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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended March 31, 2012
OR
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number 0-6233
(Exact name of registrant as specified in its charter)
INDIANA | | 35-1068133 |
(State or other jurisdiction of incorporation or organization) | | (I.R.S. Employer Identification No.) |
100 North Michigan Street | | |
South Bend, IN | | 46614 |
(Address of principal executive offices) | | (Zip Code) |
(574) 235-2000
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes o No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o | | Accelerated filer x |
| | |
Non-accelerated filer o (Do not check if a smaller reporting company) | | Smaller reporting company o |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes x No
Number of shares of common stock outstanding as of April 20, 2012 – 24,259,894 shares
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1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Unaudited - Dollars in thousands)
| | March 31, | | December 31, | |
| | 2012 | | 2011 | |
ASSETS | | | | | |
Cash and due from banks | | $ | 56,707 | | $ | 61,406 | |
Federal funds sold and interest bearing deposits with other banks | | 901 | | 52,921 | |
Investment securities available-for-sale (amortized cost of $872,783 and $853,204 at March 31, 2012 and December 31, 2011, respectively) | | 901,817 | | 883,000 | |
Other investments | | 18,974 | | 18,974 | |
Trading account securities | | 144 | | 132 | |
Mortgages held for sale | | 18,114 | | 12,644 | |
Loans and leases - net of unearned discount | | | | | |
Commercial and agricultural loans | | 545,057 | | 545,570 | |
Auto, light truck and environmental equipment | | 455,873 | | 435,965 | |
Medium and heavy duty truck | | 175,471 | | 159,796 | |
Aircraft financing | | 621,500 | | 620,782 | |
Construction equipment financing | | 271,475 | | 261,204 | |
Commercial real estate | | 539,112 | | 545,457 | |
Residential real estate | | 439,562 | | 423,606 | |
Consumer loans | | 98,840 | | 98,163 | |
Total loans and leases | | 3,146,890 | | 3,090,543 | |
Reserve for loan and lease losses | | (82,394 | ) | (81,644 | ) |
Net loans and leases | | 3,064,496 | | 3,008,899 | |
Equipment owned under operating leases, net | | 58,840 | | 69,551 | |
Net premises and equipment | | 39,963 | | 39,857 | |
Goodwill and intangible assets | | 88,475 | | 87,675 | |
Accrued income and other assets | | 136,265 | | 139,012 | |
Total assets | | $ | 4,384,696 | | $ | 4,374,071 | |
| | | | | |
LIABILITIES | | | | | |
Deposits: | | | | | |
Noninterest bearing | | $ | 587,324 | | $ | 580,101 | |
Interest bearing | | 2,918,350 | | 2,940,040 | |
Total deposits | | 3,505,674 | | 3,520,141 | |
Short-term borrowings: | | | | | |
Federal funds purchased and securities sold under agreements to repurchase | | 125,010 | | 106,991 | |
Other short-term borrowings | | 18,761 | | 18,243 | |
Total short-term borrowings | | 143,771 | | 125,234 | |
Long-term debt and mandatorily redeemable securities | | 39,828 | | 37,156 | |
Subordinated notes | | 89,692 | | 89,692 | |
Accrued expenses and other liabilities | | 73,840 | | 77,930 | |
Total liabilities | | 3,852,805 | | 3,850,153 | |
| | | | | |
SHAREHOLDERS’ EQUITY | | | | | |
Preferred stock; no par value | | | | | |
Authorized 10,000,000 shares; none issued or outstanding | | — | | — | |
Common stock; no par value | | | | | |
Authorized 40,000,000 shares; issued 25,643,506 at March 31, 2012 and December 31, 2011 | | 346,535 | | 346,535 | |
Retained earnings | | 198,175 | | 190,261 | |
Cost of common stock in treasury (1,383,612 shares at March 31, 2012 and 1,429,484 shares at December 31, 2011) | | (30,757 | ) | (31,389 | ) |
Accumulated other comprehensive income | | 17,938 | | 18,511 | |
Total shareholders’ equity | | 531,891 | | 523,918 | |
Total liabilities and shareholders’ equity | | $ | 4,384,696 | | $ | 4,374,071 | |
The accompanying notes are a part of the consolidated financial statements.
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1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited - Dollars in thousands, except per share amounts)
| | Three Months Ended | |
| | March 31, | |
| | 2012 | | 2011 | |
Interest income: | | | | | |
Loans and leases | | $ | 39,896 | | $ | 41,299 | |
Investment securities, taxable | | 4,327 | | 4,482 | |
Investment securities, tax-exempt | | 852 | | 1,186 | |
Other | | 226 | | 243 | |
Total interest income | | 45,301 | | 47,210 | |
| | | | | |
Interest expense: | | | | | |
Deposits | | 5,745 | | 8,355 | |
Short-term borrowings | | 53 | | 89 | |
Subordinated notes | | 1,647 | | 1,647 | |
Long-term debt and mandatorily redeemable securities | | 471 | | 259 | |
Total interest expense | | 7,916 | | 10,350 | |
| | | | | |
Net interest income | | 37,385 | | 36,860 | |
Provision for loan and lease losses | | 2,254 | | 2,198 | |
Net interest income after provision for loan and lease losses | | 35,131 | | 34,662 | |
| | | | | |
Noninterest income: | | | | | |
Trust fees | | 3,973 | | 3,992 | |
Service charges on deposit accounts | | 4,505 | | 4,236 | |
Mortgage banking income | | 1,942 | | 444 | |
Insurance commissions | | 1,357 | | 1,142 | |
Equipment rental income | | 5,350 | | 6,038 | |
Other income | | 3,001 | | 2,971 | |
Investment securities and other investment gains | | 395 | | 130 | |
Total noninterest income | | 20,523 | | 18,953 | |
| | | | | |
Noninterest expense: | | | | | |
Salaries and employee benefits | | 20,316 | | 18,638 | |
Net occupancy expense | | 2,160 | | 2,320 | |
Furniture and equipment expense | | 3,507 | | 3,349 | |
Depreciation - leased equipment | | 4,311 | | 4,805 | |
Professional fees | | 1,398 | | 1,096 | |
Supplies and communication | | 1,393 | | 1,394 | |
FDIC and other insurance | | 949 | | 1,676 | |
Business development and marketing expense | | 867 | | 622 | |
Loan and lease collection and repossession expense | | 1,501 | | 1,324 | |
Other expense | | 1,646 | | 3,252 | |
Total noninterest expense | | 38,048 | | 38,476 | |
| | | | | |
Income before income taxes | | 17,606 | | 15,139 | |
Income tax expense | | 5,891 | | 4,531 | |
| | | | | |
Net income | | $ | 11,715 | | $ | 10,608 | |
| | | | | |
Per common share | | | | | |
Basic net income per common share | | $ | 0.48 | | $ | 0.43 | |
Diluted net income per common share | | $ | 0.48 | | $ | 0.43 | |
Dividends | | $ | 0.16 | | $ | 0.16 | |
Basic weighted average common shares outstanding | | 24,259,416 | | 24,271,366 | |
Diluted weighted average common shares outstanding | | 24,270,866 | | 24,279,517 | |
The accompanying notes are a part of the consolidated financial statements.
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1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited - Dollars in thousands)
| | Three Months Ended | |
| | March 31, | |
| | 2012 | | 2011 | |
| | | | | |
Net income | | $ | 11,715 | | $ | 10,608 | |
| | | | | |
Other comprehensive (loss) income, net of tax: | | | | | |
Change in unrealized appreciation of available-for-sale securities, net of tax | | (402 | ) | (1,250 | ) |
Reclassification adjustment for gains included in net income, net of tax | | (171 | ) | (128 | ) |
Other comprehensive (loss) income | | (573 | ) | (1,378 | ) |
| | | | | |
Comprehensive income | | $ | 11,142 | | $ | 9,230 | |
The accompanying notes are a part of the consolidated financial statements.
1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Unaudited - Dollars in thousands, except per share amounts)
| | | | | | | | | | Cost of | | Accumulated | |
| | | | | | | | | | Common | | Other | |
| | | | Preferred | | Common | | Retained | | Stock | | Comprehensive | |
| | Total | | Stock | | Stock | | Earnings | | in Treasury | | Income (Loss), Net | |
Balance at January 1, 2011 | | $ | 486,383 | | $ | — | | $ | 350,282 | | $ | 157,875 | | $ | (32,284 | ) | $ | 10,510 | |
Net Income | | 10,608 | | — | | — | | 10,608 | | — | | — | |
Other Comprehensive Loss | | (1,378 | ) | — | | — | | — | | — | | (1,378 | ) |
Issuance of 139,736 common shares under stock based compensation awards, including related tax effects | | 2,666 | | — | | — | | (126 | ) | 2,792 | | — | |
Cost of 8,900 shares of common stock acquired for treasury | | (163 | ) | — | | — | | — | | (163 | ) | — | |
Repurchase of common stock warrant | | (3,750 | ) | — | | (3,750 | ) | — | | — | | — | |
Common stock dividend ($0.16 per share) | | (3,902 | ) | — | | — | | (3,902 | ) | — | | — | |
Stock based compensation | | 3 | | — | | 3 | | — | | — | | — | |
Balance at March 31, 2011 | | $ | 490,467 | | $ | — | | $ | 346,535 | | $ | 164,455 | | $ | (29,655 | ) | $ | 9,132 | |
| | | | | | | | | | | | | |
Balance at January 1, 2012 | | $ | 523,918 | | $ | — | | $ | 346,535 | | $ | 190,261 | | $ | (31,389 | ) | $ | 18,511 | |
Net Income | | 11,715 | | — | | — | | 11,715 | | — | | — | |
Other Comprehensive Loss | | (573 | ) | — | | — | | — | | — | | (573 | ) |
Issuance of 150,343 common shares under stock based compensation awards, including related tax effects | | 3,375 | | — | | — | | 126 | | 3,249 | | — | |
Cost of 104,471 shares of common stock acquired for treasury | | (2,617 | ) | — | | — | | — | | (2,617 | ) | — | |
Common stock dividend ($0.16 per share) | | (3,927 | ) | — | | — | | (3,927 | ) | — | | — | |
Balance at March 31, 2012 | | $ | 531,891 | | $ | — | | $ | 346,535 | | $ | 198,175 | | $ | (30,757 | ) | $ | 17,938 | |
The accompanying notes are a part of the consolidated financial statements.
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1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited - Dollars in thousands)
| | Three Months Ended March 31, | |
| | 2012 | | 2011 | |
Operating activities: | | | | | |
Net income | | $ | 11,715 | | $ | 10,608 | |
Adjustments to reconcile net income to net cash provided (used) by operating activities: | | | | | |
Provision for loan and lease losses | | 2,254 | | 2,198 | |
Depreciation of premises and equipment | | 1,032 | | 873 | |
Depreciation of equipment owned and leased to others | | 4,311 | | 4,805 | |
Amortization of investment security premiums and accretion of discounts, net | | 1,012 | | 485 | |
Amortization of mortgage servicing rights | | 692 | | 734 | |
Mortgage servicing asset (recovery) impairment | | (234 | ) | 5 | |
Deferred income taxes | | (1,080 | ) | (297 | ) |
Investment securities and other investment gains | | (395 | ) | (130 | ) |
Originations of loans held for sale, net of principal collected | | (35,772 | ) | (25,343 | ) |
Proceeds from the sales of loans held for sale | | 31,574 | | 52,560 | |
Net gain on sale of loans held for sale | | (1,272 | ) | (85 | ) |
Change in trading account securities | | (12 | ) | (8 | ) |
Change in interest receivable | | (665 | ) | (116 | ) |
Change in interest payable | | 1,400 | | 1,905 | |
Change in other assets | | 3,311 | | 6,701 | |
Change in other liabilities | | (1,596 | ) | (2,083 | ) |
Other | | 346 | | 1,696 | |
Net change in operating activities | | 16,621 | | 54,508 | |
| | | | | |
Investing activities: | | | | | |
Proceeds from sales of investment securities | | 40,236 | | 66,989 | |
Proceeds from maturities of investment securities | | 99,619 | | 67,756 | |
Purchases of investment securities | | (160,052 | ) | (110,522 | ) |
Net change in other investments | | — | | 840 | |
Loans sold or participated to others | | 6,312 | | 4,010 | |
Net change in loans and leases | | (65,320 | ) | 11,983 | |
Net change in equipment owned under operating leases | | 6,399 | | (7,971 | ) |
Purchases of premises and equipment | | (1,161 | ) | (3,047 | ) |
Net change in investing activities | | (73,967 | ) | 30,038 | |
| | | | | |
Financing activities: | | | | | |
Net change in demand deposits, NOW accounts and savings accounts | | (17,501 | ) | (33,730 | ) |
Net change in certificates of deposit | | 3,034 | | 19,992 | |
Net change in short-term borrowings | | 18,537 | | (23,836 | ) |
Proceeds from issuance of long-term debt | | — | | 417 | |
Payments on long-term debt | | (199 | ) | (114 | ) |
Net proceeds from issuance of treasury stock | | 3,375 | | 2,666 | |
Acquisition of treasury stock | | (2,617 | ) | (163 | ) |
Repurchase of common stock warrant | | — | | (3,750 | ) |
Cash dividends paid on common stock | | (4,002 | ) | (3,968 | ) |
Net change in financing activities | | 627 | | (42,486 | ) |
| | | | | |
Net change in cash and cash equivalents | | (56,719 | ) | 42,060 | |
| | | | | |
Cash and cash equivalents, beginning of year | | 114,327 | | 96,872 | |
| | | | | |
Cash and cash equivalents, end of period | | $ | 57,608 | | $ | 138,932 | |
| | | | | |
Non-cash transactions: | | | | | |
Loans transferred to other real estate and repossessed assets | | $ | 1,158 | | $ | 3,931 | |
Common stock matching contribution to Employee Stock Ownership and Profit Sharing Plan | | 2,643 | | 2,420 | |
The accompanying notes are a part of the consolidated financial statements.
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1ST SOURCE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1. Basis of Presentation
1st Source Corporation is a bank holding company headquartered in South Bend, Indiana that provides, through its subsidiaries (collectively referred to as “1st Source” or “the Company”), a broad array of financial products and services. The accompanying unaudited consolidated financial statements reflect all adjustments (all of which are normal and recurring in nature) which are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, the results of operations, changes in comprehensive income, changes in shareholders’ equity, and cash flows for the periods presented. These unaudited consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) have been omitted.
The Notes to the Consolidated Financial Statements appearing in 1st Source Corporation’s Annual Report on Form 10-K (2011 Annual Report), which include descriptions of significant accounting policies, should be read in conjunction with these interim financial statements. The balance sheet at December 31, 2011 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. Certain amounts in the prior period consolidated financial statements have been reclassified to conform to the current year presentation.
Note 2. Recent Accounting Pronouncements
Offsetting Assets and Liabilities: In December 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-11 “Balance Sheet (Topic 210) - Disclosures about Offsetting Assets and Liabilities.” ASU 2011-11 requires an entity to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. ASU 2011-11 is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. Retrospective disclosure is required for all comparative periods presented. The Company is assessing the impact of ASU 2011-11 on its disclosures.
Goodwill: In September 2011, the FASB issued ASU No. 2011-08 “Intangibles — Goodwill and Other (Topic 350) - Testing Goodwill for Impairment.” ASU 2011-08 allows an entity the option to make a qualitative evaluation about the likelihood of goodwill impairment to determine whether it should calculate the fair value of the reporting unit. ASU 2011-08 was effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption was permitted. The Company does not expect an impact on its financial condition or results of operations.
Comprehensive Income: In June 2011, the FASB issued ASU No. 2011-05 “Comprehensive Income (Topic 220) - Presentation of Comprehensive Income.” ASU 2011-05 requires that all nonowner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. In December 2011, FASB issued ASU No. 2011-12 which defers the effective date of the requirement in ASU 2011-05 to present items that are
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reclassified from accumulated other comprehensive income to net income alongside their respective components of net income and other comprehensive income. ASU 2011-05 was effective retrospectively for fiscal years, and interim periods within those years, beginning after December 15, 2011. The effect of applying this standard is reflected in the Consolidated Statements of Comprehensive Income and Consolidated Statements of Shareholders’ Equity.
Fair Value Measurements: In May 2011, the FASB issued ASU No. 2011-04 “Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” ASU 2011-04 changed the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. Consequently, the amendments in this update result in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs (International Financial Reporting Standards). ASU 2011-04 was effective prospectively during interim and annual periods beginning on or after December 15, 2011. Early application by public entities was not permitted. The effect of applying this standard is reflected in Note 12 — Fair Value Measurements.
Transfers and Servicing: In April 2011, the FASB issued ASU No. 2011-03 “Transfers and Servicing (Topic 860) - Reconsideration of Effective Control for Repurchase Agreement.” ASU 2011-03 removed from the assessment of effective control the criterion relating to the transferor’s ability to repurchase or redeem financial assets on substantially the agreed terms, even in the event of default by the transferee. ASU 2011-03 was effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occured on or after the effective date. Early adoption was not permitted. ASU 2011-03 did not have an impact on the Company’s financial condition, results of operations, or disclosures.
Note 3. Investment Securities
Investment securities available-for-sale were as follows:
| | Amortized | | Gross | | Gross | | | |
(Dollars in thousands) | | Cost | | Unrealized Gains | | Unrealized Losses | | Fair Value | |
March 31, 2012 | | | | | | | | | |
U.S. Treasury and Federal agencies securities | | $ | 388,248 | | $ | 9,795 | | $ | (268 | ) | $ | 397,775 | |
U.S. States and political subdivisions securities | | 103,951 | | 6,124 | | (842 | ) | 109,233 | |
Mortgage-backed securities — Federal agencies | | 337,295 | | 11,660 | | (124 | ) | 348,831 | |
Corporate debt securities | | 36,236 | | 380 | | (319 | ) | 36,297 | |
Foreign government and other securities | | 4,686 | | 42 | | (1 | ) | 4,727 | |
Total debt securities | | 870,416 | | 28,001 | | (1,554 | ) | 896,863 | |
Marketable equity securities | | 2,367 | | 2,743 | | (156 | ) | 4,954 | |
Total investment securities available-for-sale | | $ | 872,783 | | $ | 30,744 | | $ | (1,710 | ) | $ | 901,817 | |
| | | | | | | | | |
December 31, 2011 | | | | | | | | | |
U.S. Treasury and Federal agencies securities | | $ | 390,819 | | $ | 10,356 | | $ | (50 | ) | $ | 401,125 | |
U.S. States and political subdivisions securities | | 101,587 | | 6,433 | | (660 | ) | 107,360 | |
Mortgage-backed securities — Federal agencies | | 317,392 | | 11,565 | | (9 | ) | 328,948 | |
Corporate debt securities | | 36,349 | | 325 | | (364 | ) | 36,310 | |
Foreign government and other securities | | 4,690 | | 24 | | (1 | ) | 4,713 | |
Total debt securities | | 850,837 | | 28,703 | | (1,084 | ) | 878,456 | |
Marketable equity securities | | 2,367 | | 2,673 | | (496 | ) | 4,544 | |
Total investment securities available-for-sale | | $ | 853,204 | | $ | 31,376 | | $ | (1,580 | ) | $ | 883,000 | |
At March 31, 2012 and December 31, 2011, the residential mortgage-backed securities held by the Company consisted primarily of GNMA, FNMA and FHLMC pass-through certificates which are guaranteed by those respective agencies of the United States government (or Government Sponsored Enterprise, GSEs).
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The contractual maturities of debt securities available-for-sale at March 31, 2012 are shown below. Expected maturities will differ from contractual maturities, because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
(Dollars in thousands) | | Amortized Cost | | Fair Value | |
Due in one year or less | | $ | 27,743 | | $ | 28,152 | |
Due after one year through five years | | 379,459 | | 388,521 | |
Due after five years through ten years | | 115,566 | | 121,689 | |
Due after ten years | | 10,353 | | 9,670 | |
Mortgage-backed securities | | 337,295 | | 348,831 | |
Total debt securities available-for-sale | | $ | 870,416 | | $ | 896,863 | |
The following table shows the gross realized gains and losses on sale of securities from the securities available-for-sale portfolio, including marketable equity securities. Realized gains and losses on the sales of all securities are computed using the specific identification cost basis. There were no other-than-temporary-impairment (OTTI) write-downs in 2012 or 2011.
| | Three Months Ended | |
| | March 31, | |
(Dollars in thousands) | | 2012 | | 2011 | |
Gross realized gains | | $ | 275 | | $ | 445 | |
Gross realized losses | | — | | (238 | ) |
Net realized gains (losses) | | $ | 275 | | $ | 207 | |
The following table summarizes gross unrealized losses and fair value by investment category and age:
| | Less than 12 Months | | 12 months or Longer | | Total | |
| | Fair | | Unrealized | | Fair | | Unrealized | | Fair | | Unrealized | |
(Dollars in thousands) | | Value | | Losses | | Value | | Losses | | Value | | Losses | |
March 31, 2012 | | | | | | | | | | | | | |
U.S. Treasury and Federal agencies securities | | $ | 110,118 | | $ | (268 | ) | $ | — | | $ | — | | $ | 110,118 | | $ | (268 | ) |
U.S. States and political subdivisions securities | | 8,828 | | (172 | ) | 5,131 | | (670 | ) | 13,959 | | (842 | ) |
Mortgage-backed securities - Federal agencies | | 49,401 | | (90 | ) | 17,002 | | (34 | ) | 66,403 | | (124 | ) |
Corporate debt securities | | 4,927 | | (73 | ) | 8,513 | | (246 | ) | 13,440 | | (319 | ) |
Foreign government and other securities | | 199 | | (1 | ) | — | | — | | 199 | | (1 | ) |
Total debt securities | | 173,473 | | (604 | ) | 30,646 | | (950 | ) | 204,119 | | (1,554 | ) |
Marketable equity securities | | 961 | | (153 | ) | 4 | | (3 | ) | 965 | | (156 | ) |
Total investment securities available-for-sale | | $ | 174,434 | | $ | (757 | ) | $ | 30,650 | | $ | (953 | ) | $ | 205,084 | | $ | (1,710 | ) |
| | | | | | | | | | | | | |
December 31, 2011 | | | | | | | | | | | | | |
U.S. Treasury and Federal agencies securities | | $ | 42,536 | | $ | (50 | ) | $ | — | | $ | — | | $ | 42,536 | | $ | (50 | ) |
U.S. States and political subdivisions securities | | 423 | | (9 | ) | 5,149 | | (651 | ) | 5,572 | | (660 | ) |
Mortgage-backed securities - Federal agencies | | 5,071 | | (1 | ) | 13,099 | | (8 | ) | 18,170 | | (9 | ) |
Corporate debt securities | | 4,858 | | (142 | ) | 8,579 | | (222 | ) | 13,437 | | (364 | ) |
Foreign government and other securities | | 1,011 | | (1 | ) | — | | — | | 1,011 | | (1 | ) |
Total debt securities | | 53,899 | | (203 | ) | 26,827 | | (881 | ) | 80,726 | | (1,084 | ) |
Marketable equity securities | | 622 | | (492 | ) | 4 | | (4 | ) | 626 | | (496 | ) |
Total investment securities available-for-sale | | $ | 54,521 | | $ | (695 | ) | $ | 26,831 | | $ | (885 | ) | $ | 81,352 | | $ | (1,580 | ) |
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The initial indication of OTTI for both debt and equity securities is a decline in fair value below amortized cost. Quarterly, the impaired securities are analyzed on a qualitative and quantitative basis in determining OTTI. Declines in the fair value of available-for-sale debt securities below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of impairment related to other factors is recognized in other comprehensive income. In estimating OTTI impairment losses, the Company considers among other things, (i) the length of time and the extent to which fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) whether it is more likely than not that the Company will not have to sell any such securities before a recovery of cost.
At March 31, 2012, the Company does not have the intent to sell any of the available-for-sale securities in the table above and believes that it is more likely than not that it will not have to sell any such securities before an anticipated recovery of cost. The unrealized losses on debt securities are due to increases in market interest rates over the yields available at the time the underlying securities were purchased and market illiquidity on auction rate securities which are reflected in U.S. States and Political subdivisions securities. The fair value is expected to recover on all debt securities as they approach their maturity date or repricing date or if market yields for such investments decline. The Company does not believe any of the securities are impaired due to reasons of credit quality.
The unrealized losses on marketable equity securities relate primarily to one common stock investment. The Company evaluated the investments’ near term prospects in relation to the severity and duration of the impairment. Based on the evaluation and the intent to hold the investment for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider the investment other-than-temporarily impaired at March 31, 2012. Accordingly, as of March 31, 2012, the Company believes the impairments detailed in the table above are temporary and no impairment loss has been realized in its consolidated statements of income.
At March 31, 2012 and December 31, 2011, investment securities with carrying values of $230.86 million and $250.36 million, respectively, were pledged as collateral to secure government deposits, security repurchase agreements, and for other purposes.
Note 4. Loan and Lease Financings
The Company evaluates loans and leases for credit quality at least annually but more frequently if certain circumstances occur (such as material new information which becomes available and indicates a potential change in credit risk). The Company uses two methods to assess credit risk: loan or lease credit quality grades and credit risk classifications. The purpose of the loan or lease credit quality grade is to document the degree of risk associated with individual credits as well as inform management of the degree of risk in the portfolio taken as a whole. Credit risk classifications are used to categorize loans by degree of risk and to designate individual or committee approval authorities for higher risk credits at the time of origination. Credit risk classifications include categories for: Acceptable, Marginal, Special Attention, Special Risk, Restricted by Policy, Regulated and Prohibited by Law.
All loans and leases, except residential real estate loans and consumer loans, are assigned credit quality grades on a scale from 1 to 12 with grade 1 representing superior credit quality. The criteria used to assign grades to extensions of credit that exhibit potential problems or well-defined weaknesses are primarily based upon the degree of risk and the likelihood of orderly repayment, and their effect on the Company’s safety and soundness. Loans or leases graded 7 or weaker are considered “special attention” credits and, as such, relationships in excess of $100,000 are reviewed quarterly as part of management’s evaluation of the appropriateness of the reserve for loan and lease losses. Grade 7 credits are defined as “watch” and contain greater than average credit
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risk and are monitored to limit the exposure to increased risk; grade 8 credits are “special mention” and, following regulatory guidelines, are defined as having potential weaknesses that deserve management’s close attention. Credits that exhibit well-defined weaknesses and a distinct possibility of loss are considered ‘‘classified’’ and are graded 9 through 12 corresponding to the regulatory definitions of “substandard” (grades 9 and 10) and the more severe ‘‘doubtful’’ (grade 11) and ‘‘loss’’ (grade 12).
The table below presents the credit quality grades of the recorded investment in loans and leases, segregated by class.
| | Credit Quality Grades | |
(Dollars in thousands) | | 1-6 | | 7-12 | | Total | |
March 31, 2012 | | | | | | | |
Commercial and agricultural loans | | $ | 514,269 | | $ | 30,788 | | $ | 545,057 | |
Auto, light truck and environmental equipment | | 450,261 | | 5,612 | | 455,873 | |
Medium and heavy duty truck | | 171,644 | | 3,827 | | 175,471 | |
Aircraft financing | | 580,508 | | 40,992 | | 621,500 | |
Construction equipment financing | | 246,552 | | 24,923 | | 271,475 | |
Commercial real estate | | 485,803 | | 53,309 | | 539,112 | |
Total | | $ | 2,449,037 | | $ | 159,451 | | $ | 2,608,488 | |
| | | | | | | |
December 31, 2011 | | | | | | | |
Commercial and agricultural loans | | $ | 513,011 | | $ | 32,559 | | $ | 545,570 | |
Auto, light truck and environmental equipment | | 432,288 | | 3,677 | | 435,965 | |
Medium and heavy duty truck | | 154,261 | | 5,535 | | 159,796 | |
Aircraft financing | | 580,004 | | 40,778 | | 620,782 | |
Construction equipment financing | | 239,643 | | 21,561 | | 261,204 | |
Commercial real estate | | 487,576 | | 57,881 | | 545,457 | |
Total | | $ | 2,406,783 | | $ | 161,991 | | $ | 2,568,774 | |
For residential real estate and consumer loans, credit quality is based on the aging status of the loan and by payment activity. The table below presents the recorded investment in residential real estate and consumer loans by performing or nonperforming status. Nonperforming loans are those loans which are on nonaccrual status or are 90 days or more past due.
(Dollars in thousands) | | Performing | | Nonperforming | | Total | |
March 31, 2012 | | | | | | | |
Residential real estate | | $ | 436,350 | | $ | 3,212 | | $ | 439,562 | |
Consumer | | 97,200 | | 1,640 | | 98,840 | |
Total | | $ | 533,550 | | $ | 4,852 | | $ | 538,402 | |
| | | | | | | |
December 31, 2011 | | | | | | | |
Residential real estate | | $ | 418,810 | | $ | 4,796 | | $ | 423,606 | |
Consumer | | 97,857 | | 306 | | 98,163 | |
Total | | $ | 516,667 | | $ | 5,102 | | $ | 521,769 | |
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The table below presents the recorded investment of loans and leases, segregated by class, with delinquency aging and nonaccrual status.
| | | | | | | | 90 Days | | | | | | | |
| | | | | | | | or More | | | | | | | |
| | | | 30-59 Days | | 60-89 Days | | Past Due | | Total | | | | Total Financing | |
(Dollars in thousands) | | Current | | Past Due | | Past Due | | and Accruing | | Accruing Loans | | Nonaccrual | | Receivables | |
March 31, 2012 | | | | | | | | | | | | | | | |
Commercial and agricultural loans | | $ | 533,744 | | $ | 667 | | $ | — | | $ | — | | $ | 534,411 | | $ | 10,646 | | $ | 545,057 | |
Auto, light truck and environmental equipment | | 450,550 | | 777 | | 45 | | — | | 451,372 | | 4,501 | | 455,873 | |
Medium and heavy duty truck | | 174,240 | | — | | — | | — | | 174,240 | | 1,231 | | 175,471 | |
Aircraft financing | | 607,038 | | 2,265 | | — | | — | | 609,303 | | 12,197 | | 621,500 | |
Construction equipment financing | | 265,709 | | 862 | | 1,160 | | — | | 267,731 | | 3,744 | | 271,475 | |
Commercial real estate | | 520,650 | | 67 | | 145 | | — | | 520,862 | | 18,250 | | 539,112 | |
Residential real estate | | 433,414 | | 2,123 | | 813 | | 177 | | 436,527 | | 3,035 | | 439,562 | |
Consumer | | 96,266 | | 832 | | 102 | | 217 | | 97,417 | | 1,423 | | 98,840 | |
Total | | $ | 3,081,611 | | $ | 7,593 | | $ | 2,265 | | $ | 394 | | $ | 3,091,863 | | $ | 55,027 | | $ | 3,146,890 | |
| | | | | | | | | | | | | | | |
December 31, 2011 | | | | | | | | | | | | | | | |
Commercial and agricultural loans | | $ | 534,053 | | $ | 550 | | $ | 1 | | $ | — | | $ | 534,604 | | $ | 10,966 | | $ | 545,570 | |
Auto, light truck and environmental equipment | | 433,048 | | 674 | | 241 | | — | | 433,963 | | 2,002 | | 435,965 | |
Medium and heavy duty truck | | 158,192 | | 5 | | — | | — | | 158,197 | | 1,599 | | 159,796 | |
Aircraft financing | | 608,032 | | 224 | | — | | — | | 608,256 | | 12,526 | | 620,782 | |
Construction equipment financing | | 256,691 | | 376 | | — | | — | | 257,067 | | 4,137 | | 261,204 | |
Commercial real estate | | 522,883 | | 2,005 | | — | | — | | 524,888 | | 20,569 | | 545,457 | |
Residential real estate | | 415,177 | | 2,894 | | 739 | | 416 | | 419,226 | | 4,380 | | 423,606 | |
Consumer | | 96,824 | | 762 | | 271 | | 45 | | 97,902 | | 261 | | 98,163 | |
Total | | $ | 3,024,900 | | $ | 7,490 | | $ | 1,252 | | $ | 461 | | $ | 3,034,103 | | $ | 56,440 | | $ | 3,090,543 | |
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The table below presents impaired loans and leases, segregated by class, and the corresponding reserve for impaired loan and lease losses.
| | | | Unpaid | | | |
| | Recorded | | Principal | | Related | |
(Dollars in thousands) | | Investment | | Balance | | Allowance | |
March 31, 2012 | | | | | | | |
With no related allowance recorded: | | | | | | | |
Commercial and agricultural loans | | $ | 1,903 | | $ | 1,903 | | $ | — | |
Auto, light truck and environmental equipment | | 381 | | 381 | | — | |
Medium and heavy duty truck | | 1,227 | | 1,227 | | — | |
Aircraft financing | | 10,936 | | 10,936 | | — | |
Construction equipment financing | | 3,431 | | 3,431 | | — | |
Commercial real estate | | 14,249 | | 14,248 | | — | |
Residential real estate | | 108 | | 108 | | — | |
Consumer loans | | — | | — | | — | |
Total with no related allowance recorded | | 32,235 | | 32,234 | | — | |
With an allowance recorded: | | | | | | | |
Commercial and agricultural loans | | 7,651 | | 7,651 | | 1,187 | |
Auto, light truck and environmental equipment | | 3,148 | | 3,148 | | 1,200 | |
Medium and heavy duty truck | | — | | — | | — | |
Aircraft financing | | 1,086 | | 1,086 | | 557 | |
Construction equipment financing | | — | | — | | — | |
Commercial real estate | | 5,491 | | 5,491 | | 277 | |
Residential real estate | | — | | — | | — | |
Consumer loans | | — | | — | | — | |
Total with an allowance recorded | | 17,376 | | 17,376 | | 3,221 | |
Total impaired loans | | $ | 49,611 | | $ | 49,610 | | $ | 3,221 | |
| | | | | | | |
December 31, 2011 | | | | | | | |
With no related allowance recorded: | | | | | | | |
Commercial and agricultural loans | | $ | 2,002 | | $ | 2,002 | | $ | — | |
Auto, light truck and environmental equipment | | 770 | | 770 | | — | |
Medium and heavy duty truck | | 959 | | 959 | | — | |
Aircraft financing | | 11,206 | | 11,206 | | — | |
Construction equipment financing | | 3,949 | | 3,949 | | — | |
Commercial real estate | | 17,088 | | 17,091 | | — | |
Residential real estate | | — | | — | | | |
Consumer loans | | 211 | | 210 | | | |
Total with no related allowance recorded | | 36,185 | | 36,187 | | — | |
With an allowance recorded: | | | | | | | |
Commercial and agricultural loans | | 8,406 | | 8,406 | | 1,461 | |
Auto, light truck and environmental equipment | | 113 | | 113 | | 35 | |
Medium and heavy duty truck | | 645 | | 645 | | 165 | |
Aircraft financing | | 1,118 | | 1,118 | | 534 | |
Construction equipment financing | | — | | — | | — | |
Commercial real estate | | 6,029 | | 6,029 | | 294 | |
Residential real estate | | — | | — | | — | |
Consumer loans | | — | | — | | — | |
Total with an allowance recorded | | 16,311 | | 16,311 | | 2,489 | |
Total impaired loans | | $ | 52,496 | | $ | 52,498 | | $ | 2,489 | |
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Average recorded investment and interest income recognized on impaired loans and leases, segregated by class, is shown in the table below.
| | Three Months Ended March 31, | |
| | 2012 | | 2011 | |
(Dollars in thousands) | | Average Recorded Investment | | Interest Income | | Average Recorded Investment | | Interest Income | |
Commercial and agricultural loans | | $ | 9,993 | | $ | 8 | | $ | 12,970 | | $ | 116 | |
Auto, light truck and environmental equipment | | 1,591 | | 7 | | 2,237 | | 1 | |
Medium and heavy duty truck | | 1,375 | | 1 | | 4,810 | | 1 | |
Aircraft financing | | 12,268 | | — | | 16,277 | | 9 | |
Construction equipment financing | | 3,665 | | 4 | | 8,311 | | 9 | |
Commercial real estate | | 21,226 | | 49 | | 29,863 | | 65 | |
Residential real estate | | 36 | | 1 | | — | | — | |
Consumer | | — | | — | | — | | — | |
Total | | $ | 50,154 | | $ | 70 | | $ | 74,468 | | $ | 201 | |
Performing loans and leases classified as troubled debt restructuring (TDR) during the three months ended March 31, 2012, segregated by class, are shown in the table below. Nonperforming TDRs are shown as nonperforming assets. During 2012, modification programs focused on extending maturity dates or modifying payment patterns. The modification did not result in the contractual forgiveness of principal or interest or interest rate reductions below market rates. Consequently, the financial impact of the modification is immaterial.
| | Three Months Ended | |
| | March 31, 2012 | |
| | Number of | | Recorded | |
(Dollars in thousands) | | Modifications | | Investment | |
Commercial and agricultural loans | | — | | $ | — | |
Auto, light truck and environmental equipment | | — | | — | |
Medium and heavy duty truck | | — | | — | |
Aircraft financing | | — | | — | |
Construction equipment financing | | — | | — | |
Commercial real estate | | — | | — | |
Residential real estate | | 1 | | 108 | |
Consumer | | — | | — | |
Total | | 1 | | $ | 108 | |
There were no troubled debt restructured loans and leases which had payment defaults within twelve months following modification during the three months ended March 31, 2012. Default occurs when a loan or lease is 90 days or more past due under the modified terms or transferred to nonaccrual.
As of March 31, 2012 and December 31, 2011, the Company had $2.20 million and $3.29 million, respectively of performing loans and leases classified as troubled debt restructurings.
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Note 5. Reserve for Loan and Lease Losses
The reserve for loan and lease loss methodology has been consistently applied for several years, with enhancements instituted periodically. Reserve ratios are reviewed quarterly and revised periodically to reflect recent loss history and to incorporate current risks and trends which may not be recognized in historical data. As the historical charge-off analysis is updated, the Company reviews the look-back periods for each business loan portfolio. Furthermore, a thorough analysis of charge-offs, non-performing asset levels, special attention outstandings and delinquency is performed in order to review portfolio trends and other factors, including specific industry risks and economic conditions, which may have an impact on the reserves and reserve ratios applied to various portfolios. The Company adjusts the calculated historical based ratio as a result of the analysis of environmental factors, principally economic risk and concentration risk. Key economic factors affecting the portfolios are growth in gross domestic product, unemployment rates, housing market trends, commodity prices, inflation, national and international economic volatility, global debt and capital markets and political stability or lack thereof. Concentration risk is impacted primarily by geographic concentration in Northern Indiana and Southwestern Lower Michigan in the business banking and commercial real estate portfolios and by collateral concentration in the specialty finance portfolios and exposure to foreign markets by geographic risk.
The reserve for loan and lease losses is maintained at a level believed to be appropriate by management to absorb probable losses inherent in the loan and lease portfolio. The determination of the reserve requires significant judgment reflecting management’s best estimate of probable loan and lease losses related to specifically identified loans and leases as well as probable losses in the remainder of the various loan and lease portfolios. For purposes of determining the reserve, the Company has segmented loans and leases into classes based on the associated risks within these segments. The Company has determined that eight classes exist within the loan and lease portfolio. The methodology for assessing the appropriateness of the reserve consists of several key elements, which include: specific reserves for impaired loans, percentage allocations for special attention loans and leases without specific reserves, formula reserves for each business lending division portfolio including percentage allocations for special attention loans and leases not deemed impaired, and reserves for pooled homogeneous loans and leases. Management’s evaluation is based upon a continuing review of these portfolios, estimates of customer performance, collateral values and dispositions, and assessments of economic and geopolitical events, all of which are subject to judgment and will change.
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Changes in the reserve for loan and lease losses, segregated by class, for the three months ended March 31, 2012 and 2011 are shown below.
| | | | Auto, light truck | | | | | | Construction | | | | | | | | | |
| | Commercial and | | and environmental | | Medium and | | Aircraft | | equipment | | Commercial | | Residential | | Consumer | | | |
(Dollars in thousands) | | agricultural loans | | equipment | | heavy duty truck | | financing | | financing | | real estate | | real estate | | loans | | Total | |
March 31, 2012 | | | | | | | | | | | | | | | | | | | |
Reserve for loan and lease losses | | | | | | | | | | | | | | | | | | | |
Balance, beginning of period | | $ | 13,091 | | $ | 8,469 | | $ | 3,742 | | $ | 28,626 | | $ | 6,295 | | $ | 16,772 | | $ | 3,362 | | $ | 1,287 | | $ | 81,644 | |
Charge-offs | | 146 | | 2,033 | | — | | 139 | | 119 | | 33 | | 41 | | 256 | | 2,767 | |
Recoveries | | 96 | | 783 | | 21 | | 125 | | 34 | | 34 | | 32 | | 138 | | 1,263 | |
Net charge-offs (recoveries) | | 50 | | 1,250 | | (21 | ) | 14 | | 85 | | (1 | ) | 9 | | 118 | | 1,504 | |
Provision (recovery of provision) | | (516 | ) | 2,550 | | (96 | ) | (14 | ) | 641 | | (447 | ) | 25 | | 111 | | 2,254 | |
Balance, end of period | | $ | 12,525 | | $ | 9,769 | | $ | 3,667 | | $ | 28,598 | | $ | 6,851 | | $ | 16,326 | | $ | 3,378 | | $ | 1,280 | | $ | 82,394 | |
Ending balance: individually evaluated for impairment | | $ | 1,187 | | $ | 1,200 | | $ | — | | $ | 557 | | $ | — | | $ | 277 | | $ | — | | $ | — | | $ | 3,221 | |
Ending balance: collectively evaluated for impairment | | $ | 11,338 | | $ | 8,569 | | $ | 3,667 | | $ | 28,041 | | $ | 6,851 | | $ | 16,049 | | $ | 3,378 | | $ | 1,280 | | $ | 79,173 | |
| | | | | | | | | | | | | | | | | | | |
Financing receivables: | | | | | | | | | | | | | | | | | | | |
Ending balance | | $ | 545,057 | | $ | 455,873 | | $ | 175,471 | | $ | 621,500 | | $ | 271,475 | | $ | 539,112 | | $ | 439,562 | | $ | 98,840 | | $ | 3,146,890 | |
Ending balance: individually evaluated for impairment | | $ | 9,554 | | $ | 3,529 | | $ | 1,227 | | $ | 12,022 | | $ | 3,431 | | $ | 19,740 | | $ | 108 | | $ | — | | $ | 49,611 | |
Ending balance: collectively evaluated for impairment | | $ | 535,503 | | $ | 452,344 | | $ | 174,244 | | $ | 609,478 | | $ | 268,044 | | $ | 519,372 | | $ | 439,454 | | $ | 98,840 | | $ | 3,097,279 | |
| | | | | | | | | | | | | | | | | | | |
March 31, 2011 | | | | | | | | | | | | | | | | | | | |
Reserve for loan and lease losses | | | | | | | | | | | | | | | | | | | |
Balance, beginning of period | | $ | 20,544 | | $ | 7,542 | | $ | 5,768 | | $ | 29,811 | | $ | 8,439 | | $ | 11,177 | | $ | 2,518 | | $ | 1,075 | | $ | 86,874 | |
Charge-offs | | 422 | | 68 | | — | | 1,098 | | 585 | | 1,231 | | 34 | | 595 | | 4,033 | |
Recoveries | | 124 | | 45 | | 1 | | 674 | | 35 | | 105 | | 3 | | 134 | | 1,121 | |
Net charge-offs (recoveries) | | 298 | | 23 | | (1 | ) | 424 | | 550 | | 1,126 | | 31 | | 461 | | 2,912 | |
Provision (recovery of provision) | | (3,941 | ) | 405 | | (704 | ) | 1,516 | | (1,091 | ) | 5,484 | | 55 | | 474 | | 2,198 | |
Balance, end of period | | $ | 16,305 | | $ | 7,924 | | $ | 5,065 | | $ | 30,903 | | $ | 6,798 | | $ | 15,535 | | $ | 2,542 | | $ | 1,088 | | $ | 86,160 | |
Ending balance: individually evaluated for impairment | | $ | 4,025 | | $ | 308 | | $ | 171 | | $ | 2,174 | | $ | 47 | | $ | 1,348 | | $ | — | | $ | — | | $ | 8,073 | |
Ending balance: collectively evaluated for impairment | | $ | 12,280 | | $ | 7,616 | | $ | 4,894 | | $ | 28,729 | | $ | 6,751 | | $ | 14,187 | | $ | 2,542 | | $ | 1,088 | | $ | 78,087 | |
| | | | | | | | | | | | | | | | | | | |
Financing receivables: | | | | | | | | | | | | | | | | | | | |
Ending balance | | $ | 547,381 | | $ | 416,957 | | $ | 156,022 | | $ | 601,480 | | $ | 271,490 | | $ | 578,648 | | $ | 386,290 | | $ | 93,450 | | $ | 3,051,718 | |
Ending balance: individually evaluated for impairment | | $ | 12,769 | | $ | 1,993 | | $ | 4,692 | | $ | 16,462 | | $ | 8,065 | | $ | 31,489 | | $ | — | | $ | — | | $ | 75,470 | |
Ending balance: collectively evaluated for impairment | | $ | 534,612 | | $ | 414,964 | | $ | 151,330 | | $ | 585,018 | | $ | 263,425 | | $ | 547,159 | | $ | 386,290 | | $ | 93,450 | | $ | 2,976,248 | |
Note 6. Mortgage Servicing Assets
The Company recognizes the rights to service residential mortgage loans for others as separate assets, whether the servicing rights are acquired through a separate purchase or through the sale of originated loans with servicing rights retained. The Company allocates a portion of the total proceeds of a mortgage loan to servicing rights based on the fair value. The unpaid principal balance of residential mortgage loans serviced for third parties was $959.12 million and $995.09 million at March 31, 2012 and December 31, 2011, respectively.
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Mortgage servicing assets are evaluated for impairment. For purposes of impairment measurement, mortgage servicing assets are stratified based on the predominant risk characteristics of the underlying servicing, principally by loan type and interest rate. If temporary impairment exists within a tranche, a valuation allowance is established through a charge to income equal to the amount by which the carrying value exceeds the fair value. If it is later determined all or a portion of the temporary impairment no longer exists for a particular tranche, the valuation allowance is reduced through a recovery of income.
Changes in the carrying value of mortgage servicing assets and the associated valuation allowance follow:
| | Three Months Ended | |
| | March 31, | |
(Dollars in thousands) | | 2012 | | 2011 | |
Mortgage servicing assets: | | | | | |
Balance at beginning of period | | $ | 5,610 | | $ | 7,556 | |
Additions | | 330 | | 146 | |
Amortization | | (692 | ) | (734 | ) |
Sales | | — | | — | |
Carrying value before valuation allowance at end of period | | 5,248 | | 6,968 | |
| | | | | |
Valuation allowance: | | | | | |
Balance at beginning of period | | (238 | ) | — | |
Impairment recoveries (charges) | | 234 | | (5 | ) |
Balance at end of period | | $ | (4 | ) | $ | (5 | ) |
Net carrying value of mortgage servicing assets at end of period | | $ | 5,244 | | $ | 6,963 | |
Fair value of mortgage servicing assets at end of period | | $ | 7,494 | | $ | 10,194 | |
During the three months ended March 31, 2012 and 2011, the Company determined that it was not necessary to permanently write-down any previously established valuation allowance. At March 31, 2012 and 2011, the fair value of mortgage servicing assets exceeded the carrying value reported in the consolidated statement of financial condition by $2.25 million and $3.23 million, respectively. This difference represents increases in the fair value of certain mortgage servicing assets that could not be recorded above cost basis.
Mortgage loan contractual servicing fees, including late fees and ancillary income, were $0.94 million and $1.02 million for the three months ended March 31, 2012 and 2011, respectively. Mortgage loan contractual servicing fees are included in mortgage banking income in the consolidated statements of income.
Note 7. Commitments and Financial Instruments with Off-Balance-Sheet Risk
1st Source Corporation and its subsidiaries are parties to financial instruments with off-balance-sheet risk in the normal course of business. These off-balance-sheet financial instruments include commitments to originate and sell loans and standby letters of credit. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. The exposure to credit loss in the event of nonperformance by the other party to the financial instruments for loan commitments and standby letters of credit is represented by the dollar amount of those instruments. The Company uses the same credit policies and collateral requirements in making commitments and conditional obligations as it does for on-balance-sheet instruments.
1st Source Bank (Bank), a subsidiary of 1st Source Corporation, grants mortgage loan commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan commitments is managed by entering into contracts for future deliveries of loans. Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the
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commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
The Company issues letters of credit which are conditional commitments that guarantee the performance of a client to a third party. The credit risk involved and collateral obtained in issuing letters of credit is essentially the same as that involved in extending loan commitments to clients. Standby letters of credit totaled $15.63 million and $14.66 million at March 31, 2012 and December 31, 2011, respectively. Standby letters of credit generally have terms ranging from six months to one year.
On December 28, 2010, 1st Source entered into an agreement with the City of South Bend for the sale of the South Bend headquarters building parking garage for $1.95 million. Although the City of South Bend took possession of the parking garage on that date, the proceeds were placed in an escrow account. Under the terms of the agreement, receipt of the proceeds from the escrow is contingent upon 1st Source investing $5.40 million into its properties within the City of South Bend by December 31, 2013. 1st Source intends to fulfill that commitment and expects to receive the proceeds from escrow within the next twelve months. As of June 30, 2011, the parking garage asset was classified as held for sale and included in accrued income and other assets on the Statement of Financial Condition.
Note 8. Derivative Financial Instruments
Commitments to originate residential mortgage loans held for sale and forward commitments to sell residential mortgage loans are considered derivative instruments. See Note 7 for further information.
The Company has certain interest rate derivative positions that are not designated as hedging instruments. These derivative positions relate to transactions in which the Company enters into an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution. In connection with each transaction, the Company agrees to pay interest to the client on a notional amount at a variable interest rate and receive interest from the client on the same notional amount at a fixed interest rate. At the same time, the Company agrees to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows the client to effectively convert a variable rate loan to a fixed rate. Because the terms of the swaps with the customers and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact the Company’s results of operations.
At March 31, 2012 and December 31, 2011, the amounts of non-hedging derivative financial instruments are shown in the chart below:
| | | | Asset derivatives | | Liability derivatives | |
| | Notional or | | Statement of | | | | Statement of | | | |
| | contractual | | Financial Condition | | Fair | | Financial Condition | | Fair | |
(Dollars in thousands) | | amount | | classification | | value | | classification | | value | |
March 31, 2012 | | | | | | | | | | | |
Interest rate swap contracts | | $ | 432,013 | | Other assets | | $ | 15,912 | | Other liabilities | | $ | 16,286 | |
Loan commitments | | 54,437 | | Mortgages held for sale | | 402 | | N/A | | — | |
Forward contracts | | 42,606 | | N/A | | 58 | | N/A | | — | |
Total | | $ | 529,056 | | | | $ | 16,372 | | | | $ | 16,286 | |
| | | | | | | | | | | |
December 31, 2011 | | | | | | | | | | | |
Interest rate swap contracts | | $ | 453,428 | | Other assets | | $ | 17,496 | | Other liabilities | | $ | 17,945 | |
Loan commitments | | 38,209 | | Mortgages held for sale | | 189 | | N/A | | — | |
Forward contracts | | 21,247 | | N/A | | — | | Mortgages held for sale | | 218 | |
Total | | $ | 512,884 | | | | $ | 17,685 | | | | $ | 18,163 | |
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For the three months ended March 31, 2012 and 2011, the amounts included in the consolidated statements of income for non-hedging derivative financial instruments are shown in the chart below:
| | | | Gain (loss) | |
| | | | Three Months Ended | |
| | Statement of | | March 31, | |
(Dollars in thousands) | | Income classification | | 2012 | | 2011 | |
Interest rate swap contracts | | Other expense | | $ | 75 | | $ | 2 | |
Interest rate swap contracts | | Other income | | 39 | | 27 | |
Loan commitments | | Mortgage banking income | | 213 | | 41 | |
Forward contracts | | Mortgage banking income | | 276 | | (493 | ) |
Total | | | | $ | 603 | | $ | (423 | ) |
Note 9. Earnings Per Share
Earnings per common share is computed using the two-class method. Basic earnings per common share is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during the applicable period, excluding outstanding participating securities. Participating securities include non-vested restricted stock awards. Non-vested restricted stock awards are considered participating securities to the extent the holders of these securities receive non-forfeitable dividends at the same rate as holders of common stock. Diluted earnings per common share is computed using the weighted-average number of shares determined for the basic earnings per common share computation plus the dilutive effect of stock compensation using the treasury stock method. Stock options, where the exercise price was greater than the average market price of the common shares, were excluded from the computation of diluted earnings per common share because the result would have been antidilutive. Stock options of 33,000 were considered antidilutive as of March 31, 2011. No stock options were considered antidilutive as of March 31, 2012.
The following table presents a reconciliation of the number of shares used in the calculation of basic and diluted earnings per common share for the three months ended March 31, 2012 and 2011.
| | Three Months Ended | |
| | March 31, | |
(Dollars in thousands - except per share amounts) | | 2012 | | 2011 | |
Distributed earnings allocated to common stock | | $ | 3,891 | | $ | 3,888 | |
Undistributed earnings allocated to common stock | | 7,651 | | 6,612 | |
Net earnings allocated to common stock | | 11,542 | | 10,500 | |
Net earnings allocated to participating securities | | 173 | | 108 | |
Net income allocated to common stock and participating securities | | $ | 11,715 | | $ | 10,608 | |
| | | | | |
Weighted average shares outstanding for basic earnings per common share | | 24,259,416 | | 24,271,366 | |
Dilutive effect of stock compensation | | 11,450 | | 8,151 | |
Weighted average shares outstanding for diluted earnings per common share | | 24,270,866 | | 24,279,517 | |
| | | | | |
Basic earnings per common share | | $ | 0.48 | | $ | 0.43 | |
Diluted earnings per common share | | $ | 0.48 | | $ | 0.43 | |
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Note 10. Stock-Based Compensation
As of March 31, 2012, the Company had four active stock-based employee compensation plans, which are more fully described in Note 16 of the Consolidated Financial Statements in 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2011. These plans include the 2001 Stock Option Plan, the Employee Stock Purchase Plan, the Executive Incentive Plan, and the Restricted Stock Award Plan. The 2011 Stock Option Plan was approved by the shareholders on April 21, 2011 but no grants had been made through March 31, 2012.
Stock-based compensation expense for all stock-based compensation awards granted is based on the grant-date fair value. For all awards except stock option awards, the grant date fair value is either the fair market value per share or book value per share (corresponding to the type of stock awarded) as of the grant date. For stock option awards, the grant date fair value is estimated using the Black-Scholes option pricing model. For all awards the Company recognizes these compensation costs only for those shares expected to vest on a straight-line basis over the requisite service period of the award, for which the Company uses the related vesting term. The Company estimates forfeiture rates based on historical employee option exercise and employee termination experience. The Company has identified separate groups of awardees that exhibit similar option exercise behavior and employee termination experience and have considered them as separate groups in the valuation models and expense estimates.
The stock-based compensation expense recognized in the condensed consolidated statement of income for the three months ended March 31, 2012 and 2011 was based on awards ultimately expected to vest, and accordingly has been adjusted by the amount of estimated forfeitures. GAAP requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based partially on historical experience.
The aggregate intrinsic value in the table below represents the total pretax intrinsic value (the difference between 1st Source’s closing stock price on the last trading day of the first quarter of 2012 (March 31, 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 options on March 31, 2012. This amount changes based on the fair market value of 1st Source’s stock. Total fair value of options vested and expensed was zero and $3 thousand, net of tax, for the three months ended March 31, 2012 and 2011, respectively.
| | | | | | Average | | | |
| | | | Weighted | | Remaining | | Total | |
| | | | Average | | Contractual | | Intrinsic | |
| | Number of | | Exercise | | Term | | Value | |
| | Shares | | Price | | (in years) | | (in 000’s) | |
Options outstanding, beginning of year | | 22,000 | | $ | 12.04 | | | | | |
Granted | | — | | — | | | | | |
Exercised | | — | | — | | | | | |
Forfeited | | — | | — | | | | | |
Options outstanding at March 31, 2012 | | 22,000 | | $ | 12.04 | | 1.06 | | $ | 274 | |
| | | | | | | | | |
Vested and expected to vest at March 31, 2012 | | 22,000 | | $ | 12.04 | | 1.06 | | $ | 274 | |
Exercisable at March 31, 2012 | | 22,000 | | $ | 12.04 | | 1.06 | | $ | 274 | |
As of March 31, 2012, there was $7.75 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 3.74 years.
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Note 11. Income Taxes
The total amount of unrecognized tax benefits that would affect the effective tax rate if recognized was $1.80 million at March 31, 2012 and $1.67 million at December 31, 2011. Interest and penalties were recognized through the income tax provision. For the three months ending March 31, 2012 and 2011, the Company recognized approximately $(0.05) million and $(0.12) million in interest, net of tax effect, and penalties, respectively. Interest and penalties of approximately $0.52 million and $0.57 million were accrued at March 31, 2012 and December 31, 2011, respectively.
Tax years that remain open and subject to audit include the federal 2008-2011 years and the Indiana 2008-2011 years. The Company does not anticipate a significant change in the amount of uncertain tax positions within the next 12 months.
Note 12. Fair Value Measurements
The Company records certain assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are also utilized to determine the initial value of certain assets and liabilities, to perform impairment assessments, and for disclosure purposes. The Company uses quoted market prices and observable inputs to the maximum extent possible when measuring fair value. In the absence of quoted market prices, various valuation techniques are utilized to measure fair value. When possible, observable market data for identical or similar financial instruments are used in the valuation. When market data is not available, fair value is determined using valuation models that incorporate management’s estimates of the assumptions a market participant would use in pricing the asset or liability.
Fair value measurements are classified within one of three levels based on the observability of the inputs used to determine fair value, as follows:
· Level 1 — The valuation is based on quoted prices in active markets for identical instruments.
· Level 2 — The valuation is based on observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
· Level 3 — The valuation is based on unobservable inputs that are supported by minimal or no market activity and that are significant to the fair value of the instrument. Level 3 valuations are typically performed using pricing models, discounted cash flow methodologies, or similar techniques that incorporate management’s own estimates of assumptions that market participants would use in pricing the instrument, or valuations that require significant management judgment or estimation.
A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.
The Company elected fair value accounting for mortgages held for sale. The Company believes the election for mortgages held for sale (which are hedged with free-standing derivatives [economic hedges]) will reduce certain timing differences and better match changes in the value of these assets with changes in the value of derivatives used as economic hedges for these assets. At March 31, 2012 and December 31, 2011, all mortgages held for sale are carried at fair value.
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The following table reflects the differences between the fair value carrying amount of mortgages held for sale measured at fair value and the aggregate unpaid principal amount the Company is contractually entitled to receive at maturity on March 31, 2012 and December 31, 2011:
(Dollars in thousands) | | Fair value carrying amount | | Aggregate unpaid principal | | Excess of fair value carrrying amount over (under) unpaid principal | |
March 31, 2012 | | | | | | | |
Mortgages held for sale reported at fair value | | $ | 18,114 | | $ | 17,327 | | $ | 787 | (1) |
| | | | | | | |
December 31, 2011 | | | | | | | |
Mortgages held for sale reported at fair value | | $ | 12,644 | | $ | 12,265 | | $ | 379 | (1) |
(1) The excess of fair value carrying amount over unpaid principal is included in mortgage banking income and includes changes in fair value at and subsequent to funding, gains and losses on the related loan commitment prior to funding, and premiums on acquired loans.
Financial Instruments on Recurring Basis:
The following is a description of the valuation methodologies used for financial instruments measured at fair value on a recurring basis:
Investment securities available for sale are valued primarily by a third party pricing agent. Prices supplied by the independent pricing agent, as well as their pricing methodologies and assumptions, are reviewed for reasonableness and to ensure such prices are aligned with traditional pricing matrices. In general, the Company’s investment securities do not possess a complex structure that could introduce greater valuation risk. The portfolio mainly consists of traditional investments including U.S. Treasury and Federal agencies securities, federal agency mortgage pass-through securities, and general obligation and revenue municipal bonds. Pricing for such instruments is fairly generic and is easily obtained. On a quarterly basis, prices supplied by the pricing agent are validated by comparison to prices obtained from other third party sources for a material portion of the portfolio.
The valuation policy and procedures for Level 3 fair value measurements of available for sale debt securities are decided through collaboration between management of the Corporate Accounting and Funds Management departments. The changes in fair value measurement for Level 3 securities are analyzed on a periodic basis under a collaborative framework with the aforementioned departments. The methodology and variables used for input are derived from the combination of observable and unobservable inputs. The unobservable inputs are determined through internal assumptions that may vary from period to period due to external factors, such as market movement and credit rating adjustments.
Both the market and income valuation approaches are implemented using the following types of inputs:
· U.S. treasuries are priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.
· Government-sponsored agency debt securities and corporate bonds are primarily priced using available market information through processes such as benchmark curves, market valuations of like securities, sector groupings and matrix pricing.
· Other government-sponsored agency securities, mortgage-backed securities and some of the actively traded REMICs and CMOs, are primarily priced using available market information including
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benchmark yields, prepayment speeds, spreads and volatility of similar securities.
· Other inactive government-sponsored agency securities are primarily priced using consensus pricing and dealer quotes.
· State and political subdivisions are largely grouped by characteristics, i.e., geographical data and source of revenue in trade dissemination systems. Since some securities are not traded daily and due to other grouping limitations, active market quotes are often obtained using benchmarking for like securities. Local tax anticipation warrants, with very little market activity, are priced using an appropriate market yield curve.
· Marketable equity (common) securities are primarily priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.
Trading account securities are priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.
Mortgages held for sale and the related loan commitments and forward contracts (hedges) are valued using a market value approach and utilizing an appropriate current market yield and a loan commitment closing rate based on historical analysis.
Interest rate swap positions, both assets and liabilities, are valued by a third party pricing agent using an income approach and utilizing models that use as their basis readily observable market parameters. This valuation process considers various factors including interest rate yield curves, time value and volatility factors. Validation of third party agent valuations is accomplished by comparing those values to the Company’s swap counterparty valuations. Management believes an adjustment is required to “mid-market” valuations for derivatives tied to its performing loan portfolio to recognize the imprecision and related exposure inherent in the process of estimating expected credit losses as well as velocity of deterioration evident with systemic risks imbedded in these portfolios.
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The table below presents the balance of assets and liabilities at March 31, 2012 and December 31, 2011 measured at fair value on a recurring basis:
(Dollars in thousands) | | Level 1 | | Level 2 | | Level 3 | | Total | |
March 31, 2012 | | | | | | | | | |
Assets: | | | | | | | | | |
Investment securities available-for-sale: | | | | | | | | | |
U.S. Treasury and Federal agencies securities | | $ | 20,415 | | $ | 377,360 | | $ | — | | $ | 397,775 | |
U.S. States and political subdivisions securities | | — | | 99,299 | | 9,934 | | 109,233 | |
Mortgage-backed securities — Federal agencies | | — | | 348,831 | | — | | 348,831 | |
Corporate debt securities | | — | | 36,297 | | — | | 36,297 | |
Foreign government and other securities | | — | | 4,727 | | — | | 4,727 | |
Total debt securities | | 20,415 | | 866,514 | | 9,934 | | 896,863 | |
Marketable equity securities | | 4,954 | | — | | — | | 4,954 | |
Total investment securities available-for-sale | | 25,369 | | 866,514 | | 9,934 | | 901,817 | |
Trading account securities | | 144 | | — | | — | | 144 | |
Mortgages held for sale | | — | | 18,114 | | — | | 18,114 | |
Accrued income and other assets (Interest rate swap agreements) | | — | | 15,912 | | — | | 15,912 | |
Total | | $ | 25,513 | | $ | 900,540 | | $ | 9,934 | | $ | 935,987 | |
| | | | | | | | | |
Liabilities: | | | | | | | | | |
Accrued expenses and other liabilities (Interest rate swap agreements) | | $ | — | | $ | 16,286 | | $ | — | | $ | 16,286 | |
Total | | $ | — | | $ | 16,286 | | $ | — | | $ | 16,286 | |
| | | | | | | | | |
December 31, 2011 | | | | | | | | | |
Assets: | | | | | | | | | |
Investment securities available-for-sale: | | | | | | | | | |
U.S. Treasury and Federal agencies securities | | $ | 20,016 | | $ | 381,109 | | $ | — | | $ | 401,125 | |
U.S. States and political subdivisions securities | | — | | 96,867 | | 10,493 | | 107,360 | |
Mortgage-backed securities — Federal agencies | | — | | 328,948 | | — | | 328,948 | |
Corporate debt securities | | — | | 36,310 | | — | | 36,310 | |
Foreign government and other securities | | — | | 4,038 | | 675 | | 4,713 | |
Total debt securities | | 20,016 | | 847,272 | | 11,168 | | 878,456 | |
Marketable equity securities | | 4,403 | | 141 | | — | | 4,544 | |
Total investment securities available-for-sale | | 24,419 | | 847,413 | | 11,168 | | 883,000 | |
Trading account securities | | 132 | | — | | — | | 132 | |
Mortgages held for sale | | — | | 12,644 | | — | | 12,644 | |
Accrued income and other assets (Interest rate swap agreements) | | — | | 17,496 | | — | | 17,496 | |
Total | | $ | 24,551 | | $ | 877,553 | | $ | 11,168 | | $ | 913,272 | |
| | | | | | | | | |
Liabilities: | | | | | | | | | |
Accrued expenses and other liabilities (Interest rate swap agreements) | | $ | — | | $ | 17,945 | | $ | — | | $ | 17,945 | |
Total | | $ | — | | $ | 17,945 | | $ | — | | $ | 17,945 | |
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The changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the quarter ended March 31, 2012 and 2011 are summarized as follows:
(Dollars in thousands) | | U.S. States and political subdivisions securities | | Corporate debt securities | | Foreign government and other securities | | Investment securities available- for-sale | |
Beginning balance January 1, 2012 | | $ | 10,493 | | $ | — | | $ | 675 | | $ | 11,168 | |
Total gains or losses (realized/unrealized): | | | | | | | | | |
Included in earnings | | — | | — | | — | | — | |
Included in other comprehensive income | | 17 | | — | | — | | 17 | |
Purchases | | — | | — | | — | | — | |
Issuances | | — | | — | | — | | — | |
Settlements | | — | | — | | — | | — | |
Maturities | | (576 | ) | — | | — | | (576 | ) |
Transfers into Level 3 | | — | | — | | — | | — | |
Transfers out of Level 3 | | — | | — | | (675 | ) | (675 | ) |
Ending balance March 31, 2012 | | $ | 9,934 | | $ | — | | $ | — | | $ | 9,934 | |
| | | | | | | | | |
Beginning balance January 1, 2011 | | $ | 16,306 | | $ | 9,992 | | $ | 675 | | $ | 26,973 | |
Total gains or losses (realized/unrealized): | | | | | | | | | |
Included in earnings | | — | | — | | — | | — | |
Included in other comprehensive income | | 577 | | — | | — | | 577 | |
Purchases | | 350 | | — | | — | | 350 | |
Issuances | | — | | — | | — | | — | |
Settlements | | — | | — | | — | | — | |
Maturities | | (695 | ) | (9,992 | ) | — | | (10,687 | ) |
Transfers into Level 3 | | — | | — | | — | | — | |
Transfers out of Level 3 | | — | | — | | — | | — | |
Ending balance March 31, 2011 | | $ | 16,538 | | $ | — | | $ | 675 | | $ | 17,213 | |
There were no gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at March 31, 2012 or 2011. One transfer between levels occurred during the three months ended March 31, 2012. No transfers between Level 1 and 2 occurred during the period ended March 31, 2012. A foreign government debt security was transferred from Level 3 to Level 2 as of March 31, 2012 due to the Company’s periodic review of valuation methodologies and inputs. The Company determined that the observable inputs used in determining fair value warranted a transfer to Level 2 as the unobservable inputs were deemed to be insignificant to the overall fair value measurement.
The table below presents the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a recurring basis at March 31, 2012.
| | | | Valuation | | | | | |
(Dollars in thousands) | | Fair Value | | Methodology | | Unobservable Inputs | | Range of Inputs | |
Investment securities available-for sale | | | | | | | | | |
Adjustable rate securities | | $ | 5,130 | | Discounted cash flows | | Illiquidity adjustment | | 4% - 8% | |
| | | | | | Term assumption (1) | | 5 years | |
| | | | | | Coupon forecast assumption | | 0.38% - 0.66% | |
| | | | | | | | | |
Tax anticipation warrants | | 4,804 | | Discounted cash flows | | Credit spread assumption | | 1.56% - 2.75% | |
| | | | | | | | | |
Total investment securities available-for-sale | | $ | 9,934 | | | | | | | |
(1) Term assumption is influenced by security call history
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The sensitivity to changes in the unobservable inputs and their impact on the fair value measurement can be significant. The significant unobservable inputs for Adjustable Rate Securities are illiquidity, term and coupon forecast assumptions. The illiquidity adjustment is negatively correlated to the fair value measure. An increase (decrease) in the determined illiquidity adjustment will lower (increase) the fair value measure. The term assumption is negatively correlated to the fair value measure. An increase (decrease) in the determined term adjustment will decrease (increase) the fair value measure. The coupon forecast is positively correlated to the fair value measure. An increase (decrease) in the determined coupon forecast will increase (decrease) the fair value measure. A permutation that includes a change in the coupon forecast with a change in either or both of the two variables will mitigate the significance of the change to the fair value measure. The significant unobservable input for Tax Anticipation Warrants is the underlying market level used to determine the fair value measure. An increase (decrease) in the estimated yield level of the market will decrease (increase) the fair value measure of the securities.
Financial Instruments on Non-recurring Basis:
The Company may be required, from time to time, to measure certain other financial assets at fair value on a non-recurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower of cost or market accounting or impairment charges of individual assets.
The Credit Policy Committee is responsible for overseeing the valuation processes and procedures for Level 3 measurements of impaired loans, other real estate and repossessions. The Committee reviews these assets on a quarterly basis to determine the accuracy of the observable inputs, generally third party appraisals, auction values, values derived from trade publications and data submitted by the borrower, and the appropriateness of the unobservable inputs, generally discounts due to current market conditions and collection issues. The Committee establishes discounts based on asset type and valuation source; deviations from the standard are documented. The discounts are reviewed periodically, annually at a minimum, to determine they remain appropriate. Consideration is given to current trends in market values for the asset categories and gain and losses on sales of similar assets. The Loan and Funds Management Committee of the Board of Directors is responsible for overseeing the Credit Policy Committee.
Discounts range from 10% to 90% depending on the nature of the assets and the source of value. Aircraft are generally valued using quarterly trade publications adjusted for engine time, condition, maintenance programs, discounted by 10%. Likewise, autos are valued using current auction values, discounted by 10%; medium and heavy duty trucks are valued using trade publications and auction values, discounted by 15%. Construction equipment and environmental equipment is generally valued using trade publications and auction values, discounted by 20%. Real estate is valued based on appraisals or evaluations, discounted by 20% at a minimum with higher discounts for property in poor condition or property with characteristics which may make it more difficult to market. Commercial loans subject to borrowing base certificates are generally discounted by 20% for receivables and 40-75% for inventory with higher discounts when monthly borrowing base certificates are not required or received.
Impaired loans and related write-downs are based on the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are reviewed quarterly and estimated using customized discounting criteria, appraisals and dealer and trade magazine quotes which are used in a market valuation approach.
Partnership investments and the adjustments to fair value primarily result from application of lower of cost or fair value accounting. The partnership investments are priced using financial statements provided by the partnerships. Quantitative unobservable inputs are not reasonably available for reporting purposes.
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The Company has established mortgage servicing rights (MSRs) valuation policies and procedures based on industry standards and to ensure valuation methodologies are consistent and verifiable. MSRs and related adjustments to fair value result from application of lower of cost or fair value accounting. For purposes of impairment, MSRs are stratified based on the predominant risk characteristics of the underlying servicing, principally by loan type and interest rate. The fair value of each tranche of the servicing portfolio is estimated by calculating the present value of estimated future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates, servicing costs, and other economic factors. Prepayment rates and discount rates are derived through a third party pricing agent. Changes in the most significant inputs, including prepayment rates and discount rates, are compared to the changes in the fair value measurements and appropriate resolution is made. A fair value analysis is also obtained from an independent third party agent and compared to the internal valuation for reasonableness. MSRs do not trade in an active, open market with readily observable prices and though sales of MSRs do occur, precise terms and conditions typically are not readily available and the characteristics of the Company’s servicing portfolio may differ from those of any servicing portfolios that do trade.
Other real estate is based on the lower of cost or fair value of the underlying collateral less expected selling costs. Collateral values are estimated primarily using appraisals and reflect a market value approach. Fair values are reviewed quarterly and new appraisals are obtained annually. Repossessions are similarly valued.
For assets measured at fair value on a nonrecurring basis the following represents impairment charges (recoveries) recognized on these assets during the quarter ended March 31, 2012: impaired loans - $2.14 million; partnership investments — $(0.10) million; mortgage servicing rights - $(0.23) million; repossessions - $0.31 million, and other real estate - $0.15 million.
The table below presents the carrying value of assets at March 31, 2012 and December 31, 2011 measured at fair value on a non-recurring basis:
(Dollars in thousands) | | Level 1 | | Level 2 | | Level 3 | | Total | |
March 31, 2012 | | | | | | | | | |
Impaired loans | | $ | — | | $ | — | | $ | 46,390 | | $ | 46,390 | |
Accrued income and other assets (partnership investments) | | — | | — | | 1,920 | | 1,920 | |
Accrued income and other assets (mortgage servicing rights) | | — | | — | | 5,244 | | 5,244 | |
Accrued income and other assets (repossessions) | | — | | — | | 6,109 | | 6,109 | |
Accrued income and other assets (other real estate) | | — | | — | | 8,853 | | 8,853 | |
| | $ | — | | $ | — | | $ | 68,516 | | $ | 68,516 | |
| | | | | | | | | |
December 31, 2011 | | | | | | | | | |
Impaired loans | | $ | — | | $ | — | | $ | 50,007 | | $ | 50,007 | |
Accrued income and other assets (partnership investments) | | — | | — | | 2,799 | | 2,799 | |
Accrued income and other assets (mortgage servicing rights) | | — | | — | | 5,372 | | 5,372 | |
Accrued income and other assets (repossessions) | | — | | — | | 6,792 | | 6,792 | |
Accrued income and other assets (other real estate) | | — | | — | | 8,755 | | 8,755 | |
| | $ | — | | $ | — | | $ | 73,725 | | $ | 73,725 | |
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The table below presents the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a non-recurring basis at March 31, 2012.
(Dollars in thousands) | | Fair Value | | Valuation Methodology | | Unobservable Inputs | | Range of Inputs | |
Impaired loans | | $ | 6,389 | | Discounted cash flows | | Expected percent of total contractual cash flows not expected to be collected | | 0% - 50% | |
| | | | | | | | | |
| | 40,001 | | Collateral based measurements | | Discount to reflect current market conditions and ultimate collectibility | | 0% - 90% | |
| | 46,390 | | | | | | | |
| | | | | | | | | |
Mortgage servicing rights | | 7,494 | | Discounted cash flows | | Constant prepayment rate (CPR) | | 17.8% - 22.5% | |
| | | | | | Discount rate | | 8.5% - 11.5% | |
| | | | | | | | | |
Repossessions | | 6,559 | | Appraisals, trade publications and auction values | | Discount to reflect current market conditions | | 0% - 30% | |
| | | | | | | | | |
Other real estate | | 8,853 | | Appraisals | | Discount to reflect current market conditions | | 0% - 55% | |
| | | | | | | | | | |
GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring or non-recurring basis.
The fair values of the Company’s financial instruments as of March 31, 2012 and December 31, 2011 are summarized in the table below.
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| | Carrying or | | | | | | | | | |
(Dollars in thousands) | | Contract Value | | Fair Value | | Level 1 | | Level 2 | | Level 3 | |
March 31, 2012 | | | | | | | | | | | |
Assets: | | | | | | | | | | | |
Cash and due from banks | | $ | 56,707 | | $ | 56,707 | | $ | 56,707 | | $ | — | | $ | — | |
Federal funds sold and interest bearing deposits with other banks | | 901 | | 901 | | 901 | | — | | — | |
Investment securities, available-for-sale | | 901,817 | | 901,817 | | 25,369 | | 866,514 | | 9,934 | |
Other investments and trading account securities | | 19,118 | | 19,118 | | 19,118 | | — | | — | |
Mortgages held for sale | | 18,114 | | 18,114 | | — | | 18,114 | | — | |
Loans and leases, net of reserve for loan and lease losses | | 3,064,496 | | 3,178,230 | | — | | 3,123,023 | | 55,027 | |
Cash surrender value of life insurance policies | | 55,223 | | 55,223 | | 55,223 | | — | | — | |
Mortgage servicing rights | | 5,244 | | 7,494 | | — | | — | | 7,494 | |
Interest rate swaps | | 15,912 | | 15,912 | | — | | 15,912 | | — | |
Liabilities: | | | | | | | | | | | |
Deposits | | $ | 3,505,674 | | $ | 3,529,341 | | $ | 2,315,584 | | $ | 1,213,757 | | $ | — | |
Short-term borrowings | | 143,770 | | 143,770 | | 132,094 | | 11,676 | | — | |
Long-term debt and mandatorily redeemable securities | | 39,828 | | 40,497 | | — | | 40,497 | | — | |
Subordinated notes | | 89,692 | | 97,891 | | — | | 97,891 | | — | |
Interest rate swaps | | 16,286 | | 16,286 | | — | | 16,286 | | — | |
Off-balance-sheet instruments * | | — | | 150 | | — | | 150 | | — | |
| | | | | | | | | | | |
December 31, 2011 | | | | | | | | | | | |
Assets: | | | | | | | | | | | |
Cash and due from banks | | $ | 61,406 | | $ | 61,406 | | | | | | | |
Federal funds sold and interest bearing deposits with other banks | | 52,921 | | 52,921 | | | | | | | |
Investment securities, available-for-sale | | 883,000 | | 883,000 | | | | | | | |
Other investments and trading account securities | | 19,106 | | 19,106 | | | | | | | |
Mortgages held for sale | | 12,644 | | 12,644 | | | | | | | |
Loans and leases, net of reserve for loan and lease losses | | 3,008,899 | | 3,125,581 | | | | | | | |
Cash surrender value of life insurance policies | | 54,729 | | 54,729 | | | | | | | |
Mortgage servicing rights | | 5,372 | | 6,725 | | | | | | | |
Interest rate swaps | | 17,496 | | 17,496 | | | | | | | |
Liabilities: | | | | | | | | | | | |
Deposits | | $ | 3,520,141 | | $ | 3,546,366 | | | | | | | |
Short-term borrowings | | 125,234 | | 125,234 | | | | | | | |
Long-term debt and mandatorily redeemable securities | | 37,156 | | 37,865 | | | | | | | |
Subordinated notes | | 89,692 | | 87,527 | | | | | | | |
Interest rate swaps | | 17,945 | | 17,945 | | | | | | | |
Off-balance-sheet instruments * | | — | | 131 | | | | | | | |
* Represents estimated cash outflows required to currently settle the obligations at current market rates.
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The methodologies for estimating fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above. The estimated fair value approximates carrying value for cash and due from banks, federal funds sold and interest bearing deposits with other banks, other investments, and cash surrender value of life insurance policies. The methodologies for other financial assets and financial liabilities are discussed below:
Loans and Leases — For variable rate loans and leases that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values of other loans and leases are estimated using discounted cash flow analyses which use interest rates currently being offered for loans and leases with similar terms to borrowers of similar credit quality.
Deposits — The fair values for all deposits other than time deposits are equal to the amounts payable on demand (the carrying value). Fair values of variable rate time deposits are equal to their carrying values. Fair values for fixed rate time deposits are estimated using discounted cash flow analyses using interest rates currently being offered for deposits with similar remaining maturities.
Short-Term Borrowings — The carrying values of Federal funds purchased, securities sold under repurchase agreements, and other short-term borrowings, including the liability related to mortgage loans available for repurchase under GNMA optional repurchase programs, approximate their fair values.
Long-Term Debt and Mandatorily Redeemable Securities — The fair values of long-term debt are estimated using discounted cash flow analyses, based on the current estimated incremental borrowing rates for similar types of borrowing arrangements. The carrying values of mandatorily redeemable securities are based on the current estimated cost of redeeming these securities which approximate their fair values.
Subordinated Notes — Fair values are based on quoted market prices, where available. If quoted market prices are not available, fair values are estimated based on calculated market prices of comparable securities.
Off-Balance-Sheet Instruments — Contract and fair values for certain off-balance-sheet financial instruments (guarantees) are estimated based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.
Limitations — Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments. Because no market exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other such factors.
These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. These estimates are subjective in nature and require considerable judgment to interpret market data. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange, nor are they intended to represent the fair value of 1st Source as a whole. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The fair value estimates presented herein are based on pertinent information available to management as of the respective balance sheet date. Although the Company is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.
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Other significant assets, such as premises and equipment, other assets, and liabilities not defined as financial instruments, are not included in the above disclosures. Also, the fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.
ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following management’s discussion and analysis is presented to provide information concerning 1st Source Corporation and its subsidiaries’ (collectively referred to as the “Company”, “we”, and “our”) financial condition as of March 31, 2012, as compared to December 31, 2011, and the results of operations for the three months ended March 31, 2012 and 2011. This discussion and analysis should be read in conjunction with our consolidated financial statements and the financial and statistical data appearing elsewhere in this report and our 2011 Annual Report.
Except for historical information contained herein, the matters discussed in this document express “forward-looking statements.” Generally, the words “believe,” “contemplate,” “seek,” “plan,” “possible,” “assume,” “expect,” “intend,” “targeted,” “continue,” “remain,” “estimate,” “anticipate,” “project,” “will,” “should,” “indicate,” “would,” “may” and similar expressions indicate forward-looking statements. Those statements, including statements, projections, estimates or assumptions concerning future events or performance, and other statements that are other than statements of historical fact, are subject to material risks and uncertainties. We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made. We may make other written or oral forward-looking statements from time to time. Readers are advised that various important factors could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected in such forward-looking statements. Such factors include, but are not limited to, changes in law, regulations or U.S. generally accepted accounting principles; our competitive position within the markets we serve; increasing consolidation within the banking industry; unforeseen changes in interest rates; unforeseen changes in loan prepayment assumptions; unforeseen downturns in or major events affecting the local, regional or national economies or the industries in which we have credit concentrations; and other matters discussed in our filings with the SEC, including our Annual Report on Form 10-K for 2011, which filings are available from the SEC. We undertake no obligation to publicly update or revise any forward-looking statements.
FINANCIAL CONDITION
Our total assets at March 31, 2012 were $4.38 billion, an increase of $10.63 million or 0.24% from December 31, 2011. Total loans and leases were $3.15 billion, an increase of $56.35 million or 1.82% from December 31, 2011. Fed funds sold and interest bearing deposits with other banks were $0.09 million, a decrease of $52.02 million or 98.30% from December 31, 2011 as a result of funding for loan growth. Total investment securities, available for sale were $901.82 million which represented an increase of $18.82 million or 2.13% and total deposits were $3.51 billion, a decrease of $14.47 million or 0.41% over the comparable figures at the end of 2011.
Nonperforming assets at March 31, 2012 were $70.42 million, which was a decrease of $2.06 million or 2.83% from the $72.48 million reported at December 31, 2011. At March 31, 2012 and December 31, 2011, nonperforming assets were 2.19% and 2.28%, respectively of net loans and leases.
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Accrued income and other assets were as follows:
| | March 31, | | December 31, | |
(Dollars in thousands) | | 2012 | | 2011 | |
Accrued income and other assets: | | | | | |
Bank owned life insurance cash surrender value | | $ | 55,223 | | $ | 54,729 | |
Accrued interest receivable | | 14,291 | | 13,626 | |
Mortgage servicing assets | | 5,244 | | 5,372 | |
Other real estate | | 7,719 | | 7,621 | |
Former bank premises held for sale | | 1,134 | | 1,134 | |
Repossessions | | 6,109 | | 6,792 | |
All other assets | | 46,545 | | 49,738 | |
Total accrued income and other assets | | $ | 136,265 | | $ | 139,012 | |
CAPITAL
As of March 31, 2012, total shareholders’ equity was $531.89 million, up $7.97 million or 1.52% from the $523.92 million at December 31, 2011. In addition to net income of $11.72 million, other significant changes in shareholders’ equity during the first three months of 2012 included $3.93 million of dividends paid. The accumulated other comprehensive income/(loss) component of shareholders’ equity totaled $17.94 million at March 31, 2012, compared to $18.51 million at December 31, 2011. The decrease in accumulated other comprehensive income/(loss) during 2012 was the result of changes in unrealized gain/(loss) on securities in the available-for-sale portfolio. Our equity-to-assets ratio was 12.13% as of March 31, 2012, compared to 11.98% at December 31, 2011. Book value per common share rose to $21.92 at March 31, 2012, from $21.64 at December 31, 2011.
We declared and paid dividends per common share of $0.16 during the first quarter of 2012. The trailing four quarters dividend payout ratio, representing dividends per common share divided by diluted earnings per common share, was 31.84%. The dividend payout is continually reviewed by management and the Board of Directors subject to the Company’s capital and dividend policy.
The banking regulators have established guidelines for leverage capital requirements, expressed in terms of Tier 1 or core capital as a percentage of average assets, to measure the soundness of a financial institution. In addition, banking regulators have established risk-based capital guidelines for U.S. banking organizations. The actual capital amounts and ratios of 1st Source Corporation and 1st Source Bank as of March 31, 2012, are presented in the table below:
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| | | | | | | | | | To Be Well | |
| | | | | | | | | | Capitalized Under | |
| | | | Minimum Capital | | Prompt Corrective | |
| | Actual | | Adequacy | | Action Provisions | |
(Dollars in thousands) | | Amount | | Ratio | | Amount | | Ratio | | Amount | | Ratio | |
Total Capital (to Risk-Weighted Assets): | | | | | | | | | | | | | |
1st Source Corporation | | $ | 556,295 | | 16.49 | % | $ | 269,858 | | 8.00 | % | $ | 337,323 | | 10.00 | % |
1st Source Bank | | 542,751 | | 16.14 | | 268,995 | | 8.00 | | 336,243 | | 10.00 | |
Tier 1 Capital (to Risk-Weighted Assets): | | | | | | | | | | | | | |
1st Source Corporation | | 512,440 | | 15.19 | | 134,929 | | 4.00 | | 202,394 | | 6.00 | |
1st Source Bank | | 500,178 | | 14.88 | | 134,497 | | 4.00 | | 201,746 | | 6.00 | |
Tier 1 Capital (to Average Assets): | | | | | | | | | | | | | |
1st Source Corporation | | 512,440 | | 12.08 | | 169,717 | | 4.00 | | 212,146 | | 5.00 | |
1st Source Bank | | 500,178 | | 11.82 | | 169,244 | | 4.00 | | 211,555 | | 5.00 | |
| | | | | | | | | | | | | | | | |
LIQUIDITY AND INTEREST RATE SENSITIVITY
Effective liquidity management ensures that the cash flow requirements of depositors and borrowers, as well as the operating cash needs of 1st Source Corporation, are met. Funds are available from a number of sources, including the securities portfolio, the core deposit base, Federal Home Loan Bank (FHLB) borrowings, Federal Reserve Bank (FRB) borrowings, and the capability to package loans for sale.
We have borrowing sources available to supplement deposits and meet our funding needs. 1st Source Bank has established relationships with several banks to provide short term borrowings in the form of federal funds purchased. While at March 31, 2012 there was $16.00 million outstanding, we could borrow approximately $265.00 million for a short time from these banks on a collective basis. As of March 31, 2012, we had $25.90 million outstanding in FHLB advances and could borrow an additional $169.79 million. We also had $343.36 million available to borrow from the FRB with no amounts outstanding as of March 31, 2012.
Our loan to asset ratio was 71.77% at March 31, 2012 compared to 70.66% at December 31, 2011 and 69.16% at March 31, 2011. Cash and cash equivalents totaled $57.61 million at March 31, 2012 compared to $114.33 million at December 31, 2011 and $138.93 million at March 31, 2011. At March 31, 2012, the consolidated statement of financial condition was rate sensitive by $189.57 million more liabilities than assets scheduled to reprice within one year, or approximately 0.93%. Management believes that the present funding sources provide adequate liquidity to meet our cash flow needs.
In addition, the State of Indiana recently changed the law governing the collateralization of public fund deposits. Under the new law, the Indiana Board of Depositories will determine what financial institutions are required to pledge collateral on a quarterly basis. We have been informed that no collateral is necessary for our Indiana public fund deposits. However, pending legislation could alter this requirement in the future. Our potential liquidity exposure if we must pledge collateral is approximately $447 million.
RESULTS OF OPERATIONS
Net income for the three month period ended March 31, 2012 was $11.72 million, compared to $10.61 million for the same period in 2011. Diluted net income per common share was $0.48 for the three month period ended March 31, 2012, compared to $0.43 for the same period in 2011. Return on average common shareholders’ equity was 8.84% for the three months ended March 31, 2012, compared to 8.73% in 2011. The return on total average assets was 1.08% for the three months ended March 31, 2012, compared to 0.97% in 2011.
The increase in net income for the three months ended March 31, 2012, over the first three months of 2011, was primarily the result of an increase in noninterest income. Details of the changes in the various components of net income are discussed further below.
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NET INTEREST INCOME
The taxable equivalent net interest income for the three months ended March 31, 2012 was $37.92 million, an increase of 0.95% over the same period in 2011. The net interest margin on a fully taxable equivalent basis was 3.77% for the three months ended March 31, 2012, compared to 3.71% for the three months ended March 31, 2011.
During the three month period ended March 31, 2012, average earning assets decreased $59.91 million or 1.46%, over the comparable period in 2011. Average interest-bearing liabilities decreased $171.05 million or 5.11%, for the three month period ended March 31, 2012 over the comparable period one year ago. The yield on average earning assets decreased 18 basis points to 4.55% for the first quarter of 2012 from 4.73% for the first quarter of 2011. The rate earned on assets decreased due to the reduction in short-term market interest rates from a year ago. Total cost of average interest-bearing liabilities decreased 25 basis points to 1.00% for the first quarter 2012 from 1.25% for the first quarter 2011. The result to the net interest margin, or the ratio of net interest income to average earning assets, was an increase of 6 basis points for the three month period ended March 31, 2012 from March 31, 2011.
The largest contributor to the decrease in the yield on average earning assets for the three months ended March 31, 2012, compared to the three months ended March 31, 2011, was a reduction in yields on net loans and leases of 28 basis points. Total average investment securities decreased $66.84 million or 6.99% for the first quarter over one year ago. Average mortgages held for sale decreased $7.17 million or 41.67% for the three month period ended March 31, 2012, over the comparable period a year ago. Average net loans and leases increased $35.86 million or 1.17% for the first quarter of 2012 from the first quarter of 2011. Average other investments, which include federal funds sold, time deposits with other banks, Federal Reserve Bank excess balances, Federal Reserve Bank and Federal Home Loan Bank stock and commercial paper, decreased $21.76 million or 26.87% for the three month period ended March 31, 2012, over the comparable period a year ago.
Average interest-bearing deposits decreased $170.19 million or 5.52% for the first quarter of 2012 over the same period in 2011. The effective rate paid on average interest-bearing deposits decreased 31 basis points to 0.79% for the first quarter 2012 compared to 1.10% for the first quarter 2011. The decline in the average cost of interest-bearing deposits during the first quarter of 2012 as compared to the first quarter of 2011 was primarily the result of interest rate re-pricing on maturing certificates of deposit.
Average short-term borrowings decreased $13.81 million or 9.29% for the first quarter of 2012, compared to the same period in 2011. The decrease in average short-term borrowings was primarily due to lower repurchase agreements and lower treasury demand notes. Interest paid on short-term borrowings decreased 8 basis points for the first quarter of 2012 due to the interest rate decrease on adjustable rate borrowings. Average long-term debt increased $12.95 million or 50.93% during the first quarter of 2012 as compared to the first quarter of 2011. The increase in long-term borrowings was mainly the result of higher borrowings with the Federal Home Loan Bank. Interest paid on long-term borrowings increased 81 basis points for the first quarter due to higher effective rates on mandatorily redeemable securities.
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The following table provides an analysis of net interest income and illustrates the interest earned and interest expense charged for each major component of interest-earning assets and interest-bearing liabilities. Yields/rates are computed on a tax-equivalent basis, using a 35% rate. Nonaccrual loans and leases are included in the average loan and lease balance outstanding.
DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS’ EQUITY
INTEREST RATES AND INTEREST DIFFERENTIAL
(Dollars in thousands)
| | Three months ended March 31, | |
| | 2012 | | 2011 | |
| | | | Interest | | | | | | Interest | | | |
| | Average | | Income/ | | Yield/ | | Average | | Income/ | | Yield/ | |
| | Balance | | Expense | | Rate | | Balance | | Expense | | Rate | |
ASSETS: | | | | | | | | | | | | | |
Investment securities: | | | | | | | | | | | | | |
Taxable | | $ | 781,982 | | $ | 4,327 | | 2.23 | % | $ | 815,564 | | $ | 4,482 | | 2.23 | % |
Tax exempt | | 107,745 | | 1,260 | | 4.70 | % | 141,004 | | 1,734 | | 4.99 | % |
Mortgages - held for sale | | 10,041 | | 98 | | 3.93 | % | 17,213 | | 179 | | 4.22 | % |
Net loans and leases | | 3,089,868 | | 39,928 | | 5.20 | % | 3,054,013 | | 41,278 | | 5.48 | % |
Other investments | | 59,194 | | 226 | | 1.54 | % | 80,949 | | 243 | | 1.22 | % |
| | | | | | | | | | | | | |
Total Earning Assets | | 4,048,830 | | 45,839 | | 4.55 | % | 4,108,743 | | 47,916 | | 4.73 | % |
| | | | | | | | | | | | | |
Cash and due from banks | | 59,558 | | | | | | 58,710 | | | | | |
Reserve for loan and lease losses | | (82,462 | ) | | | | | (88,263 | ) | | | | |
Other assets | | 334,736 | | | | | | 340,974 | | | | | |
| | | | | | | | | | | | | |
Total | | $ | 4,360,662 | | | | | | $ | 4,420,164 | | | | | |
| | | | | | | | | | | | | |
LIABILITIES AND SHAREHOLDERS’ EQUITY: | | | | | | | | | | | | | |
Interest-bearing deposits | | $ | 2,914,588 | | $ | 5,745 | | 0.79 | % | $ | 3,084,779 | | $ | 8,355 | | 1.10 | % |
Short-term borrowings | | 134,919 | | 53 | | 0.16 | % | 148,729 | | 89 | | 0.24 | % |
Subordinated notes | | 89,692 | | 1,647 | | 7.39 | % | 89,692 | | 1,647 | | 7.45 | % |
Long-term debt and mandatorily redeemable securities | | 38,375 | | 471 | | 4.94 | % | 25,426 | | 259 | | 4.13 | % |
| | | | | | | | | | | | | |
Total Interest-Bearing Liabilities | | 3,177,574 | | 7,916 | | 1.00 | % | 3,348,626 | | 10,350 | | 1.25 | % |
| | | | | | | | | | | | | |
Noninterest-bearing deposits | | 574,305 | | | | | | 515,236 | | | | | |
Other liabilities | | 76,055 | | | | | | 63,629 | | | | | |
Shareholders’ equity | | 532,728 | | | | | | 492,673 | | | | | |
| | | | | | | | | | | | | |
Total | | $ | 4,360,662 | | | | | | $ | 4,420,164 | | | | | |
| | | | | | | | | | | | | |
Net Interest Income | | | | $ | 37,923 | | | | | | $ | 37,566 | | | |
| | | | | | | | | | | | | |
Net Yield on Earning Assets on a Taxable Equivalent Basis | | | | | | 3.77 | % | | | | | 3.71 | % |
PROVISION AND RESERVE FOR LOAN AND LEASE LOSSES
The provision for loan and lease losses for the three month period ended March 31, 2012 was $2.25 million, compared to a provision for loan and lease losses in the three month period ended March 31, 2011 of $2.20 million. Net charge-offs of $1.50 million were recorded for the first quarter 2012, compared to $2.91 million for the same quarter a year ago.
On March 31, 2012, 30 day and over loan and lease delinquencies were 0.33% as compared to 0.56% on March 31, 2011. The decrease in delinquencies was primarily in aircraft, construction equipment and commercial loans. The reserve for loan and lease losses as a percentage of loans and leases outstanding at the end of the period was 2.62% as compared to 2.82% one year ago. A summary of loan and lease loss experience during the three months ended March 31, 2012 and 2011 is located in Note 5 of the Consolidated Financial Statements.
A loan or lease is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or lease agreement. We evaluate loans and leases exceeding $100,000 for impairment and establish an allowance as a component of the reserve for loan and lease losses when it is probable all amounts due will not be collected pursuant to the contractual terms of the loan and lease and the recorded investment in the loan or lease exceeds its fair value. A summary of impaired loans as of March 31, 2012 and December 31, 2011 is reflected in Note 4 of the Consolidated Financial Statements.
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NONPERFORMING ASSETS
Nonperforming assets were as follows:
| | March 31, | | December 31, | | March 31, | |
(Dollars in thousands) | | 2012 | | 2011 | | 2011 | |
Loans and leases past due 90 days or more | | $ | 393 | | $ | 460 | | $ | 515 | |
Nonaccrual loans and leases | | 55,027 | | 56,440 | | 74,038 | |
Other real estate | | 7,719 | | 7,621 | | 6,813 | |
Former bank premises held for sale | | 1,134 | | 1,134 | | 1,200 | |
Repossessions | | 6,109 | | 6,792 | | 5,482 | |
Equipment owned under operating leases | | 41 | | 29 | | 300 | |
Total nonperforming assets | | $ | 70,423 | | $ | 72,476 | | $ | 88,348 | |
Nonperforming assets as a percentage of total loans and leases were 2.19% at March 31, 2012, 2.28% at December 31, 2011, and 2.81% at March 31, 2011. Nonperforming assets totaled $70.42 million at March 31, 2012, a decrease of 2.83% from the $72.48 million reported at December 31, 2011, and a 20.29% decrease from the $88.35 million reported at March 31, 2011. The decrease during the first three months of 2012 compared to the same period in 2011 was primarily related to decreases in nonaccrual loans and leases as the economy slowly improves.
The decrease in nonaccrual loans and leases at March 31, 2012 from March 31, 2011 occurred primarily in the commercial real estate, construction equipment, aircraft, and medium and heavy duty truck portfolios. The largest dollar decreases at March 31, 2012 from December 31, 2011 occurred in the commercial real estate and residential real estate portfolios and was offset by an increase in auto, light truck and environmental equipment loans. A summary of nonaccrual loans and leases and past due aging for the period ended March 31, 2012 and December 31, 2011 is located in Note 4 of the Consolidated Financial Statements.
As of March 31, 2012, the industry with the largest dollar exposure was with borrowers whose primary source of income was derived from commercial real estate. These impaired loans totaled approximately $12.22 million which were comprised of $10.57 million secured by commercial real estate and included in loans secured by real estate and $1.65 million secured by aircraft and included in aircraft financing. We have limited exposure to commercial real estate. However, our borrowers with commercial real estate exposure, have suffered as a result of declining real estate values and minimal sales activity. Furthermore, aircraft values have been declining since 2010, increasing the risk in aircraft secured transactions.
The increase over the past year in other real estate is due to foreclosing on real estate in the local market for which we have a current appraisal and is well secured.
Repossessions consisted mainly of aircraft at March 31, 2012. At the time of repossession, the recorded amount of the loan or lease is written down, if necessary, to the estimated value of the equipment or vehicle by a charge to the reserve for loan and lease losses, unless the equipment is in the process of immediate sale. Any subsequent write-downs are included in noninterest expense.
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A summary of other real estate and repossessions is shown in the table below:
| | March 31, | | December 31, | | March 31, | |
(Dollars in thousands) | | 2012 | | 2011 | | 2011 | |
Commercial and agricultural loans | | $ | — | | $ | — | | $ | — | |
Auto, light truck and environmental equipment | | 100 | | 222 | | 261 | |
Medium and heavy duty truck | | — | | — | | 60 | |
Aircraft financing | | 5,980 | | 6,490 | | 4,946 | |
Construction equipment financing | | — | | — | | 200 | |
Commercial real estate | | 6,895 | | 6,634 | | 6,083 | |
Residential real estate | | 844 | | 1,020 | | 730 | |
Consumer loans | | 9 | | 47 | | 15 | |
Total | | $ | 13,828 | | $ | 14,413 | | $ | 12,295 | |
For financial statement purposes, nonaccrual loans and leases are included in loan and lease outstandings, whereas repossessions and other real estate are included in other assets.
Foreign Outstandings — Our foreign loan and lease outstandings, all denominated in U.S. dollars were $224.13 million and $216.93 million as of March 31, 2012 and December 31, 2011, respectively. Foreign loans and leases are in aircraft financing. Loan and lease outstandings to borrowers in Brazil and Mexico were $150.34 million and $42.63 million as of March 31, 2012, respectively, compared to $149.21 million and $41.27 million as of December 31, 2011, respectively. Outstanding balances to borrowers in other countries were insignificant.
NONINTEREST INCOME
Noninterest income for the three month period ended March 31, 2012 and 2011 was $20.52 million and $18.95 million, respectively. Details of noninterest income follow:
| | Three Months Ended | |
| | March 31, | |
(Dollars in thousands) | | 2012 | | 2011 | |
Noninterest income: | | | | | |
Trust fees | | $ | 3,973 | | $ | 3,992 | |
Service charges on deposit accounts | | 4,505 | | 4,236 | |
Mortgage banking income | | 1,942 | | 444 | |
Insurance commissions | | 1,357 | | 1,142 | |
Equipment rental income | | 5,350 | | 6,038 | |
Other income | | 3,001 | | 2,971 | |
Investment securities and other investment gains | | 395 | | 130 | |
Total noninterest income | | $ | 20,523 | | $ | 18,953 | |
Noninterest income increased $1.57 million or 8.28% for the first quarter 2012 as compared to the same period in 2011.
Trust fees were flat for the three months ended March 31, 2012 over the three month period ended March 31, 2011.
Service charges on deposit accounts increased $0.27 million or 6.35% for the three months ended March 31, 2012 over the comparable period one year ago. The improvement in service charges on deposit accounts reflects higher debit card fee income.
Mortgage banking income increased $1.50 million or 337.39% in the first quarter of 2012 as compared to the first quarter of 2011. This positive variance was caused by increased gains on loan sales due to higher production volumes and improved margins in 2012.
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Insurance commissions improved $0.22 million or 18.83% in the three months ended March 31, 2012 over the same period a year ago. The increase was due to the acquisition of a book of business of a benefits agency in January 2012.
Equipment rental income declined $0.69 million or 11.39% in the first quarter of 2012 compared to the first quarter 2011. The average equipment rental portfolio decreased 10.00% in 2012 over the same period in 2011 resulting in lower rental income. In addition, new leases are at lower rates due to current market conditions including lower rates and increased competition.
Other income was relatively flat for the three month period ended March 31, 2012 as compared to the same period in 2011.
The increase in investment securities and other investment gains of $0.27 million or 203.85% in the three months ended March 31, 2012 over the comparable period one year ago was primarily due to a loss on a venture capital investment in 2011 which was not present in 2012.
NONINTEREST EXPENSE
Noninterest expense for the three month period ended March 31, 2012 and 2011 was $38.05 million and $38.48 million, respectively. Details of noninterest expense follow:
| | Three Months Ended | |
| | March 31, | |
(Dollars in thousands) | | 2012 | | 2011 | |
Noninterest expense: | | | | | |
Salaries and employee benefits | | $ | 20,316 | | $ | 18,638 | |
Net occupancy expense | | 2,160 | | 2,320 | |
Furniture and equipment expense | | 3,507 | | 3,349 | |
Depreciation - leased equipment | | 4,311 | | 4,805 | |
Professional fees | | 1,398 | | 1,096 | |
Supplies and communication | | 1,393 | | 1,394 | |
Business development and marketing expense | | 867 | | 622 | |
Intangible asset amortization | | 351 | | 325 | |
Loan and lease collection and repossession expense | | 1,501 | | 1,324 | |
FDIC and other insurance | | 949 | | 1,676 | |
Other expense | | 1,295 | | 2,927 | |
Total noninterest expense | | $ | 38,048 | | $ | 38,476 | |
Noninterest expense decreased $0.43 million or 1.11% for the first quarter as compared to the same period in 2011. Net occupancy, furniture and equipment expense, supplies and communication, and intangible asset amortization all changed slightly in 2012 over the same period in 2011.
Salaries and employee benefits increased $1.68 million or 9.00% in the three months ended March 31, 2012 versus the three months ended March 31, 2011 primarily due to higher base salaries and executive incentive costs.
Depreciation on leased equipment decreased $0.49 million or 10.28% in conjunction with the decrease in equipment rental income for the three months ended March 31, 2012 as compared to the same period one year ago.
Professional fees increased $0.30 million or 27.55% for the three month period ended March 31, 2012 as compared to the three month period ended March 31, 2011. The increase in professional fees in 2012 was the
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result of higher consulting fees offset by reduced legal fees.
Business development and marketing increased $0.25 million or 39.39% for the three months ended March 31, 2012 versus the three months ended March 31, 2011. The higher expense was primarily due to increased marketing promotions and public relations expense.
Loan and lease collection and repossession expense increased $0.18 million or 13.37% in the first quarter of 2012 as compared to the same period in 2011 mainly due to gains on sale of other real estate in 2011 which were not present in 2012 and higher negative valuation adjustments on repossessed aircraft in 2012. These negative variances were offset by lower collection activity in 2012 compared to 2011.
FDIC and other insurance expense decreased $0.73 million or 43.38% for the three months ended March 31, 2012 compared to the three months ended March 31, 2011. The lower premium expense in 2012 was a result of a new assessment base and rates imposed by the FDIC.
Other expenses decreased $1.63 million or 55.76% in the three months ended March 31, 2012 as compared to the three months ended March 31, 2011 due to a lower provision on unfunded loan commitments in 2012.
INCOME TAXES
The provision for income taxes for the three month period ended March 31, 2012 was $5.89 million compared to $4.53 million for the same period in 2011. The effective tax rates were 33.46% and 29.93% for the first quarter ended March 31, 2012 and 2011, respectively. The effective tax rates are higher in 2012 compared to 2011 due to a decrease in tax-exempt interest in relation to income before taxes. Additionally, during the first quarter of 2011 we reached a state tax settlement for the 2008 year and as a result recorded a reduction of unrecognized tax benefits in the amount of $0.84 million that affected the effective tax rate and increased earnings in the amount of $0.47 million.
ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes in market risks faced by 1st Source since December 31, 2011. For information regarding our market risk, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2011.
ITEM 4.
CONTROLS AND PROCEDURES
As of the end of the period covered by this report an evaluation was carried out, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, at March 31, 2012, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by 1st Source in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and are designed to ensure that information required to be disclosed in those reports is accumulated and communicated to management as appropriate to allow timely decisions regarding required disclosure.
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In addition, there were no changes in our internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the first fiscal quarter of 2012 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings.
1st Source and its subsidiaries are involved in various legal proceedings incidental to the conduct of our businesses. Management does not expect that the outcome of any such proceedings will have a material adverse effect on our consolidated financial position or results of operations.
We received notice in April 2011 that the United States Department of Justice has initiated an investigation of 1st Source prompted by pricing practices of certain brokers from whom we purchased mortgages in prior years that were originated by them. The investigation is pursuant to the Equal Credit Opportunity Act and Fair Housing Act. As previously disclosed, we ended our relationships with third-party mortgage brokers in 2010. We are cooperating fully with the investigation and, based on our present understanding, do not expect an outcome that would have any material adverse effect on our consolidated financial position or results of operations.
ITEM 1A. Risk Factors.
There have been no material changes in risks faced by 1st Source since December 31, 2011. For information regarding our risk factors, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2011.
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
ISSUER PURCHASES OF EQUITY SECURITIES
| | | | | | Total number of | | Maximum number (or approximate | |
| | Total number | | Average | | shares purchased | | dollar value) of shares | |
| | of shares | | price paid per | | as part of publicly announced | | that may yet be purchased under | |
Period | | purchased | | share | | plans or programs (1) | | the plans or programs | |
Jan 01 - 31, 2012 | | 24 | | $ | 24.67 | | 24 | | 1,124,639 | |
Feb 01 - 29, 2012 | | 104,000 | | 25.05 | | 104,000 | | 1,020,639 | |
Mar 01 - 31, 2012 | | 447 | | 24.16 | | 447 | | 1,020,192 | |
| | | | | | | | | | |
(1) 1st Source maintains a stock repurchase plan that was authorized by the Board of Directors on April 26, 2007. Under the terms of the plan, 1st Source may repurchase up to 2,000,000 shares of its common stock when favorable conditions exist on the open market or through private transactions at various prices from time to time. Since the inception of the plan, 1st Source has repurchased a total of 979,808 shares.
ITEM 3. Defaults Upon Senior Securities.
None
ITEM 4. Mine Safety Disclosures.
None
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ITEM 5. Other Information.
None
ITEM 6. Exhibits
The following exhibits are filed with this report:
10(a)(4) Employment agreement of Steven J. Wessell, dated June 1, 2011
31.1 Certification of Chief Executive Officer required by Rule 13a-14(a).
31.2 Certification of Chief Financial Officer required by Rule 13a-14(a).
32.1 Certification pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer.
32.2 Certification pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer.
101.INS XBRL Instance Document
101.SCH XBRL Taxonomy Extension Schema Document
101.CAL XBRL Taxonomy Extension Calculation Linkbase Document
101.LAB XBRL Taxonomy Extension Labels Linkbase Document
101.PRE XBRL Taxonomy Extension Presentation Linkbase Document
101.DEF XBRL Taxonomy Extension Definition Linkbase Document
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SIGNATURES
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.
| | 1st Source Corporation |
| | |
| | |
DATE | April 26, 2012 | | /s/ CHRISTOPHER J. MURPHY III |
| | Christopher J. Murphy III |
| | Chairman of the Board, President and CEO |
| | |
| | |
DATE | April 26, 2012 | | /s/ LARRY E. LENTYCH |
| | Larry E. Lentych |
| | Treasurer and Chief Financial Officer |
| | Principal Accounting Officer |
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