012
          
0
   
0
 


The shares were purchased in connection with the exercise of certain outstanding stock options or restricted stock.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

         None

ITEM 4.  MINE SAFETY DISCLOSURES

         Not Applicable

ITEM 5.  OTHER INFORMATION

         a. None

         b. None

 
52
 
 
FIRST MERCHANTS CORPORATION
FORM 10Q
ITEM 6.  EXHIBITS.EXHIBITS
 
Exhibit No:Description of Exhibits:
  
3.1
First Merchants Corporation Articles of Incorporation, as amended (Incorporated by reference to registrant’s Form 10-Q filed on November 9, 2011)
3.2
Bylaws of First Merchants Corporation dated October 28, 2009 (Incorporated by reference to registrant’s Form 10-Q filed on November 9, 2009)
4.1
First Merchants Corporation Amended and Restated Declaration of Trust of First Merchants Capital Trust II dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007)
4.2
Indenture dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007)
4.3
Guarantee Agreement dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007)
4.4
Form of Capital Securities Certification of First Merchants Capital Trust II (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007)
4.5
First Merchants Corporation Dividend Reinvestment and Stock Purchase Plan (Incorporated by reference to registrant’s Post-Effective Amendment No. 1 to Form S-3 filed on August 21, 2009)
31.1
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 (2)(1)
31.2
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 (2)(1)
32
Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (2)(1)
101.INS
XBRL Instance Document (3)(2)
101.SCH
XBRL Taxonomy Extension Schema Document (3)(2)
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document (3)(2)
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document (3)(2)
101.LAB
XBRL Taxonomy Extension Label Linkbase Document (3)(2)
101.PRE
XBRL Taxonomy Extension Presentation Linkebase Document (3)(2)
  
 
(1) Management contract or compensatory plan
(2) Filed herewith.
 
(3)(2) Furnished herewith.
 
 
 
53
 

SIGNATURES
FIRST MERCHANTS CORPORATION
FORM 10Q
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
First Merchants Corporation
 (Registrant)
  
Date: AugustNovember 9, 2012
by /s/ Michael C. Rechin
 Michael C. Rechin
 President and Chief Executive Officer
 (Principal Executive Officer)
Date: AugustNovember 9, 2012
by:by /s/ Mark K. Hardwick
 Mark K. Hardwick
 Executive Vice President and
 Chief Financial Officer
 (Principal Financial and Accounting Officer)
 
 
54
 

FIRST MERCHANTS CORPORATION
FORM 10Q
INDEX TO EXHIBITS
 
Exhibit No:Description of Exhibits:
  
3.1
First Merchants Corporation Articles of Incorporation, as amended (Incorporated by reference to registrant’s Form 10-Q filed on November 9, 2011)
3.2
Bylaws of First Merchants Corporation dated October 28, 2009 (Incorporated by reference to registrant’s Form 10-Q filed on November 9, 2009)
4.1
First Merchants Corporation Amended and Restated Declaration of Trust of First Merchants Capital Trust II dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007)
4.2
Indenture dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007)
4.3
Guarantee Agreement dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007)
4.4
Form of Capital Securities Certification of First Merchants Capital Trust II (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007)
4.5
First Merchants Corporation Dividend Reinvestment and Stock Purchase Plan (Incorporated by reference to registrant’s Post-Effective Amendment No. 1 to Form S-3 filed on August 21, 2009)
31.1
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 (2)(1)
31.2
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 (2)(1)
32
Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (2)(1)
101.INS
XBRL Instance Document (3)(2)
101.SCH
XBRL Taxonomy Extension Schema Document (3)(2)
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document (3)(2)
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document (3)(2)
101.LAB
XBRL Taxonomy Extension Label Linkbase Document (3)(2)
101.PRE
XBRL Taxonomy Extension Presentation Linkebase Document (3)(2)
  
 
(1) Management contract or compensatory plan
(2) Filed herewith.
 
(3)(2) Furnished herewith.
 

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