UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from_________ to________
COMMISSION FILE NUMBER 0-6233
1ST SOURCE CORPORATION
(Exact name of registrant as specified in its charter)
INDIANA 35-1068133
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
100 N. MICHIGAN STREET
SOUTH BEND, INDIANA 46601
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (574) 235-2000
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
9% CUMULATIVE TRUST PREFERRED SECURITIES AND RELATED GUARANTEE --
$25 PAR VALUE
(Title of Class)
FLOATING RATE CUMULATIVE TRUST PREFERRED SECURITIES AND RELATED GUARANTEE--
$25 PAR VALUE
(Title of Class)
COMMON STOCK -- WITHOUT PAR VALUE
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes [x] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [x] No [ ]
The aggregate market value of the voting common stock held by non-affiliates of
the registrant as of June 30, 2003 was $199,621,322.
The number of shares outstanding of each of the registrant's classes of stock as
of February 9, 2004: Common Stock, without par value -- 20,735,479 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the annual proxy statement for the 2004 annual meeting of
shareholders to be held April 28, 2004, are incorporated by reference into Part
III.
TABLE OF CONTENTS
Part I
Item 1. Business 4
Item 2. Properties 9
Item 3. Legal Proceedings 9
Item 4. Submission of Matters to a Vote of Security Holders 10
Part II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters 11
Item 6. Selected Financial Data 11
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 12
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 25
Item 8. Financial Statements and Supplementary Data 26
Consolidated Statements of Financial Condition
Consolidated Statements of Income
Consolidated Statements of Shareholders' Equity
Consolidated Statements of Cash Flow
Notes to Consolidated Financial Statements
Report of Independent Auditors
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 47
Item 9A. Controls and Procedures 47
Part III
Item 10. Directors and Executive Officers of the Registrant 48
Item 11. Executive Compensation 48
Item 12. Security Ownership of Certain Beneficial Owners and Management 48
Item 13. Certain Relationships and Related Transactions 48
Item 14. Principal Accounting Fees and Services 48
Part IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K 49
Signatures 51
Certifications 52
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ITEM 1. BUSINESS.
GENERAL
1st Source Corporation is an Indiana corporation and registered bank holding
company headquartered in South Bend, Indiana, which commenced operations as a
bank holding company in 1971. As used herein, unless the context otherwise
requires, the term "1st Source" refers to 1st Source Corporation and its
subsidiaries. At December 31, 2003, 1st Source had assets of $3.33 billion,
loans of $2.23 billion, deposits of $2.49 billion, and total shareholders'
equity of $314.69 million.
1st Source, through its principal subsidiary 1st Source Bank (hereafter known as
"Bank"), delivers a comprehensive range of consumer and commercial banking
services to individual and business customers through 60 banking locations in
the Northern Indiana-Southwestern Michigan market area. The Bank also competes
for business nationwide by offering specialized financing services for used
private and cargo aircraft, automobiles for leasing and rental agencies, medium
and heavy duty trucks, construction, and environmental equipment. The Bank,
which was chartered as an Indiana state bank in 1922, is a member of the Federal
Reserve System and its deposits are insured by the Federal Deposit Insurance
Corporation (FDIC) to the extent provided by law. The Bank is headquartered in
South Bend, Indiana, which is in Northern Indiana, approximately 95 miles east
of Chicago and 140 miles north of Indianapolis. Its principal market area
consists of 15 counties in Northern Indiana and Southwestern Michigan.
The principal executive office of 1st Source is located at 100 North Michigan
Street, South Bend, Indiana 46601 and its telephone number is 574 235-2000.
Access to 1st Source's annual report on Form 10-K, quarterly reports on Form
10-Q, current reports on Form 8-K, and all amendments to those reports is
available at www.1stsource.com soon after the material is electronically filed
with the Securities Exchange Commission (SEC).
BANKING AND FINANCIAL SERVICES
1st Source offers a broad range of consumer and commercial banking services
through its lending operations, retail branches, and fee based businesses.
COMMERCIAL, AGRICULTURAL, AND REAL ESTATE LOANS -- 1st Source's commercial and
agriculture loans (excluding Specialty Finance Group loans) at December 31,
2003, were $402.91 million and were 18.06% of total loans outstanding. The
primary focus of this lending area is with privately-held or closely-controlled
firms in 1st Source's regional market area of Northern Indiana and Southwest
Michigan.
Loans secured by real estate amounted to $533.75 million, which was 23.92% of
total loans outstanding, at December 31, 2003. The primary focus of this lending
area is commercial real estate ($360.02 million at December 31, 2003) and
residential mortgage lending ($173.73 million at December 31, 2003) in the
regional market area of Northern Indiana and Southwest Michigan. Most of the
residential mortgages are sold into the secondary market and serviced by 1st
Source's mortgage subsidiary, Trustcorp Mortgage Company (Trustcorp). Mortgage
loans held-for-sale were $60.22 million at December 31, 2003.
1st Source offers both fixed-rate and adjustable-rate consumer mortgage loans
secured by the properties, substantially all of which are located in 1st
Source's primary market area. Adjustable-rate mortgage loans help reduce 1st
Source's exposure to changes in interest rates. During periods of rising
interest rates the risk of default on adjustable-rate mortgage loans may
increase as a result of repricing and the increased payments required from the
borrower.
Commercial and commercial real estate loans generally involve higher credit
risks than residential real estate and consumer loans. Because payments on loans
secured by commercial real estate or equipment are often dependent upon the
successful operation and management of the collateral, repayment of such loans
may be influenced to a great extent by conditions in the market or the economy.
1st Source seeks to minimize these risks through its underwriting standards,
which require such loans to be qualified on the basis of the collateral's income
and debt service ratio. 1st Source obtains extensive financial information and
performs detailed credit risk analysis on its customers. 1st Source's credit
policy sets different maximum exposure limits depending on its relationship and
previous experience with each customer. Credit criteria may include, but are not
limited to, assessments of net worth, asset ownership, bank and trade credit
reference, credit bureau report, and operational history.
CONSUMER LOANS -- 1st Source's consumer loans at December 31, 2003, amounted to
$94.58 million and 4.24% of total loans outstanding. Consumer loans are
primarily all other non-real estate loans to individuals in 1st Source's
regional market area.
Consumer loans can entail risk, particularly in the case of loans that are
unsecured or secured by rapidly depreciating assets. In these cases, any
repossessed collateral may not provide an adequate source of repayment of the
outstanding loan balance. The remaining deficiency often does not warrant
further substantial collection efforts against the borrower beyond obtaining a
deficiency judgment. In addition, consumer loan collections are dependent on the
borrower's continuing financial stability, and thus are more likely to be
adversely affected by job loss, divorce, illness, or personal bankruptcy.
SPECIALTY FINANCE GROUP LOANS AND LEASES -- 1st Source's Specialty Finance Group
provides a broad range of comprehensive lease and equipment finance products
addressing the financing needs of diverse companies. This Group can be broken
down into three areas: truck and automobile financing, aircraft financing, and
construction equipment financing. The finance receivables generally provide for
monthly payments and may include prepayment penalty provisions.
4
Truck and automobile financing consists of financings to automobile rental and
leasing companies, medium and heavy duty truck operating and leasing companies,
and environmental companies. Truck and automobile financing at December 31,
2003, had outstandings of $491.05 million, an increase of 10.30% over the
December 31, 2002, balance of $445.20 million. The increase was mainly due to
growth in the financing receivables of medium and heavy duty trucks, as this
portfolio increased from $197.24 million at December 31, 2002, to $218.42
million at December 31, 2003. Truck and automobile finance receivables generally
range from $50,000 to $15 million with fixed or variable interest rates and
terms of two to seven years.
Aircraft financing consists of financings to aircraft dealers, charters, air
cargo carriers, and corporate aircraft users. Aircraft financing at December 31,
2003, had outstandings of $489.16 million, an increase of 51.07% from the
December 31, 2002, balance of $323.80 million. The majority of this increase can
be attributed to the purchase of $210.83 million of aircraft loans from the
securitized loan portfolio. Aircraft finance receivables generally range from
$100,000 to $15 million with fixed or variable interest rates and terms of two
to seven years.
Construction equipment financing includes financing of equipment to construction
related companies. Construction equipment financing at December 31, 2003, had
outstandings of $219.56 million, a decrease of 27.57% from the December 31,
2002, balance of $303.13 million. Construction equipment finance receivables
generally range from $50,000 to $7 million with fixed or variable interest rates
and terms of three to seven years.
1st Source also generates equipment rental income through the leasing of
construction equipment, various automobiles, and other equipment to customers
through operating leases, where 1st Source retains ownership of the property
being leased. Total equipment rental income for 2003 totaled $25.45 million with
depreciation on this equipment amounting to $19.77 million.
Specialty Finance Group loans and leases are subject to the same credit risk as
mentioned above in the discussion under Commercial, Agricultural, and Real
Estate Loans. In addition, 1st Source's leasing and equipment financing activity
is subject to the risk of cyclical downturns and other adverse economic
developments affecting these industries and markets. This area of lending, with
transportation in particular, is dependent upon general economic conditions and
the strength of the travel and transportation industries. An economic slow down,
exacerbated by the terrorist attacks of September 11, 2001, and its aftermath,
has had a negative impact on 1st Source's aircraft and automobile finance
originations as well as credit quality in certain industry segments such as the
transportation industry. For a further discussion of business risk, see Part I,
Item I, Business -- section titled "Business Risks."
1st Source markets its specialty finance services with sales officers based in
21 locations nationwide. 1st Source markets its financing and leasing services
directly to the equipment end users for the acquisition or leasing of equipment,
and for capital loans.
1st Source's marketing activities are relationship driven and service oriented.
1st Source focuses on providing prompt, responsive, and customized service to
its customers and business prospects with a team of dedicated marketing and
management personnel who solicit business from the users of the equipment, as
well as from dealers and manufacturers. 1st Source's relationship managers and
executive personnel have, on average, over twenty years of experience in the
industries they serve. Management believes that the knowledge base and
relationships built by this team enables 1st Source to compete effectively. The
team's experience with the customer and prospect base, equipment values, resale
markets, and local economic and industry conditions places 1st Source in a
strong competitive position. 1st Source's initiatives include making timely
credit decisions, arranging financing structures which meet the customers' needs
as well as 1st Source's underwriting criteria, providing direct contact between
customers and 1st Source executives with decision-making authority, and
providing swift and knowledgeable responses to customers' inquiries and issues.
1st Source obtains business in several ways. Officers travel throughout their
own geographic territories calling directly on prospects. Officers receive
referrals from present customers, as well as from dealers, manufacturers, and
some select, targeted advertising. Officers also attend numerous trade shows.
1st Source has developed relationships with over 100 manufacturers, whereby on a
non-exclusive basis, the manufacturers refer customers to 1st Source for
financing. However, 1st Source does not provide a captive finance service, and
thus has no expressed or written agreements or obligations with any
manufacturers. All prospects referred undergo the same credit and documentation
criteria as other customers.
DEPOSITS -- Through its network of 60 banking centers located in 15 counties in
Northern Indiana and Southwestern Michigan, 1st Source generates deposits to
fund its lending activities. Total deposits at December 31, 2003, were $2.49
billion. To enhance customer service, 1st Source offers banking services, in
addition to its traditional branches, through its network of 68 automated teller
machines, bank by phone services, and online personal and business financial
products. Service charges on deposit accounts totaled $15.53 million in 2003.
FEE BASED BUSINESSES -- 1st Source maintains various fee based businesses to
complement net interest income.
Trust fees are generated from employee benefit services, personal and agency
trusts and estate planning. In 2003, trust fees were $10.66 million.
Mortgage banking income for 2003 amounted to $19.45 million. Income from loan
sale and servicing is generated from the mortgage banking operations of
Trustcorp. Trustcorp serviced approximately $2.09 billion of mortgage loans at
December 31, 2003. During 2003, $0.58 million of net impairment charges were
recognized on Trustcorp's servicing portfolio.
Insurance commissions from 1st Source's property and casualty insurance agency
totaled $3.05 million for 2003.
SERVICES OFFERED BY THE NON-BANKING SUBSIDIARIES
1st Source's other subsidiaries include 1st Source Leasing, Inc., a leasing
subsidiary; 1st Source Insurance, Inc., a general property and casualty
insurance agency in South Bend; 1st Source Capital Corporation, a licensed small
business investment company; Michigan Transportation Finance Corporation, 1st
Source Specialty Finance, Inc., SFG Equipment Leasing, Inc., 1st Source
Intermediate Holding, LLC, 1st Source Commercial Aircraft Leasing Inc., SFG
Equipment Leasing Corporation I, and Capstone 557 (Proprietary) Limited,
companies that manage the assets of the Specialty Finance Group; 1st Source
Funding, LLC, a qualified special purpose entity established for purposes of
5
administering securitization activity; Trustcorp Mortgage Company, a mortgage
banking company with seven offices in Indiana, Ohio and Michigan, and 1st Source
Corporation Investment Advisors, Inc., a registered investment advisory
subsidiary, that provides investment management services to the 1st Source
Monogram Funds and the trust and investment clients of 1st Source Bank. 1st
Source's one inactive subsidiary is FBT Capital Corporation. 1st Source's
unconsolidated subsidiaries include, 1st Source Capital Trust I, II and III.
These subsidiaries were created to issue $54.75 million of Trust Preferred
Securities.
COMPETITION
The activities in which 1st Source and the Bank engage are highly competitive.
These activities and the geographic markets served primarily involve competition
with other banks, some of which are affiliated with large bank holding companies
headquartered outside of 1st Source's principal market. Larger financial
institutions competing within 1st Source's principal market, but headquartered
elsewhere, include Bank One, Fifth Third Bank, Key Bank, National City Bank,
Standard Federal Bank, and Wells Fargo Bank. Competition among financial
institutions is based upon interest rates offered on deposit accounts, interest
rates charged on loans, and other credit and service charges, the quality of
services rendered, the convenience of banking facilities and, in the case of
loans to large commercial borrowers, relative lending limits.
In addition to competing with other banks within its primary service areas, the
Bank also competes with other financial intermediaries, such as credit unions,
industrial loan associations, securities firms, insurance companies, small loan
companies, finance companies, mortgage companies, real estate investment trusts,
certain governmental agencies, credit organizations, and other enterprises.
Additional competition for depositors' funds comes from United States Government
securities, private issuers of debt obligations, and suppliers of other
investment alternatives for depositors. Many of 1st Source's non-bank
competitors are not subject to the same extensive federal regulations that
govern bank holding companies and banks. Such non-bank competitors may, as a
result, have certain advantages over 1st Source in providing some services.
1st Source competes against these financial institutions by offering innovative
products and highly personalized services. 1st Source also relies on a history
in the market dating back to 1863, relationships that long-term employees have
with their customers and the capacity for quick local decision-making.
EMPLOYEES
1st Source employs approximately 1,220 persons on a full-time equivalent basis.
1st Source provides a wide range of employee benefits and considers employee
relations to be good.
REGULATION AND SUPERVISION
GENERAL -- 1st Source and the Bank are extensively regulated under federal and
state law. These laws and regulations are intended to protect depositors, not
shareholders. To the extent that the following information describes statutory
or regulatory provisions, it is qualified in its entirety by reference to the
particular statutory and regulatory provisions. Any change in applicable laws or
regulations may have a material effect on the business and prospects of 1st
Source. The operations of 1st Source may be affected by legislative changes and
by the policies of various regulatory authorities. 1st Source is unable to
predict the nature or the extent of the effects on its business and earnings
that fiscal or monetary policies, economic controls or new federal or state
legislation may have in the future.
1st Source is a registered bank holding company under the Bank Holding Company
Act of 1956 (BHCA) and, as such, is subject to regulation, supervision and
examination by the Board of Governors of the Federal Reserve System (Federal
Reserve). 1st Source is required to file annual reports with the Federal Reserve
and to provide the Federal Reserve such additional information as it may
require.
The Bank, as an Indiana state bank and member of the Federal Reserve System, is
supervised by the Indiana Department of Financial Institutions (DFI) and the
Federal Reserve. As such, the Bank is regularly examined by and subject to
regulations promulgated by the DFI and the Federal Reserve. Because the FDIC
provides deposit insurance to the Bank, the Bank is also subject to supervision
and regulation by the FDIC (even though the FDIC is not its primary federal
regulator).
BANK AND BANK HOLDING COMPANY REGULATION -- As noted above, both 1st Source and
the Bank are subject to extensive regulation and supervision.
BANK HOLDING COMPANY ACT -- Under the BHCA, as amended, the activities of a bank
holding company, such as 1st Source, are limited to business so closely related
to banking, managing or controlling banks as to be a proper incident thereto.
1st Source is also subject to capital requirements applied on a consolidated
basis in a form substantially similar to those required of the Bank. The BHCA
also requires a bank holding company to obtain approval from the Federal Reserve
before (i) acquiring, or holding more than 5% voting interest in any bank or
bank holding company, (ii) acquiring all or substantially all of the assets of
another bank or bank holding company, or (iii) merging or consolidating with
another bank holding company.
The BHCA also restricts non-bank activities to those which, by statute or by
Federal Reserve regulation or order, have been identified as activities closely
related to the business of banking or of managing or controlling banks. As
discussed below, the Gramm-Leach-Bliley Act, which was enacted in 1999,
established a new type of bank holding company known as a "financial holding
company," that has powers that are not otherwise available to bank holding
companies.
FINANCIAL INSTITUTIONS REFORM, RECOVERY AND ENFORCEMENT ACT OF 1989 -- The
Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA)
reorganized and reformed the regulatory structure applicable to financial
institutions generally.
THE FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT OF 1991 -- The Federal
Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was adopted to
supervise and regulate a wide variety of banking issues. In general, FDICIA
6
provides for the recapitalization of the Bank Insurance Fund (BIF), deposit
insurance reform, including the implementation of risk-based deposit insurance
premiums, the establishment of five capital levels for financial institutions
("well capitalized," "adequately capitalized," "undercapitalized,"
"significantly undercapitalized," and "critically undercapitalized") that would
impose more scrutiny and restrictions on less capitalized institutions, along
with a number of other supervisory and regulatory issues.
RIEGLE-NEAL INTERSTATE BANKING AND BRANCHING EFFICIENCY ACT OF 1994 -- Congress
enacted the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
(Interstate Act) in September 1994. Beginning in September 1995, bank holding
companies have the right to expand, by acquiring existing banks, into all
states, even those which had theretofore restricted entry. The legislation also
provides that, subject to future action by individual states, a holding company
has the right to convert the banks which it owns in different states to branches
of a single bank. The states of Indiana and Michigan have adopted the interstate
branching provisions of the Interstate Act.
ECONOMIC GROWTH AND REGULATORY PAPERWORK REDUCTION ACT OF 1996 -- The Economic
Growth and Regulatory Paperwork Reduction Act of 1996 (EGRPRA) was signed into
law on September 30, 1996. EGRPRA streamlined the non-banking activities
application process for well-capitalized and well-managed bank holding
companies.
GRAMM-LEACH-BLILEY ACT OF 1999 -- The Gramm-Leach-Bliley Act of 1999 (the Act)
is intended to modernize the banking industry by removing barriers to
affiliation among banks, insurance companies, the securities industry, and other
financial service providers. It provides financial organizations with the
flexibility of structuring such affiliations through a holding company structure
or through a financial subsidiary of a bank, subject to certain limitations. The
Act establishes a new type of bank holding company, known as a financial holding
company, that may engage in an expanded list of activities that are "financial
in nature," which include securities and insurance brokerage, securities
underwriting, insurance underwriting, and merchant banking. The Act also sets
forth a system of functional regulation that makes the Federal Reserve the
"umbrella supervisor" for holding companies, while providing for the supervision
of the holding company's subsidiaries by other federal and state agencies. A
bank holding company may not become a financial holding company if any of its
subsidiary financial institutions are not well-capitalized or well-managed.
Further, each bank subsidiary of the holding company must have received at least
a satisfactory Community Reinvestment Act (CRA) rating. The Act also expands the
types of financial activities a national bank may conduct through a financial
subsidiary, addresses state regulation of insurance, generally prohibits unitary
thrift holding companies organized after May 4, 1999, from participating in new
financial activities, provides privacy protection for nonpublic customer
information of financial institutions, modernizes the Federal Home Loan Bank
system, and makes miscellaneous regulatory improvements. The Federal Reserve and
the Secretary of the Treasury must coordinate their supervision regarding
approval of new financial activities to be conducted through a financial holding
company or through a financial subsidiary of a bank. While the provisions of the
Act regarding activities that may be conducted through a financial subsidiary
directly apply only to national banks, those provisions indirectly apply to
state-chartered banks. In addition, the Bank is subject to other provisions of
the Act, including those relating to CRA and privacy, regardless of whether 1st
Source elects to become a financial holding company or to conduct activities
through a financial subsidiary of the Bank. 1st Source does not, however,
currently intend to file notice with the Board to become a financial holding
company or to engage in expanded financial activities through a financial
subsidiary of the Bank.
REGULATIONS GOVERNING CAPITAL ADEQUACY -- The federal bank regulatory agencies
use capital adequacy guidelines in their examination and regulation of bank
holding companies and banks. If capital falls below the minimum levels
established by these guidelines, a bank holding company or bank will be required
to submit an acceptable plan for achieving compliance with the capital
guidelines and will be subject to denial of applications and appropriate
supervisory enforcement actions. The various regulatory capital requirements
that 1st Source is subject to are disclosed in Part II, Item 8, Financial
Statements and Supplementary Data -- Note O of the Notes to Consolidated
Financial Statements. Management of 1st Source believes that the risk-weighting
of assets and the risk-based capital guidelines do not have a material adverse
impact on 1st Source's operations or on the operations of the Bank.
COMMUNITY REINVESTMENT ACT -- The Community Reinvestment Act of 1977 requires
that, in connection with examinations of financial institutions within their
jurisdiction, the federal banking regulators must evaluate the record of the
financial institutions in meeting the credit needs of their local communities,
including low and moderate income neighborhoods, consistent with the safe and
sound operation of those banks. These factors are also considered in evaluating
mergers, acquisitions, and applications to open a branch or facility.
REGULATIONS GOVERNING EXTENSIONS OF CREDIT -- The Bank is subject to certain
restrictions imposed by the Federal Reserve Act on extensions of credit to 1st
Source or its subsidiaries, or investments in its securities and on the use of
its securities as collateral for loans to any borrowers. These regulations and
restrictions may limit the ability of 1st Source to obtain funds from the Bank
for its cash needs, including funds for acquisitions and for payment of
dividends, interest and operating expenses. Further, the BHCA and certain
regulations of the Federal Reserve generally prohibit a bank from extending
credit, engaging in a lease or sale of property, or furnishing services to a
customer on the condition that the customer obtain additional services from the
bank's holding company or from one of its subsidiaries.
The Bank is also subject to certain restrictions imposed by the Federal Reserve
Act on extensions of credit to executive officers, directors, principal
shareholders, or any related interest of such persons. Extensions of credit (i)
must be made on substantially the same terms, including interest rates and
collateral, and following credit underwriting procedures that are at least as
stringent as those prevailing at the time for comparable transactions with
persons not covered above and who are not employees, and (ii) must not involve
more than the normal risk of repayment or present other unfavorable features.
The Bank is also subject to certain lending limits and restrictions on
overdrafts to such persons.
RESERVE REQUIREMENTS -- The Federal Reserve requires all depository institutions
to maintain reserves against their transaction accounts and non-personal time
deposits. Reserves of 3% must be maintained against net transaction accounts
greater than $6.6 million and less than $45.4 million (subject to adjustment by
the Federal Reserve) and reserves of 10% must be maintained against that portion
of net transaction accounts in excess of $45.4 million.
DIVIDENDS -- The ability of the Bank to pay dividends and management fees is
limited by various state and federal laws, by the regulations promulgated by its
primary regulators, and by the principles of prudent bank management.
MONETARY POLICY AND ECONOMIC CONTROL -- The commercial banking business in which
1st Source engages is affected not only by general economic conditions, but also
by the monetary policies of the Federal Reserve. Changes in the discount rate on
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member bank borrowing, availability of borrowing at the "discount window," open
market operations, the imposition of changes in reserve requirements against
member banks deposits and assets of foreign branches, and the imposition of, and
changes in, reserve requirements against certain borrowings by banks and their
affiliates are some of the instruments of monetary policy available to the
Federal Reserve. These monetary policies are used in varying combinations to
influence overall growth and distributions of bank loans, investments, and
deposits, and such use may affect interest rates charged on loans or paid on
deposits. The monetary policies of the Federal Reserve have had a significant
effect on the operating results of commercial banks and are expected to do so in
the future. The monetary policies of the Federal Reserve are influenced by
various factors, including inflation, unemployment, short-term and long-term
changes in the international trade balance, and in the fiscal policies of the
U.S. Government. Future monetary policies and the effect of such policies on the
future business and earnings of 1st Source and the Bank cannot be predicted.
PENDING LEGISLATION -- Because of concerns relating to competitiveness and the
safety and soundness of the banking industry, Congress often considers a number
of wide-ranging proposals for altering the structure, regulation, and
competitive relationships of the nation's financial institutions. It cannot be
predicted whether or in what form any proposals will be adopted or the extent to
which the business of 1st Source may be affected thereby.
BUSINESS RISKS
Like all other banking and financial service companies, 1st Source's business
and results of operations are subject to a number of risks, many of which are
outside of 1st Source's control. In addition to the other information in this
report, readers should carefully consider that the following important factors,
among others, could materially impact 1st Source's business and future results
of operations.
1ST SOURCE'S SUCCESS DEPENDS ON ITS ABILITY TO COMPETE EFFECTIVELY IN THE
COMPETITIVE FINANCIAL SERVICES INDUSTRY -- 1st Source and its operating
subsidiaries encounter strong competition for deposits, loans, and other
financial services in all of its lines of business. 1st Source's principal
competitors include other commercial banks, savings banks, credit unions,
savings and loan associations, mutual funds, money market funds, finance
companies, trust companies, insurers, leasing companies, mortgage companies,
private issuers of debt obligations, venture capital firms, and suppliers of
other investment alternatives, such as securities firms and insurance companies.
Some of its non-bank competitors are not subject to the same degree of
regulation as 1st Source and its subsidiaries and have advantages over 1st
Source in providing certain services. Many of 1st Source's competitors are
significantly larger and have greater access to capital and other resources. In
recent years there has been substantial consolidation among companies in the
financial services industry. Such consolidation may increase competition.
Further, 1st Source's ability to compete effectively is dependent on its ability
to adapt successfully to technological and other changes within the banking and
financial services industry.
1ST SOURCE'S BUSINESS MAY BE ADVERSELY AFFECTED BY THE HIGHLY REGULATED
ENVIRONMENT IN WHICH IT OPERATES -- 1st Source's failure to comply with the many
requirements of state and federal law could lead to termination or suspension of
its licenses, rights of rescission for borrowers, class action lawsuits, and
administrative enforcement actions. Recently enacted and future legislation and
regulations may have significant impact on the financial services industry.
Regulatory or legislative changes could increase 1st Source's costs of doing
business, restrict its access to new products or markets, cause 1st Source to
change some of its products or the way it operates its different lines of
business, or otherwise adversely affect its operations or the manner in which it
conducts its business and, on the whole, adversely affect the profitability of
its businesses.
1ST SOURCE MAY BE ADVERSELY AFFECTED BY A GENERAL DETERIORATION IN ECONOMIC
CONDITIONS -- The risks associated with 1st Source's business are greater in
periods of a slowing economy or recession. Economic declines may be accompanied
by a decrease in demand for consumer and commercial credit and declining real
estate and other asset values. Declining real estate and other asset values,
particularly transportation related equipment, may reduce the ability of
borrowers to use such equity to support borrowings. Delinquencies, foreclosures
and losses generally increase during economic slow downs or recessions.
Additionally, 1st Source's servicing costs, collection costs, and credit losses
may also increase in periods of economic slow down or recession.
1ST SOURCE IS SUBJECT TO CREDIT RISK INHERENT IN ITS LOAN PORTFOLIOS -- In the
financial services industry, there is always a risk that certain borrowers may
not repay borrowings. 1st Source maintains a reserve for loan losses to absorb
the level of losses that it estimates to be probable in its portfolios. However,
its reserve for loan losses may not be sufficient to cover the loan losses that
it may actually incur. If 1st Source experiences defaults by borrowers in any of
its businesses, 1st Source's earnings could be negatively affected. Changes in
local economic conditions could adversely affect credit quality in its local
business loan portfolio, and changes in national economic conditions could
adversely affect the quality of its Specialty Finance Group's portfolio.
CERTAIN 1ST SOURCE LENDING PRODUCT LINES CONTINUE TO EXPERIENCE SLOW DOWNS --
1st Source has specialty national businesses in commercial loans secured by
transportation and construction equipment, including the financing of aircraft
for dealers and air cargo operators, and the financing of vehicles for the
rental and leasing industries. 1st Source's aircraft and auto rental businesses
have been adversely affected by the slow down in the economy over the past two
years. Aircraft and used automobile values have dropped precipitously. Customers
who rely on the use of aircraft or automobiles to produce income have been
negatively affected, and 1st Source has experienced substantial loan losses in
the last two years primarily in its aircraft and auto rental financing units.
Since some of the relationships in these industries are large (up to $15
million), such a slow down could have a significant adverse impact on 1st
Source's performance.
1ST SOURCE COULD BE ADVERSELY AFFECTED BY THE LINGERING THREATS OF TERRORIST
ACTIVITY POST SEPTEMBER 11, 2001, AND PROLONGED AND INCREASED POLITICAL UNREST
IN THE MIDDLE EAST -- These factors are likely to persist throughout 2004. These
factors could have a negative impact on the travel sensitive businesses for
which 1st Source provides financing. Industry concentration limits have been
established and are monitored to potentially mitigate these risks. In addition,
1st Source has experienced significant shrinkage in these businesses over the
past two years. Although the market for used private aircraft appears to have
stabilized during 2003, substantial collateral shortfalls still exist with many
of 1st Source customers and the potential for continued losses remains possible.
1ST SOURCE MAY BE ADVERSELY AFFECTED BY INTEREST RATE CHANGES -- Although 1st
Source actively manages its interest rate sensitivity, such management is not an
exact science. Rapid increases or decreases in interest rates could adversely
affect its net interest margin if changes in its cost of funds do not correspond
8
to changes in income yields. Such fluctuations could also continue to negatively
impact its mortgage banking operations, which are very interest rate sensitive,
by increasing the runoff rates in the servicing portfolio, reducing loan
origination activities, or increasing funding costs. An increase in interest
rates that adversely affects the ability of borrowers to pay the principal or
interest on loans may lead to an increase in nonperforming assets and a
reduction of interest accrued into income, which could have a material adverse
effect on 1st Source's results of operations. 1st Source recorded non-cash
valuation adjustments in 2003 and 2002 for impairment of the carrying value of
the mortgage servicing portfolio held by Trustcorp.
PROVISIONS IN 1ST SOURCE'S RESTATED ARTICLES OF INCORPORATION, BY-LAWS, AND
INDIANA LAW MAY DELAY OR PREVENT AN ACQUISITION OF 1ST SOURCE BY A THIRD PARTY
- -- 1st Source's restated articles of incorporation, by-laws, and Indiana law
contain provisions that may make it more difficult for a third party to acquire
1st Source without the consent of its board of directors. These provisions could
also discourage proxy contests and may make it more difficult for shareholders
to elect their own representatives as directors and take other corporate
actions.
Among other provisions, 1st Source's articles of incorporation authorize its
board of directors to issue shares of preferred stock and to determine its
terms, preferences, and other rights without shareholder approval. The issuance
of preferred stock could discourage a third party from acquiring control of the
company.
1st Source's by-laws do not permit cumulative voting of shareholders in the
election of directors, allowing the holders of a majority of its outstanding
shares to control the election of all its directors. 1st Source's by-laws also
provide that only its board of directors, and not its shareholders, may adopt,
alter, amend, and repeal its by-laws.
Indiana law provides several limitations that may discourage potential acquirers
from purchasing its common shares. In particular, Indiana law prohibits business
combinations with a person who acquires 10% or more of its common shares during
the five-year period after the acquisition of 10% by that person or entity,
unless the acquirer receives prior approval for the acquisition of the shares or
business combination from its board of directors.
1ST SOURCE COULD BE HELD RESPONSIBLE FOR ENVIRONMENTAL LIABILITIES OF PROPERTIES
ACQUIRED THROUGH FORECLOSURE -- Environmentally related hazards have become a
source of high risk and potentially unlimited liability for financial
institutions relative to their loans. Environmentally contaminated properties
owned by an institution's borrowers may result in a drastic reduction in the
value of the collateral securing the institution's loans to such borrowers, high
environmental clean up costs to the borrower affecting its ability to repay the
loans, the subordination of any lien in favor of the institution to a state or
federal lien securing clean up costs, and liability to the institution for clean
up costs if it forecloses on the contaminated property or becomes involved in
the management of the borrower. To minimize this risk, 1st Source may require an
environmental examination of, and report with respect to, the property of any
borrower or prospective borrower if circumstances affecting the property
indicate a potential for contamination, taking into consideration the potential
loss to the institution in relation to the burdens to the borrower. Such
examination must be performed by an engineering firm experienced in
environmental risk studies and acceptable to the institution, and the costs of
such examinations and reports are the responsibility of the borrower. These
costs may be substantial and may deter a prospective borrower from entering into
a loan transaction with 1st Source. 1st Source is not aware of any borrower who
is currently subject to any environmental investigation or clean up proceeding
which is likely to have a material adverse effect on the financial condition or
results of operations of 1st Source.
ITEM 2. PROPERTIES.
1st Source's headquarters building is located in downtown South Bend. In 1982,
the land was leased from the City of South Bend on a 49-year lease, with a
50-year renewal option. The building is part of a larger complex, including a
300-room hotel and a 500-car parking garage. 1st Source sold the building and
entered into a leaseback agreement with the purchaser for a term of 30 years.
The bank building is a structure of approximately 160,000 square feet, with 1st
Source and its subsidiaries occupying approximately 70% of the available office
space and approximately 30% presently subleased to unrelated tenants.
1st Source also owns property and or buildings on which 41 of the Bank
subsidiary's 60 banking centers are located, including the facilities in Allen,
Elkhart, Fulton, Huntington, Kosciusko, LaPorte, Marshall, Porter, St. Joseph,
Starke, and Wells Counties in the State of Indiana and Berrien County in the
State of Michigan, as well as a computer operations center. In 1995, 1st Source
reacquired its former headquarters building through foreclosure. It has been
refurbished for additional tenants and 1st Source use. The remaining properties
utilized by the Bank are leased from unrelated parties.
ITEM 3. LEGAL PROCEEDINGS.
On May 16, 2001, Airmotive, Inc., by and through the Official Unsecured
Creditors' Committee of Airmotive, Inc. (the "Plaintiff"), commenced an
adversary proceeding against the Bank and other entities and individuals. The
proceeding was commenced in connection with the chapter 11 bankruptcy case of
Airmotive, Inc. pending in the U.S. Bankruptcy Court, Central District of
California. Other defendants in the proceeding are Airmotive Capital Group,
Inc., Pacific Aerospace Finance Co., Aviation Finance Corp., Craig Garrick and
Glenn Golenberg.
The Plaintiff alleges that the Bank and other defendants were the recipients of
payments over approximately a four-year period made by Airmotive, Inc. while it
was insolvent and for which it did not receive anything of reasonable equivalent
value in return. Plaintiff also seeks recovery of such payments, or
alternatively, damages equal to the aggregate amount of all unpaid creditor
claims against the bankruptcy estate, on the basis that the Bank and other
defendants exerted control over Airmotive, Inc. to the detriment of its
creditors and also that the Bank aided and abetted Messrs. Garrick and Golenberg
in the breach of their fiduciary duties to Airmotive, Inc. Plaintiff seeks
recovery of an unspecified amount for the payments made to the Bank over the
period, or alternatively, in excess of $10 million which it alleges represents
the aggregate of all unpaid creditor claims against the bankruptcy estate.
9
The Bank has denied the substantive allegations as without merit and is
defending the proceeding vigorously. The Bank also has filed counter and
cross-claims against Plaintiff and the corporate defendants. Since commencement
of the proceeding, the parties have engaged in substantial discovery and the
discovery phase remains ongoing. Based upon the currently available information,
management believes the ultimate resolution of the matter will not have any
material adverse effect on 1st Source's consolidated financial position or
results of operations, but there can be no assurance thereof. Absent a
negotiated resolution, management expects that the discovery phase will conclude
and a trial of the proceeding will be scheduled during 2004.
1st Source and its subsidiaries are involved in various other legal proceedings
incidental to the conduct of their businesses. Management does not expect that
the outcome of any such proceedings will have a material adverse effect on 1st
Source's consolidated financial position or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
10
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
1st Source's common stock is traded on the Nasdaq Stock Market under the symbol
"SRCE." The following table sets forth for each quarter the high and low sales
prices for the common stock of 1st Source, as reported by Nasdaq, and the cash
dividends paid per share for each quarter.
2003 SALES PRICE CASH DIVIDENDS 2002 Sales Price Cash Dividends
HIGH LOW PAID High Low Paid
---- --- ---- ---- --- ----
Common Stock Prices (quarter ended)
March 31 $17.52 $12.80 $ .090 $ 25.45 $ 19.75 $ .090
June 30 19.50 12.57 .090 26.89 21.00 .090
September 30 21.80 17.00 .090 24.58 13.54 .090
December 31 22.64 18.85 .100 17.81 10.90 .090
=============================================================================================================
As of December 31, 2003, there were 1,095 holders of record of 1st Source common
stock.
Federal laws and regulations contain restrictions on the ability of 1st Source
and the Bank to pay dividends. For information regarding restrictions on
dividends, see Part I, Item 1, Business -- Regulation and Supervision --
Dividends and Part II, Item 8, Financial Statements and Supplementary Data --
Note O of the Notes to Consolidated Financial Statements.
ITEM 6. SELECTED FINANCIAL DATA.
The following selected financial data should be read in conjunction with 1st
Source's Consolidated Financial Statements and the accompanying notes presented
elsewhere herein.
(Dollars in thousands, except per share amounts) 2003 2002 2001 2000 1999
Interest income $ 162,322 $ 199,503 $ 245,566 $ 238,222 $ 202,070
Interest expense 59,070 80,817 126,957 134,288 104,401
- -------------------------------------------------- ----- --------- ---- ---------- ---- ----------- ----- ------------ ---------
Net interest income 103,252 118,686 118,609 103,934 97,669
Provision for loan losses 17,361 39,657 25,745 11,836 3,969
- -------------------------------------------------- ----- --------- ---- ---------- ---- ----------- ----- ------------ ---------
Net interest income after provision for loan losses 85,891 79,029 92,864 92,098 93,700
Noninterest income 80,196 73,117 87,026 68,553 58,659
Noninterest expense 138,904 140,741 121,683 104,513 99,536
- --------------------------------------------- ------------------- ---------------- ----------------- ------------- -------------
Income before income taxes 27,183 11,405 58,207 56,138 52,823
Income taxes 8,029 1,366 19,709 18,565 17,055
- --------------------------------------------- ------------------- ---------------- ----------------- ------------- -------------
Net income $ 19,154 $ 10,039 $ 38,498 $ 37,573 $ 35,768
- --------------------------------------------- ------------------- ---------------- ----------------- ------------- -------------
Assets at year end $3,330,153 $3,407,468 $3,562,691 $3,182,181 $2,872,945
Long-term debt and mandatorily redeemable
securities at year end 22,082 16,878 11,939 12,060 12,174
Shareholders' equity at year end 314,691 309,429 306,190 270,572 238,820
Basic net income per common share * 0.92 0.48 1.85 1.81 1.71
Diluted net income per common share * 0.91 0.47 1.82 1.79 1.69
Cash dividends per common share* .370 .360 .351 .334 .284
Dividend payout ratio 40.66% 76.60% 19.29% 18.66% 16.80%
Return on average assets 0.59% 0.29% 1.14% 1.24% 1.31%
Return on average common equity 6.12% 3.23% 13.14% 14.88% 15.74%
Average common equity to average assets 9.60% 8.95% 8.69% 8.31% 8.29%
================================================================================================================================
*All per share amounts have been restated for stock dividends.
11
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The purpose of this analysis is to provide the reader with information relevant
to understanding and assessing 1st Source's results of operations for each of
the past three years and financial condition for each of the past two years. In
order to fully appreciate this analysis the reader is encouraged to review the
consolidated financial statements and statistical data presented in this
document.
FORWARD-LOOKING STATEMENTS
This report, including Management's Discussion and Analysis of Financial
Condition and Results of Operations, contains "forward-looking statements" about
1st Source. Generally, the words "believe," "expect," "intend," "estimate,"
"anticipate," "project," "will," 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. 1st Source cautions readers not to place undue
reliance on any forward-looking statements, which speak only as of the date
made. 1st Source may make other written or oral forward-looking statements from
time to time. Readers are advised that various important factors could cause 1st
Source's 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 laws, regulations, or
accounting principles generally accepted in the United States; 1st Source's
competitive position within its markets served; increasing consolidation within
the banking industry; unforeseen changes in interest rates; unforeseen changes
in loan prepayment assumptions; unforeseen downturns in the local, regional, or
national economies or in the industries in which 1st Source has credit
concentrations; and the matters described under Part I, Item 1, Business --
Business Risks. 1st Source undertakes no obligation to publicly update or revise
any forward-looking statements.
CRITICAL ACCOUNTING POLICIES
1st Source's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States and follow general
practices within the industries in which it operates. Application of these
principles requires management to make estimates or judgments that affect the
amounts reported in the financial statements and accompanying notes. These
estimates or judgments reflect management's view of the most appropriate manner
in which to record and report 1st Source's overall financial performance.
Because these estimates or judgments are based on current circumstances, they
may change over time or prove to be inaccurate based on actual experience. As
such, changes in these estimates, judgments, and/or assumptions may have a
significant impact on the financial statements. All accounting policies are
important, and all policies described in Part II, Item 8, Financial Statements
and Supplementary Data, Note A, (Note A) which begins on page 30, should be
reviewed for a greater understanding of how 1st Source's financial performance
is recorded and reported.
1st Source has identified three policies as being critical because they require
management to make particularly difficult, subjective and/or complex estimates
or judgments about matters that are inherently uncertain and because the
likelihood that materially different amounts would be reported under different
conditions or using different assumptions. These policies relate to the
determination of the reserve for loan losses, the valuation of mortgage
servicing rights, and the valuation of repossessed assets. Management has used
the best information available to make the estimations or judgments necessary to
value the related assets and liabilities. Actual performance that differs from
estimates or judgments and future changes in the key variables could change
future valuations and impact net income. Management has reviewed the application
of these policies with the Audit Committee of 1st Source's Board of Directors. A
brief discussion of 1st Source's critical accounting policies appears below.
RESERVE FOR LOAN LOSSES -- The reserve for loan losses represents management's
estimate of probable losses inherent in the loan portfolio and the establishment
of a reserve that is sufficient to absorb those losses. In determining an
adequate reserve, management makes numerous judgments, assumptions, and
estimates based on continuous review of the loan portfolio, estimates of future
customer performance, collateral values, and disposition, as well as historical
loss rates and expected cash flows. In assessing these factors, management
benefits from a lengthy organizational history and experience with credit
decisions and related outcomes. Nonetheless, if management's underlying
assumptions prove to be inaccurate, the reserve for loan losses would have to be
adjusted. 1st Source's accounting policy related to the reserve is disclosed in
Note A under the heading "Reserve for Loan Losses" on page 31.
MORTGAGE SERVICING RIGHTS VALUATION -- 1st Source recognizes as assets the
rights to service mortgage loans for others, known as mortgage servicing rights
whether the servicing rights are acquired through purchases or through
originated loans. Mortgage servicing rights do not trade in an active open
market with readily observable market prices. Although sales of mortgage
servicing rights do occur, the precise terms and conditions may not be readily
available. As such, the value of mortgage servicing assets are established and
valued using discounted cash flow modeling techniques which require management
to make estimates regarding estimated future net servicing cash flows, taking
into consideration actual and expected mortgage loan prepayment rates, discount
rates, servicing costs, and other economic factors. The expected and actual
rates of mortgage loan prepayments are the most significant factors driving the
value of mortgage servicing assets. Increases in mortgage loan prepayments
reduce estimated future net servicing cash flows because the life of the
underlying loan is reduced. In determining the fair value of the mortgage
servicing assets, mortgage interest rates, which are used to determine
prepayment rates, and discount rates are held constant over the estimated life
of the portfolio. Expected mortgage loan prepayment rates are derived from a
third-party model and adjusted to reflect 1st Source's actual prepayment
experience. Mortgage servicing assets are carried at the lower of the initial
capitalized amount, net of accumulated amortization or fair value. The values of
these assets are sensitive to changes in the assumptions used and readily
available market pricing does not exist. The valuation of mortgage servicing
assets is discussed further in Note A under the heading "Mortgage Banking
Activities" on page 31.
REPOSSESSED ASSETS VALUATION -- The majority of 1st Source's repossessed assets
consist of specialty finance equipment, including aircraft, construction
equipment, and vehicles acquired through foreclosure or in lieu of foreclosure.
Repossessed assets are valued at lower of cost or fair market value. 1st Source
must estimate the fair value of these repossessions as they are traded in
limited markets. 1st Source generally estimates fair value based on the best
estimate of liquidation value. Sources typically include vehicle and equipment
12
dealers, valuation guides, and other third parties, including appraisers. Due to
the nature of these repossessed assets the fair value estimates are sensitive to
environment and economic factors, including, but not limited to, their use
before repossession, condition, age, and limited resale market for such assets.
The valuation of repossessed assets is discussed further in Note A under the
heading "Repossessed Assets" on page 32.
EARNINGS SUMMARY
Net income in 2003 was $19.15 million, up from $10.04 million in 2002 and down
from $38.50 million in 2001. Diluted net income per common share was $0.91 in
2003, $0.47 in 2002, and $1.82 in 2001. Return on average total assets was 0.59%
in 2003, compared to 0.29% in 2002, and 1.14% in 2001. Return on average common
equity was 6.12% in 2003 versus 3.23% in 2002, and 13.14% in 2001.
Net income in 2003 was unfavorably affected by reduced average loan
outstandings, lower net interest margin, continued high costs to secure and
dispose of collateral, and impairment charges for the securitization retained
asset, prior to the purchase of the securitized loan portfolio. On a positive
note, on a year-over-year basis impairment charges were dramatically reduced on
mortgage servicing rights due to the increasing rates for home mortgages, loan
charge-offs decreased significantly, and gains on mortgage loan sales were
recorded in 2003. In addition, 1st Source was moderately successful in
generating additional noninterest income in core services and products.
Dividends declared on common stock in 2003 amounted to $.370 per share, compared
to $.360 in 2002, and $.351 in 2001. The level of earnings reinvested and
dividend payouts are based on management's assessment of future growth
opportunities and the level of capital necessary to support them.
SECURITIZED LOAN PORTFOLIO PURCHASE -- In December 2003, the Bank purchased its
securitized loan portfolio for $226 million. For several years, 1st Source
originated and serviced loans sold to and owned by the 1st Source Master Trust.
The loans were secured by business or personal use aircraft or by car rental
company vehicles, two of 1st Source's longstanding specialty finance product
lines. The loans served as collateral for note certificates issued by the Master
Trust and purchased by institutional investors.
At its peak in 2002, the Master Trust owned $400 million in aircraft and auto
rental loans. However, because of increased costs, the growing complexity of
managing off-balance sheet entities, and reduced loan demand, 1st Source stopped
selling new loans to the Master Trust during the first quarter of 2003, and in
May 2003, with the agreement of all interested parties, began a voluntary
liquidation of the Master Trust. As previously reported, the credit insurer of
the certificates issued by the Master Trust questioned the manner in which the
Bank had handled certain loans in the portfolio and notified the trustee to
retain excess cash in the Master Trust reserve account pending a response from
1st Source. 1st Source arranged for a detailed audit by an independent
accounting firm, the results of which verified that the Bank had handled the
loans in accordance with the agreements governing the Master Trust and
consistent with industry standards.
After a comprehensive analysis, 1st Source decided to make an offer to purchase
the portfolio back from the Master Trust for a variety of reasons. Demand for
loans, in general, and particularly for loans for business or personal use
aircraft, has remained soft, reducing the need for external sources of funding.
Moreover, the costs of maintaining the Master Trust, including the time required
to manage the issues associated with an "off-balance-sheet" entity, continued to
increase. Purchasing the portfolio greatly simplifies the issues and enhances
transparency by bringing the loans back "on-balance sheet." The purchase also
simplifies 1st Source's relationships with customers that have had loans in both
portfolios.
The portfolio purchased included $210.83 million in aircraft loans, $15.19
million in auto rental loans, and $4.39 million of loan-related assets. Excess
cash of $24.53 million in the Master Trust was used to repay 1st Source its
retained interest in the Master Trust. The Bank has established a loss reserve
of $6.82 million against the portfolio, which is consistent with current loss
reserves maintained for the Bank's on-balance sheet portfolios. The transaction
did not materially change 1st Source's overall loan loss reserve as a percentage
of loans outstanding, nor did it have a material impact on the results of
operations in 2003.
NET INTEREST INCOME -- Net interest income, the difference between income from
earning assets and the interest cost of funding those assets, is 1st Source's
primary source of earnings. Net interest income, on a fully taxable equivalent
basis, decreased 12.79% in 2003, following a 0.09% decrease in 2002.
Net interest margin, the ratio of net interest income to average earning assets,
is affected by movements in interest rates and changes in the mix of earning
assets and the liabilities that fund those assets. Net interest margin on a
fully taxable equivalent basis was 3.56% in 2003 compared to 3.87% in 2002, and
3.95% in 2001. The net interest margin was negatively impacted in 2003,
primarily due to a moderate change in the mix of our earning assets and the
decrease in the overall level of interest rates. In addition, fees on loans
which are included in loan interest income decreased in 2003 from 2002 by $1.17
million due to the recognition of these fees over the life of the loans.
The yield on earning assets in 2003 was 5.54%, compared to 6.43% in 2002, and
8.07% in 2001. Average earning assets in 2003 decreased 5.33%, following a 2.15%
increase in 2002. The effective rate on interest bearing liabilities was 2.38%
in 2003, compared to 2.95% for 2002, and 4.68% for 2001.
13
The following table provides an analysis of net interest income and illustrates
the interest income earned and interest expense charged for each major component
of interest earning assets and interest bearing liabilities. The net interest
spread is the difference between the average yield earned on assets and the
average rate incurred on liabilities:
2003 2002 2001
INTEREST Interest Interest
AVERAGE INCOME/ YIELD/ Average Income/ Yield/ Average Income/ Yield/
(Dollars in thousands) BALANCE EXPENSE RATE Balance Expense Rate Balance Expense Rate
ASSETS
- ------------------------------------------------------------------------------------------------------------------------------------
Investment securities
Taxable $ 535,233 $ 18,410 3.44% $ 486,835 $ 21,359 4.39% $ 434,154 $ 26,078 6.01%
Tax-exempt(1) 167,740 8,306 4.95 152,343 8,865 5.82 151,993 9,925 6.53
Mortgages held for sale 112,157 6,496 5.79 118,546 7,881 6.65 117,052 10,398 8.88
Net loans(2,3) 2,091,004 131,186 6.27 2,332,992 163,456 7.01 2,347,746 201,669 8.60
Other investments 75,488 916 1.21 58,916 1,078 1.83 32,462 820 2.53
- ------------------------------- ------------------------- ------------------- ---------- -------------------- ------------ -------
Total earning assets 2,981,622 165,314 5.54 3,149,632 202,639 6.43 3,083,407 248,890 8.07
Cash and due from banks 86,483 91,217 99,453
Reserve for loan losses (63,123) (59,171) (50,895)
Other assets 253,192 284,704 237,978
- ------------------------------- ------------------------- ------------------- ---------- -------------------- ------------ -------
Total assets $3,258,174 $ 3,466,382 $3,369,943
====================================================================================================================================
LIABILITIES AND
SHAREHOLDERS' EQUITY
Interest bearing deposits $2,145,467 $ 49,153 2.29% $ 2,408,801 $ 71,084 2.95% $2,330,988 $ 108,069 4.64%
Short-term borrowings 256,628 5,121 2.00 270,747 5,659 2.09 325,456 14,455 4.44
Subordinated notes 55,604 3,804 6.84 46,010 3,249 7.06 44,750 3,560 7.96
Long-term debt and
mandatorily redeemable
securities 20,132 992 4.93 13,066 825 6.31 12,078 873 7.23
- ------------------------------- ------------------------- ------------------- ---------- -------------------- ------------ -------
Total interest bearing liabilities 2,477,831 59,070 2.38 2,738,624 80,817 2.95 2,713,272 126,957 4.68
Noninterest bearing deposits 413,794 362,509 305,373
Other liabilities 53,756 54,837 58,312
Shareholders' equity 312,793 310,412 292,986
- ------------------------------- ------------------------- ------------------- ---------- -------------------- ------------ -------
Total liabilities and
shareholders' equity $3,258,174 $ 3,466,382 $3,369,943
====================================================================================================================================
Net interest income $ 106,244 $121,822 $ 121,933
====================================================================================================================================
Net interest margin on a tax
equivalent basis 3.56% 3.87% 3.95%
====================================================================================================================================
(1) Interest income includes the effects of tax equivalent adjustments, using a
35% rate. Tax equivalent adjustments were $2,692 in 2003, $2,828 in 2002
and $3,058 in 2001.
(2) Loan income includes fees on loans of $4,102 in 2003, $5,042 in 2002 and
$6,394 in 2001. Loan income also includes the effects of tax equivalent
adjustments, using a 35% rate. Tax equivalent adjustments were $300 in
2003, $308 in 2002 and $266 in 2001.
(3) For purposes of this computation, nonaccruing loans are included in the
average loan balance outstanding.
14
The following table shows changes in tax equivalent interest earned and interest
paid, resulting from changes in volume and changes in rates:
Increase (Decrease) due to *
(Dollars in thousands) Volume Rate Net
2003 COMPARED TO 2002
INTEREST EARNED ON:
INVESTMENT SECURITIES:
TAXABLE $ 2,531 $ (5,480) $ (2,949)
TAX-EXEMPT 1,184 (1,743) (559)
MORTGAGES HELD FOR SALE (405) (980) (1,385)
NET LOANS (15,914) (16,356) (32,270)
OTHER INVESTMENTS 841 (1,003) (162)
- ------------------------------------------------------------------------------------------------------
TOTAL EARNING ASSETS $(11,763) $(25,562) $(37,325)
======================================================================================================
INTEREST PAID ON:
INTEREST BEARING DEPOSITS $ (7,200) $(14,731) $(21,931)
SHORT-TERM BORROWINGS (300) (238) (538)
SUBORDINATED NOTES 652 (97) 555
LONG-TERM DEBT AND MANDATORILY REDEEMABLE SECURITIES 280 (113) 167
- -----------------------------------------------------------------------------------------------------
TOTAL INTEREST BEARING LIABILITIES (6,568 ) $(15,179) $(21,747)
======================================================================================================
NET INTEREST INCOME $ (5,195 ) $(10,383) $(15,578)
======================================================================================================
2002 compared to 2001
Interest earned on:
Investment securities:
Taxable $ 3,867 $ (8,585) $ (4,718)
Tax-exempt 21 (1,081) (1,060)
Mortgages held for sale 128 (2,645) (2,517)
Net loans (1,345) (36,869) (38,214)
Other investments 390 (132) 258
- ------------------------------------------------------------------------------------------------------
Total earning assets $ 3,061 $(49,312) $(46,251)
======================================================================================================
Interest paid on:
Interest bearing deposits $ 3,861 $(40,846) $ (36,985)
Short-term borrowings (2,124) (6,672) (8,796)
Subordinated notes 107 (418) (311)
Long-term debt and mandatorily redeemable securities 88 (136) (48)
- ------------------------------------------------------------------------------------------------------
Total interest bearing liabilities $ 1,932 $(48,072) $ (46,140)
======================================================================================================
Net interest income $ 1,129 $ (1,240) $ (111)
======================================================================================================
* The change in interest due to both rate and volume has been allocated to
volume and rate changes in proportion to the relationship of the absolute dollar
amounts of the change in each.
NONINTEREST INCOME -- Noninterest income for the most recent three years ended
December 31 was as follows:
(Dollars in thousands) 2003 2002 2001
- -----------------------------------------------------------------------------------------------------------------------------------
Noninterest income:
Trust fees $10,664 $10,252 $ 9,672
Service charges on deposit accounts 15,532 14,947 11,714
Mortgage banking 19,451 7,593 24,531
Securitization income 3,206 4,833 5,714
Insurance commissions 3,047 2,431 2,202
Equipment rental income 25,448 28,773 26,249
Other income 6,784 7,124 6,505
Investment securities and other investment (losses) gains (3,936) (2,836) 439
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL NONINTEREST INCOME $80,196 $73,117 $87,026
====================================================================================================================================
On the strength of mortgage banking, noninterest income was up 9.68% in 2003.
Growth in trust and deposit fees and insurance commission income also
contributed to the increase in noninterest income in 2003.
Mortgage banking income increased 156.17% in 2003 from 2002 compared to a
decrease of 69.05% in 2002 from 2001. The increase in 2003 was the result of the
strong mortgage origination market driven by the historically low interest rate
15
environment and increased mark to market gains on pipeline loans as mortgage
rates continued to fall. In 2001, a sale of approximately $1.0 billion of bulk
mortgage servicing rights, resulted in an $11.06 million gain. In 2003
and 2002, respectively, there were impairments of mortgage servicing assets of
$0.58 million and $7.33 million. During 2003, 1st Source determined that $4.63
million of impairment was unrecoverable and was recorded as a direct write-down
to the carrying value of the asset.
Securitization income was down 33.66% in 2003 from 2002 compared to a
decrease of 15.42% in 2002 from 2001. In the first half of 2003, 1st Source
began allowing the Master Trust to liquidate due to adequate capital and
liquidity to hold the loans, otherwise eligible for securitization, on the
balance sheet, and the desire to eliminate the expenses associated with
securitization. This resulted in lower gains on loan sales and reduced servicing
income for 2003. Servicing income was $3.50 million, $3.78 million and $3.44
million in 2003, 2002, and 2001, respectively. Gains (losses) on loan sales were
$(0.30) million, $1.05 million, and $2.27 million in 2003, 2002, and 2001,
respectively. In December 2003, the remaining securitized loans were purchased
by the Bank.
Trust fees increased by 4.01% in 2003 from 2002 compared to an increase of 6.00%
in 2002 over 2001. These increases are reflective of the increase in new clients
bringing assets to 1st Source for management and the improvement in the equity
markets.
Service charges on deposit accounts increased 3.91% in 2003 from 2002 compared
to an increase of 27.60% in 2002 from 2001. The increase in 2003 is attributed
primarily to greater transaction account volume and fewer fees waived. In 2002,
overdraft, business service, and debit card fees primarily accounted for the
increase in service charges on deposit accounts along with increases in
transaction account volume, attributed primarily to branch acquisitions in 2001.
Insurance commissions are up 25.34% in 2003 from 2002 compared to an increase of
10.40% in 2002 from 2001. The increases for 2003 and 2002 are attributed to
growth in commercial lines and higher premiums.
Equipment rental income generated from operating leases declined by 11.56%
during 2003 from 2002 compared to an increase of 9.62% in 2002 from 2001.
Revenues from operating leases for construction equipment, automobiles, and
other equipment declined due to the soft economy.
Other income decreased 4.77% in 2003 from 2002 compared to an increase of 9.52%
in 2002 from 2001. The decrease in 2003 is primarily the result of the deferral
of standby letters of credit fees of $0.22 million. The increase in 2002 from
2001 was primarily the result of $0.56 million of gains recorded on trading
account securities.
Included in investment securities and other investment losses in 2003 and 2002,
are impairment charges on the securitization retained asset, prior to purchase
of loans, of $2.99 million and $1.49 million, respectively. The majority of the
2003 impairment, $2.47 million, was taken in the third quarter. This charge was
the result of a change in assumption in the model used to estimate the value of
the Bank's retained interest asset. The model assumed monthly payments of excess
cash in the securitization. However, in September 2003, the credit insurer of
the Master Trust's indebtedness to note holders delivered a notice to the
trustee of the Master Trust directing the trustee to retain the excess cash in
the Master Trust. The stated basis for the directive was the credit insurer's
belief that an "Early Amortization Event" (as defined in the Master Trust
agreements) had occurred citing purported deficiencies in the loan servicing
practices of the Bank. As a consequence, the excess cash was retained in the
Master Trust. 1st Source changed the model assumption relating to excess cash
receipts, to assume all cash would be received upon completion of the
liquidation of the Master Trust. The change in assumption led to the $2.47
million impairment charge. The remainder of the 2003 impairment charge of $0.52
million and the $1.49 million impairment charge recorded in 2002 was mainly the
result of decreased credit quality and the general decline in aircraft and auto
values. There were no impairment charges relating to the securitization in 2001.
The balance of the net investment securities and other investment (losses) gains
in 2003, 2002, and 2001 were primarily the result of valuation adjustments on
venture capital and other investments.
NONINTEREST EXPENSE -- Noninterest expense for the recent three years ended
December 31 was as follows:
(Dollars in thousands) 2003 2002 2001
- ------------------------------------------------------------------ ---------------------------------- ----------------- ------------
Noninterest expense:
Salaries and employee benefits $ 69,457 $ 67,398 $ 62,614
Net occupancy expense 6,881 6,861 6,199
Furniture and equipment expense 10,363 10,719 9,428
Depreciation - leased equipment 19,773 23,494 21,034
Supplies and communication 6,163 6,582 6,498
Business development and marketing expense 3,480 3,006 4,359
Intangible asset amortization 2,748 2,136 429
Loan collection and repossession expense 8,112 9,851 809
Other expense 11,927 10,694 10,313
- ------------------------------------------------------------------ ---------------------------------- ----------------- ------------
TOTAL NONINTEREST EXPENSE $138,904 $140,741 $121,683
====================================================================================================================================
1st Source experienced a decrease in noninterest expense of 1.31% in 2003 from
2002 compared to a 15.66% increase in 2002 from 2001. The leading factors
contributing to the decrease in noninterest expense in 2003 were reduced
depreciation on leased equipment, a decrease in loan collection and repossession
expenses, and lower supplies and communications expenses offset by increases in
salaries and benefits, intangible asset amortization, and other expenses. The
leading factors contributing to the increase in 2002 from 2001 include the
effects of a full year of operations relating to the 2001 branch acquisitions,
an increase in loan collection and repossession expenses, higher depreciation
charges on leased equipment, and increased intangible asset amortization.
16
Salaries and employee benefits increased 3.05% in 2003 from 2002, following a
7.64% increase in 2002 from 2001. Salaries decreased 2.55% in 2003 and increased
12.76% in 2002. The largest component of the 2003 decrease was the impact of the
capitalization of $2.65 million in salaries and benefits in connection with the
deferral of loan origination costs, whereas the increase in 2002 was the result
of the first full year of operations for the branches acquired in 2001. The
number of full-time equivalent employees was 1,220 at the end of 2003, compared
to 1,233 and 1,260 at the end of 2002 and 2001, respectively. Employee benefits
increased 31.83% in 2003, following a 12.70% decrease in 2002. The 2003 change
in employee benefits was primarily the result of increased executive incentives
combined with an increase in group insurance expense. In 2002, the decrease in
employee benefits was primarily the result of lower executive incentives offset
by an increase in group insurance expense.
Occupancy expense increased by 0.29% in 2003 from 2002, compared to a 10.68%
increase in 2002 from 2001. The normal annual lease and operating cost increases
in 2003 exceeded the impact of three branch closings. In addition, Indiana
property taxes decreased due to the state wide property reassessment. In
contrast, the 2002 increase was due to the 17 branches acquired in 2001, 13 of
which were acquired in the fourth quarter.
Furniture and equipment expense, including depreciation, decreased in 2003 from
2002 by 3.32%, compared to a 13.69% increase in 2002 from 2001. The decrease in
2003 is the result of reduced equipment repair costs offset by increased
computer processing charges. The increase in 2002 is attributed primarily to
upgrades in hardware and computer systems and increased computer processing
charges relating to the new branches acquired during 2001.
Depreciation on operating leases decreased 15.84% in 2003, following an 11.70%
increase in 2002. Compared to the increase in 2002, the operating lease
portfolio declined in 2003 due to the slow economy.
Supplies and communications expense decreased 6.37% in 2003 from 2002, compared
to a 1.29% increase in 2002 from 2001. The decrease in 2003 was due to continued
cost controls over printing, supplies, and communications.
Business development and marketing expense increased 15.77% in 2003 from 2002,
compared to a decrease of 31.04% in 2002 from 2001. During 2003, 1st Source
continued to engage in effective target advertising and marketing campaigns.
Additionally, charitable contributions increased in 2003 compared to 2002. The
increased expense in 2001 was primarily the result of marketing efforts in the
newly acquired branches.
Finite-lived intangible asset amortization increased $0.61 million in 2003 from
2002 compared to a $1.71 million increase in 2002 from 2001. The increase in
2003 was due to the full year effect of amortization on finite-lived intangible
assets. The increase in 2002 was attributed to core deposit intangibles
amortization from the prior year branch acquisitions.
Loan collection and repossession expenses decreased $1.74 million in 2003 from
2002 compared to a significant $9.04 million increase in 2002 from 2001. The
2003 decrease was the result of fewer valuation adjustments recorded on
repossessed assets netted against increased legal and collection efforts. The
2002 increase reflects the collection costs and valuation adjustments on the
substantial nonperforming asset portfolio held during the year.
An increase of 11.53% occurred in other expenses during 2003, compared to a
3.69% increase in 2002 from 2001. The primary cause of the increase was due to
increased insurance costs, professional fees, and losses on the disposal of
fixed assets. During 2003, 1st Source and Trustcorp experienced a favorable
reduction in fraud and forgery losses compared to 2002.
INCOME TAXES -- 1st Source recognized income tax expense in 2003 of $8.03
million, compared to $1.37 million in 2002, and $19.71 million in 2001. The
effective tax rate in 2003 was 29.54% compared to 11.98% in 2002, and 33.86% in
2001. The effective tax rate in 2003 compared to 2002 was due to tax-exempt
income remaining constant while net income before tax increased. For detailed
analysis of 1st Source's income taxes see Part II, Item 8, Financial Statements
and Supplementary Data -- Note L of the Notes to Consolidated Financial
Statements.
FINANCIAL CONDITION
LOAN PORTFOLIO -- The following table shows 1st Source's loan distribution at
the end of each of the last five years as of December 31:
(Dollars in thousands) 2003 2002 2001 2000 1999
Commercial and agricultural loans $ 402,905 $ 428,367 $ 460,373 $ 496,303 $ 455,560
Truck and automobile financing 491,052 445,195 344,014 259,382 215,390
Aircraft financing 489,155 323,802 514,573 508,278 422,076
Construction equipment financing 219,562 303,126 328,004 272,250 244,745
Loans secured by real estate 533,749 567,950 586,580 593,287 526,929
Consumer loans 94,577 111,012 128,305 127,808 134,017
- ----------------------------------------- ------------ ---------------- ----------------- ---------------- --------------
TOTAL LOANS $2,231,000 $ 2,179,452 $ 2,361,849 $ 2,257,308 $ 1,998,717
=========================================================================================================================
At December 31, 2003, 12.8% and 13.4% of total loans was concentrated with
borrowers in trucking and truck leasing and aircraft operators and dealers,
respectively.
Average loans, net of unearned discount, decreased 10.37% in 2003 following a
0.63% decrease in 2002. Loans, net of unearned discount, at December 31, 2003
were $2.23 billion and were 66.99% of total assets, compared to $2.18 billion or
63.96% of total assets at December 31, 2002.
Commercial and agricultural lending outstandings, excluding those secured by
real estate, decreased 5.94% during 2003. Many of the industries 1st Source
17
serves experienced a marked decline in business activity in 2003, resulting in
reduced loan needs.
Truck and automobile financing increased 10.30% in 2003. The largest increase
was in medium and heavy duty truck loans which experienced growth of $21.18
million, or 10.74%, in 2003. Much of this increase can be attributed to the
rigorous sales force which captured a large share of available market despite
decreased demand for medium and heavy duty trucks. Other loans in this category
include automobile and light truck and environmental equipment financing which
grew by 14.60% and 0.46%, respectively. The overriding factor contributing to
the increase in automobile and light truck financing was the purchase of $15.19
million of loans from the securitized loan portfolio. Excluding the impact of
the purchase, automobile and light truck financing increased 5.48% during 2003.
Aircraft financing at year-end 2003 increased 51.07% from year-end 2002. The
majority of this increase can be attributed to the purchase of $210.83 million
of aircraft loans from the securitized loan portfolio. Without this acquisition,
aircraft financing for 2003 decreased approximately 14.05% due to run-off of the
portfolio, continued poor economic conditions, and decreased demand for loans
for business or personal aircraft.
Construction equipment financing decreased 27.57% in 2003 following a 7.58%
decrease in 2002. This division continued to be negatively impacted by the
sluggish economy.
Loans secured by real estate decreased 6.02% during 2003. This decrease was due
to declines in the year-end balances of portfolio mortgage loans. Residential
mortgage loan refinancing was heavy through most of the year as customers took
advantage of record low fixed interest rates. All of these low interest rate
loans were sold off into the secondary market.
Consumer loans decreased 14.81% in 2003 compared to a decrease of 13.48% for
2002. Consumer fears over the slow economy remained strong which lead to a
decrease in loan demand and stagnant growth in this area. In addition, mortgage
refinancings allowed consumers to pay down other debt.
The following table shows the maturities of loans in the categories of
commercial and agriculture, truck and automobile, aircraft and construction
equipment outstanding as of December 31, 2003. The amounts due after one year
are also classified according to the sensitivity to changes in interest rates.
(Dollars in thousands) 0 - 1 Year 1 - 5 Years Over 5 Years Total
- ---------------------------------------------------------------------------------------
Commercial and agricultural loans $ 292,234 $ 108,817 $ 1,854 $ 402,905
Truck and automobile financing 209,763 276,345 4,944 491,052
Aircraft financing 172,269 295,929 20,957 489,155
Construction equipment financing 84,353 134,326 883 219,562
- ---------------------------------------------------------------------------------------
TOTAL $ 758,619 $ 815,417 $ 28,638 $1,602,674
=======================================================================================
Rate Sensitivity (Dollars in thousands) Fixed Rate Variable Rate Total
- ---------------------------------------------------------------------------------------
1 - 5 Years $ 500,891 $ 314,526 $ 815,417
Over 5 Years 8,188 20,450 28,638
- ---------------------------------------------------------------------------------------
TOTAL $ 509,079 $ 334,976 $ 844,055
=======================================================================================
CREDIT EXPERIENCE
RESERVE FOR LOAN LOSSES -- 1st Source's reserve for loan losses is provided for
by direct charges to operations. Losses on loans are charged against the reserve
and likewise, recoveries during the period for prior losses are credited to the
reserve. Management evaluates the adequacy of the reserve quarterly,
reviewing all loans over a fixed-dollar amount ($50,000), where the internal
credit rating is at or below a predetermined classification, actual and
anticipated loss experience, current economic events in specific industries, and
other pertinent factors including general economic conditions. Determination of
the reserve is inherently subjective as it requires significant estimates,
including the amounts and timing of expected future cash flows or fair value of
collateral on collateral-dependent impaired loans, estimated losses on pools of
homogeneous loans based on historical loss experience, and consideration of
economic trends, all of which may be susceptible to significant change.
Management of 1st Source reviews the status of the loan portfolio to identify
borrowers that might develop financial problems, in order to aid borrowers in
the handling of their accounts and to mitigate losses. See Part II, Item 8,
Financial Statements and Supplementary Data -- Note A of the Notes to
Consolidated Financial Statements for additional information on management's
evaluation of the adequacy of the reserve for loan losses.
The reserve for loan losses at December 31, 2003 totaled $70.05 million and was
3.14% of loans, compared to $59.22 million or 2.72% of loans at December 31,
2002 and $57.62 million or 2.44% of loans at December 31, 2001. It is
management's opinion that the reserve for loan losses is adequate to absorb
losses inherent in the loan portfolio as of December 31, 2003.
The provision for loan losses for 2003 was $17.36 million, compared to $39.66
million in 2002 and $25.75 million in 2001. The decrease in the provision is
consistent with the lower charge-offs and the stabilization of the loan
portfolio. Losses on loans to aircraft dealers and operators and loans secured
by construction equipment remained relatively high in 2003, but the aircraft
18
portfolio continued to show improving trends. Net charge-offs to aircraft
dealers and operators were $5.05 million, $26.48 million and $5.21 million in
2003, 2002, and 2001, respectively. The reserve for loan losses increased $6.82
million, $0, and $0.60 million in 2003, 2002, and 2001, respectively, for
reserves acquired in acquisitions.
The following table summarizes the 1st Source's loan loss experience for each of
the last five years ended December 31:
(Dollars in thousands) 2003 2002 2001 2000 1999
- ------------------------------------------------------------------------------------------------------------------------------------
AMOUNTS OF LOANS OUTSTANDING AT END OF PERIOD $2,231,000 $ 2,179,452 $ 2,361,849 $ 2,257,308 $ 1,998,717
- ------------------------------------------------------------------------------------------------------------------------------------
AVERAGE AMOUNT OF NET LOANS OUTSTANDING DURING PERIOD $2,091,004 $ 2,332,992 $ 2,347,746 $ 2,156,489 $ 1,864,189
- ------------------------------------------------------------------------------------------------------------------------------------
Balance of reserve for loan losses at beginning of period $ 59,218 $ 57,624 $ 44,644 $ 40,210 $ 38,629
- ------------------------------------------------------------------------------------------------------------------------------------
Charge-offs:
Commercial and agricultural loans 1,187 2,376 4,916 1,818 895
Truck and automobile financing 2,858 7,151 753 109 3
Aircraft financing 6,877 27,401 5,584 4,987 -
Construction equipment financing 4,712 2,326 762 393 510
Loans secured by real estate 344 340 215 30 105
Consumer loans 1,560 2,127 2,102 1,738 1,514
- ------------------------------------------------------------------------------------------------------------------------------------
TOTAL CHARGE-OFFS 17,538 41,721 14,332 9,075 3,027
- ------------------------------------------------------------------------------------------------------------------------------------
Recoveries:
Commercial and agricultural loans 519 1,311 328 298 110
Truck and automobile financing 1,182 616 71 631 52
Aircraft financing 1,698 759 92 230 -
Construction equipment financing 248 465 129 50 34
Loans secured by real estate 11 26 - 2 25
Consumer loans 523 481 351 462 418
- ------------------------------------------------------------------------------------------------------------------------------------
TOTAL RECOVERIES 4,181 3,658 971 1,673 639
- ------------------------------------------------------------------------------------------------------------------------------------
Net charge-offs 13,357 38,063 13,361 7,402 2,388
Provisions charged to operating expense 17,361 39,657 25,745 11,836 3,969
Reserves acquired in acquisitions 6,823 - 596 - -
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE AT END OF PERIOD $ 70,045 $ 59,218 $ 57,624 $ 44,644 $ 40,210
====================================================================================================================================
RATIO OF NET CHARGE-OFFS TO AVERAGE NET LOANS 0.64% 1.63% 0.57% 0.34% 0.13%
OUTSTANDING
====================================================================================================================================
Net charge-offs as a percentage of average loans by portfolio type follow:
2003 2002 2001 2000 1999
- ---------------------------------------------------- -------------------------------------
Commercial and agricultural 0.16% 0.23% 0.96% 0.31% 0.18%
Truck and automobile financing 0.36 1.56 0.22 (0.21) (0.02)
Aircraft financing 1.73 6.40 1.03 1.04 -
Construction equipment financing 1.67 0.55 0.21 0.13 0.21
Loans secured by real estate 0.03 0.03 0.02 - 0.01
Consumer loans 0.19 0.28 0.29 0.23 0.22
- ---------------------------------------------------- -------------------------------------
TOTAL NET CHARGE-OFFS TO AVERAGE PORTFOLIO LOANS 0.64% 1.63% 0.57% 0.34% 0.13%
==========================================================================================
19
The reserve for loan losses has been allocated according to the amount deemed
necessary to provide for the possibility of losses being incurred within the
categories of loans set forth in the table below. The amount of such components
of the reserve at December 31 and the ratio of such loan categories to total
outstanding loan balances, are as follows:
2003 2002 2001 2000 1999
PERCENT Percent Percent Percent Percent
OF LOANS of Loans of Loans of Loans of Loans
IN EACH in Each in Each in Each in Each
CATEGORY Category Category Category Category
RESERVE TO TOTAL Reserve to Total Reserve to Total Reserve to Total Reserve to Total
(Dollars in thousands) AMOUNT LOANS Amount Loans Amount Loans Amount Loans Amount Loans
- -----------------------------------------------------------------------------------------------------------------------------------
Commercial and agricultural loans $ 9,589 18.06% $11,163 19.65% $14,247 19.49% $15,532 21.99% $ 9,495 22.79%
Truck and automobile financing 13,966 22.01 11,006 20.43 9,924 14.57 5,764 11.49 4,308 10.78
Aircraft financing 31,733 21.93 21,603 14.86 19,987 21.79 12,884 22.52 15,530 21.12
Construction equipment financing 9,061 9.84 9,394 13.91 6,463 13.89 5,304 12.06 5,406 12.25
Loans secured by real estate 3,798 23.92 3,656 26.06 4,268 24.84 2,692 26.28 3,091 26.36
Consumer loans 1,898 4.24 2,396 5.09 2,735 5.42 2,468 5.66 2,380 6.70
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL $ 70,045 100.00% $59,218 100.00% $57,624 100.00% $44,644 100.00% $40,210 100.00%
====================================================================================================================================
NONPERFORMING ASSETS -- 1st Source's policy is to discontinue the accrual of
interest on loans where principal or interest is past due and remains unpaid for
90 days or more, except for mortgage loans, which are placed on nonaccrual at
the time the loan is placed in foreclosure. Nonperforming assets amounted to
$36.83 million at December 31, 2003 compared to $64.12 million at December 31,
2002, and $43.29 million at December 31, 2001. Impaired loans totaled $60.04
million, $60.10 million, and $45.40 million at December 31, 2003, 2002, and
2001, respectively. During 2003, interest income which would have been recorded
on nonaccrual loans under their original terms was $3.66 million, compared to
$3.92 million in 2002. Interest income that was recorded on nonaccrual loans was
$0.84 million and $1.08 million in 2003 and 2002, respectively.
The overall decrease in nonperforming assets for 2003 is primarily the result of
the disposition of repossessed assets. The repossessions were primarily
attributed to defaulted loans to air cargo businesses and aircraft dealers and
operators. In addition, there was a decrease in nonaccrual loans as 1st
Source continued to work to resolve problem credits.
Nonperforming assets at December 31(Dollars in thousands) 2003 2002 2001 2000 1999
- ------------------------------------------------------------- -------------- ------------ ----------- ----------- ---------
Loans past due over 90 days $ 212 $ 154 $ 453 $ 385 $ 254
Nonaccrual loans and restructured loans:
Commercial and agricultural 2,578 4,819 6,580 8,044 6,542
Truck and automobile financing 4,242 6,114 3,746 1,769 -
Aircraft financing 12,900 12,281 16,365 2,725 323
Construction equipment financing 4,663 9,844 5,126 3,026 2,141
Loans secured by real estate 1,786 2,191 3,349 2,755 2,485
Consumer loans 916 415 659 849 476
- ------------------------------------------------------------- -------------- ------------ ----------- ----------- ---------
Total nonaccrual loans and restructured loans 27,085 35,664 35,825 19,168 11,967
- ------------------------------------------------------------- -------------- ------------ ----------- ----------- ---------
TOTAL NONPERFORMING LOANS 27,297 35,818 36,278 19,553 12,221
- ------------------------------------------------------------- -------------- ------------ ----------- ----------- ---------
Other real estate 3,010 4,362 3,137 1,698 1,167
Repossessions:
Commercial and agricultural 34 - - 157 -
Truck and automobile financing 847 1,364 2,590 341 352
Aircraft financing 4,551 19,242 770 1,700 -
Construction equipment financing 753 681 53 913 308
Consumer loans 78 56 96 100 135
- ------------------------------------------------------------- -------------- ------------ ----------- ----------- ---------
Total repossessions 6,263 21,343 3,509 3,211 795
- ------------------------------------------------------------- -------------- ------------ ----------- ----------- ---------
Operating leases 257 2,594 369 534 1,172
- ------------------------------------------------------------- -------------- ------------ ----------- ----------- ---------
TOTAL NONPERFORMING ASSETS $ 36,827 $ 64,117 $ 43,293 $ 24,996 $ 15,355
===========================================================================================================================
Nonperforming loans to loans, net of unearned discount 1.22% 1.64% 1.54% 0.87% 0.61%
===========================================================================================================================
Nonperforming assets to loans and leases,
net of unearned discount 1.59% 2.79% 1.74% 1.06% 0.74%
===========================================================================================================================
POTENTIAL PROBLEM LOANS -- At December 31, 2003, management was not aware of any
potential problem loans that would have a material effect on loan delinquency or
loan charge-offs. However, the value of collateral securing many aircraft loans
20
has deteriorated over the past two years and 1st Source collateral coverage
rates have decreased. If a customer were to fail, 1st Source may not be able to
rely on the collateral value to mitigate losses. Loans and leases are subject to
continual review and are given management's attention whenever a problem
situation appears to be developing.
INVESTMENT PORTFOLIO
Securities at year-end 2003 increased 17.93% from 2002, following a 1.43%
decrease from year-end 2001 to year-end 2002. Securities at December 31, 2003
were $763.76 million or 22.93% of total assets, compared to $647.62 million or
19.00% of total assets at December 31, 2002.
The carrying amounts of securities available-for-sale as of December 31 are
summarized as follows:
(Dollars in thousands) 2003 2002 2001
- --------------------------------------------------------------------------- ----------------- ------------
U.S. Treasury and government agencies and corporations $504,722 $391,653 $ 434,867
States and political subdivisions 171,515 156,010 144,000
Other securities 87,526 99,954 78,174
- --------------------------------------------------------------------------- ----------------- ------------
TOTAL SECURITIES AVAILABLE-FOR-SALE $763,763 $647,617 $ 657,041
==========================================================================================================
The following table shows the maturities of securities available-for-sale at
December 31, 2003, at the carrying amounts and the weighted average yields of
such securities:
(Dollars in thousands) Amount Yield(1)
- ----------------------------------------------------------- ----------
U.S. Treasuries and agencies
Under 1 year $ 60,796 3.42%
1 - 5 years 382,693 2.37
5 - 10 years 11,493 2.31
Over 10 years 49,740 2.71
- ----------------------------------------------------------- ----------
TOTAL U.S. TREASURIES AND AGENCIES 504,722 2.53
- ----------------------------------------------------------- ----------
State and political subdivisions
Under 1 year 30,767 5.99
1 - 5 years 126,380 3.77
5 - 10 years 13,857 6.72
Over 10 years 511 3.78
- ----------------------------------------------------------- ----------
TOTAL STATE AND POLITICAL SUBDIVISIONS 171,515 4.41
- ----------------------------------------------------------- ----------
Other securities
Under 1 year 840 5.30
1 - 5 years 8,796 2.90
5 - 10 years 75 6.55
Over 10 years 4,638 2.32
Marketable equity securities 73,177 4.36
- ----------------------------------------------------------- ----------
TOTAL OTHER SECURITIES 87,526 4.11
- ----------------------------------------------------------- ----------
TOTAL SECURITIES AVAILABLE-FOR-SALE $763,763 3.13%
======================================================================
(1)Weighted average yields are based on amortized cost. Yields on tax-exempt
obligations are calculated on a fully tax equivalent basis assuming a 35% tax
rate. Marketable equity securities are excluded.
DEPOSITS
The average daily amounts of deposits and rates paid on such deposits
are summarized as follows:
2003 2002 2001
(Dollars in thousands) AMOUNT RATE Amount Rate Amount Rate
- ------------------------------------------------------- ---------- --------------- --------------------- -------
Noninterest bearing demand deposits $ 413,794 -% $ 362,509 -% $ 305,373 -%
Interest bearing demand deposits 645,131 0.79 686,763 1.40 596,330 2.82
Savings deposits 233,737 0.53 232,067 1.20 165,820 1.78
Other time deposits 1,266,599 3.38 1,489,971 3.94 1,568,838 5.63
- ------------------------------------------------------- ---------- --------------- --------------------- -------
TOTAL $2,559,261 $2,771,310 $2,636,361
================================================================================================================
21
The amount of certificates of deposit of $100,000 or more and other time
deposits of $100,000 or more outstanding at December 31, 2003, by time remaining
until maturity is as follows:
(Dollars in thousands)
- --------------------------------------------------------------------- ----------
Under 3 months $ 64,070
4 - 6 months 30,161
7 - 12 months 19,625
Over 12 months 96,858
- --------------------------------------------------------------------- ----------
TOTAL $210,714
================================================================================
SHORT-TERM BORROWINGS
The following table shows the distribution of 1st Source's short-term borrowings
and the weighted average interest rates thereon at the end of each of the last
three years. Also provided are the maximum amount of borrowings and the average
amount of borrowings, as well as weighted average interest rates for the
last three years.
Federal Funds
Purchased and
Security Other
Repurchase Commercial Short-Term Total
(Dollars in thousands) Agreements Paper Borrowings Borrowings
- ------------------------------------------------------------------------- ------------- -------------- ------------
2003
BALANCE AT DECEMBER 31, 2003 $276,040 $ 982 $113,832 $390,854
MAXIMUM AMOUNT OUTSTANDING AT ANY MONTH-END 276,040 4,492 113,832 394,364
AVERAGE AMOUNT OUTSTANDING 209,098 2,442 45,088 256,628
WEIGHTED AVERAGE INTEREST RATE DURING THE YEAR 0.85% 1.06% 7.36% 2.00%
WEIGHTED AVERAGE INTEREST RATE FOR OUTSTANDING AMOUNTS AT
DECEMBER 31, 2003 0.85% 0.86% 1.42% 1.02%
- ------------------------------------------------------------------------- ------------- -------------- ------------
2002
Balance at December 31, 2002 $212,040 $ 2,814 $ 45,824 $260,678
Maximum amount outstanding at any month-end 266,370 5,580 86,059 358,009
Average amount outstanding 218,009 4,023 48,715 270,747
Weighted average interest rate during the year 1.36% 1.64% 5.40% 2.09%
Weighted average interest rate for outstanding amounts at
December 31, 2002 0.65% 1.06% 1.76% 0.85%
- ------------------------------------------------------------------------- ------------- -------------- ------------
2001
Balance at December 31, 2001 $214,709 $ 4,992 $ 44,772 $264,473
Maximum amount outstanding at any month-end 298,717 17,545 144,951 461,213
Average amount outstanding 226,758 11,763 86,935 325,456
Weighted average interest rate during the year 3.19% 4.52% 7.68% 4.44%
Weighted average interest rate for outstanding amounts at
December 31, 2001 1.43% 1.79% 1.28% 1.41%
===================================================================================================================
LIQUIDITY
CORE DEPOSITS -- 1st Source's major source of investable funds is provided by
stable core deposits consisting of all interest bearing and noninterest bearing
deposits, excluding brokered certificates of deposit and certain certificates of
deposit of $100,000 and over. In 2003, average core deposits equaled 70.83% of
average total assets, compared to 66.56% in 2002 and 61.18% in 2001. The
effective cost rate of core deposits in 2003 was 1.81%, compared to 2.40% in
2002 and 3.76% in 2001. During 2001, 1st Source Bank acquired a total of 17
branch offices with core and other deposits of $322 million.
Average demand deposits (noninterest bearing core deposits) increased 14.15% in
2003 compared to an increase of 18.71% in 2002. These represented 17.93% of
total core deposits in 2003, compared to 15.71% in 2002, and 14.81% in 2001.
PURCHASED FUNDS -- 1st Source's purchased funds are used to supplement core
deposits and include certain certificates of deposit of $100,000 and over,
brokered certificates of deposit, Federal funds, securities sold under
agreements to repurchase, commercial paper, and other short-term borrowings.
Purchased funds are raised from customers seeking short-term investments and are
used to manage the bank's interest rate sensitivity. During 2003, 1st Source's
reliance on purchased funds decreased to 15.60% of average total assets from
21.19% in 2002.
SHAREHOLDERS' EQUITY -- Management continues to emphasize profitable asset
growth and retention of equity in the business. Average shareholders' equity
equated to 9.60% of average total assets in 2003 compared to 8.95% in 2002.
22
Shareholders' equity was 9.45% of total assets at year-end 2003, compared to
9.08% at year-end 2002. In accordance with Statements of Financial Accounting
Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," 1st Source includes unrealized gain (loss) on available-for-sale
securities, net of income taxes, as accumulated other comprehensive income which
is a component of shareholders' equity. While regulatory capital adequacy ratios
exclude unrealized gain (loss) in the calculation thereof, it does impact 1st
Source's equity as reported in the audited financial statements. The unrealized
gain on available-for-sale securities, net of income taxes, was $2.35 million
and $4.59 million at December 31, 2003 and 2002, respectively.
LIQUIDITY RISK MANAGEMENT -- The Bank's liquidity is monitored and closely
managed by the Asset/Liability Management Committee (ALCO), whose members are
comprised of the Bank's senior management. Asset and liability management
includes the management of interest rate sensitivity and the maintenance of an
adequate liquidity position. The purpose of interest rate sensitivity management
is to stabilize net interest income during periods of changing interest rates.
Liquidity management is the process by which the Bank ensures that adequate
liquid funds are available to meet financial commitments on a timely basis.
Financial institutions must maintain liquidity to meet day-to-day requirements
of depositors and borrowers, take advantage of market opportunities and provide
a cushion against unforeseen needs.
Liquidity of the Bank is derived primarily from core deposits, principal
payments received on loans, the sale and maturity of investment securities, net
cash provided by operating activities, and access to other funding sources. The
most stable source of liability funded liquidity is deposit growth and retention
of the core deposit base. The principal source of asset-funded liquidity is
available-for-sale investment securities, cash and due from banks, Federal funds
sold, securities purchased under agreements to resell, and loans and interest
bearing deposits with other banks maturing within one year. Additionally,
liquidity is provided by bank lines of credit, repurchase agreements, and the
ability to borrow from the Federal Reserve Bank and Federal Home Loan Bank.
INTEREST RATE RISK MANAGEMENT -- 1st Source's Asset/Liability Management
Committee monitors and manages the relationship of earning assets to interest
bearing liabilities and the responsiveness of asset yields, interest expense,
and interest margins to changes in market interest rates. In the normal course
of business, 1st Source faces ongoing interest rate risks and uncertainties. 1st
Source occasionally utilizes interest rate swaps to partially manage the primary
market exposures associated with the interest rate risk related to underlying
assets, liabilities, and anticipated transactions. Under the current interest
rate swaps, assumed from the Master Trust, 1st Source has agreements with
another party to exchange, at specific intervals, the difference between
fixed-rate and floating-rate interest amounts as calculated by reference to a
notional amount as a means to convert floating rate liabilities to a fixed rate.
The notional amounts totaled $130 million at December 31, 2003. At December 31,
2003, the consolidated statement of financial condition (excluding Trustcorp
Mortgage) was rate sensitive by $93.5 million more assets than liabilities
scheduled to repriced within one year, or approximately 1.06%.
A hypothetical change in earnings was modeled by calculating an immediate 100
basis point (1.00%) change in interest rates across all maturities. This
analysis presents the hypothetical change in earnings of those rate sensitive
financial instruments and interest rate swaps held by 1st Source (excluding
Trustcorp) at December 31, 2003. The aggregate hypothetical decrease in pre-tax
earnings is estimated to be $0.19 million on an annualized basis on all
rate-sensitive financial instruments, based on a hypothetical increase of a 100
basis point change in interest rates. The aggregate hypothetical decrease in
pre-tax earnings is estimated to be $5.33 million on an annualized basis on all
rate-sensitive financial instruments based on a hypothetical decrease of a 100
basis point change in interest rates. Actual results may differ materially from
those projected. The use of this methodology to quantify the market risk of the
balance sheet should not be construed as an endorsement of its accuracy or the
accuracy of the related assumptions.
Due to the nature of the mortgage banking business, 1st Source manages the
earning assets and interest-bearing liabilities of Trustcorp on a separate
basis. The predominant assets on Trustcorp's balance sheet are mortgage loans
held for sale, which are funded by short-term borrowings (normally less than 30
days). These borrowings are managed on a daily basis. A portion of Trustcorp's
other borrowings for working capital is funded by 1st Source.
Trustcorp manages the interest rate risk related to loan commitments by entering
into contracts for future delivery of loans. See Part II, Item 8, Financial
Statements and Supplementary Data -- Note N of the Notes to Consolidated
Financial Statements.
CONTRACTUAL OBLIGATIONS
In the ordinary course of operations, 1st Source enters into certain contractual
obligations. Such obligations include the funding of operations through debt
issuances as well as leases for premises and equipment. The following table
summarizes 1st Source's significant fixed and determinable contractual
obligations, by payment date, at December 31, 2003, except for obligations
associated with short-term borrowing arrangements. Further discussion of the
nature of each obligation is included in the referenced note to the consolidated
financial statements.
Contractual obligations payments by period.
Indeterminate
(Dollars in thousands) Note 0 - 1 Year 1 - 3 Years 3 - 5 Years Over 5 Years maturity Total
- --------------------------------------------------------------------------------------------------------------------------------
Deposits without stated maturity - $1,338,842 $ - $ - $ - $ - $1,338,842
Certificates of deposit - 509,699 510,365 111,356 16,953 - 1,148,373
Long-term debt and mandatorily
redeemable securities H 258 357 15,146 978 6,064 22,803
Subordinated notes J - - - 56,444 - 56,444
Operating leases M 2,440 3,352 2,706 4,617 - 13,115
Purchase obligations - 99 - - - - 99
- --------------------------------------------------------------------------------------------------------------------------------
TOTAL CONTRACTUAL OBLIGATIONS $1,851,338 $514,074 $129,208 $78,992 $ 6,064 $2,579,676
================================================================================================================================
23
1st Source also enters into derivative contracts under which 1st Source is
required to either receive cash from, or pay cash to, counterparties depending
on changes in interest rates. Derivative contracts are carried at fair value on
the consolidated balance sheet with the fair value representing the net present
value of expected future cash receipts or payments based on market interest
rates as of the balance sheet date. The fair value of the contracts change daily
as market interest rates change. Because the derivative liabilities recorded on
the balance sheet at December 31, 2003 do not represent the amounts that may
ultimately be paid under these contracts, these liabilities are not included in
the table of contractual obligations presented above.
Additionally, 1st Source routinely enters into contracts for services. These
contracts may require payment for services to be provided in the future and may
also contain penalty clauses for early termination of the contract. Management
is not aware of any additional commitments or contingent liabilities which may
have a material adverse impact on the liquidity or capital resources of 1st
Source.
1st Source is also party to financial instruments with off-balance sheet risk in
the normal course of business to meet the financing needs of its customers.
These financial instruments include commitments to extend credit and standby
letters of credit. Further discussion of these commitments is included in Part
II, Item 8, Financial Statements and Supplementary Data -- Note N of the Notes
to Consolidated Financial Statements.
QUARTERLY RESULTS OF OPERATIONS
Three Months Ended (Dollars in thousands, except per share amounts)
March 31 June 30 September 30 December 31
- ------------------------------------------------------------------ ------------- ----------------- ------------
2003
INTEREST INCOME $42,729 $42,553 $38,991 $38,049
INTEREST EXPENSE 16,173 15,813 14,447 12,637
NET INTEREST INCOME 26,556 26,740 24,544 25,412
PROVISION FOR LOAN LOSSES 5,550 4,901 4,078 2,832
INVESTMENT SECURITIES AND OTHER INVESTMENT LOSSES (280) (275) (3,134) (247)
INCOME BEFORE INCOME TAXES 6,243 6,482 6,616 7,842
NET INCOME 4,460 4,690 4,643 5,361
DILUTED NET INCOME PER COMMON SHARE 0.21 0.22 0.22 0.26
- ------------------------------------------------------------------ ------------- ----------------- ------------
2002
Interest income $52,539 $50,397 $ 48,859 $47,708
Interest expense 21,998 20,445 19,717 18,657
Net interest income 30,541 29,952 29,142 29,051
Provision for loan losses 11,809 10,750 8,765 8,333
Investment securities and other investment losses (488) - (600) (1,748)
Income before income taxes 5,169 3,481 2,474 281
Net income 4,208 2,767 2,101 963
Diluted net income per common share 0.20 0.13 0.10 0.05
==============================================================================================================
Net income was $5.36 million for the fourth quarter of 2003 compared to the
$0.96 million of net income reported for the fourth quarter of 2002. Diluted net
income per common share for the fourth quarter of 2003 amounted to $0.26,
compared to $0.05 per common share reported in the fourth quarter of 2002.
The provision for loan losses was $2.83 million in the fourth quarter compared
to $8.33 million in the fourth quarter of 2002. 1st Source's reserve for loan
losses as of December 31, 2003, was 3.14% of total loans, compared to 2.72% as
of December 31, 2002. Net charge-offs were $2.83 million for the fourth quarter
2003, compared to $8.06 million a year ago. Net charge-offs for the year were
$13.36 million compared to $38.06 million in 2002. The ratio of nonperforming
assets to net loans and leases was 1.59% on December 31, 2003, compared to 2.79%
on December 31, 2002.
Noninterest income for the fourth quarter of 2003 was $19.39 million, down 7.18%
from the fourth quarter of 2002. This decrease was due to the slowdown of
mortgage loan refinancings, lower trading account securities gains, and lower
securitization impairment in the fourth quarter of 2003 compared to the same
period in 2002. For the year, noninterest income was $80.20 million, up 9.68%
from 2002. The predominant factor behind the growth in 2003 was mortgage loan
servicing and sale income. This increase was partially offset by a decrease in
equipment rental income and increased securitization impairment charges.
Noninterest expense was $34.12 million for the fourth quarter of 2003, down
17.42% from the fourth quarter of 2002. This quarter to quarter decrease was
primarily due to decreased loan collection and repossession expense, including
lower valuation adjustments on repossessed aircraft. Also, depreciation on
leased equipment decreased due to reduced demand for equipment leases; and
salaries and employee benefits decreased due to lower mortgage commissions. For
the year, noninterest expense was $138.90 million, down 1.31% from 2002. In
general, 2003 noninterest expense reflects decreased depreciation on equipment
owned under operating leases and decreased loan collection and repossession
expense offset by increased salary and employee benefit expense.
The 2003 earnings represent a return on average shareholders' equity of 6.12%,
compared to 3.23% for 2002. Return on total assets was 0.59% compared to 0.29%
for 2002.
As of December 31, 2003, the 1st Source common equity-to-assets ratio was 9.45%,
compared to 9.08% a year ago. Shareholders' equity was $314.70 million, up 1.70%
from $309.43 million a year ago. Total assets at the end of 2003 were $3.33
24
billion compared to $3.41 billion at the end of 2002. Total deposits were $2.49
billion, down 8.32% from the end of 2002, and total loans were $2.23 billion, up
2.37% from 2002.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
For information regarding Quantitative and Qualitative Disclosures about Market
Risk, see Part II, Item 7, Management's Discussion and Analysis of Financial
Condition and Results of Operations, Interest Rate Risk Management.
25
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
December 31 (Dollars in thousands) 2003 2002
- -------------------------------------------------------------------------------------------- - ----------- ---- -----------
ASSETS
Cash and due from banks $ 109,787 $ 120,894
Federal funds sold and interest bearing deposits with other banks 1,355 81,881
Investment securities, available-for-sale
(amortized cost of $759,945 and $640,224 at December 31, 2003 and 2002, respectively) 763,763 647,617
Trading account securities - 13,347
Mortgages held for sale 60,215 146,640
Loans, net of unearned discount:
Commercial and agricultural loans 402,905 428,367
Truck and automobile financing 491,052 445,195
Aircraft financing 489,155 323,802
Construction equipment financing 219,562 303,126
Loans secured by real estate 533,749 567,950
Consumer loans 94,577 111,012
- -------------------------------------------------------------------------------------------- - --------- ---- -----------
TOTAL LOANS 2,231,000 2,179,452
Reserve for loan losses (70,045) (59,218)
- -------------------------------------------------------------------------------------------- - --------- ---- -----------
NET LOANS 2,160,955 2,120,234
Equipment owned under operating leases
(net of accumulated depreciation of $49,387 and $46,188 at
December 31, 2003 and 2002, respectively) 70,305 93,893
Net premises and equipment 38,431 40,899
Accrued income and other assets 125,342 142,063
- ---------------------------------------------------------------------------------------------------------- ----------------
TOTAL ASSETS $3,330,153 $3,407,468
===========================================================================================================================
LIABILITIES
Deposits:
Noninterest bearing $ 396,026 $ 419,289
Interest bearing 2,091,189 2,293,616
- ------------------------------------------------------------------------------------------------------------ --------------
TOTAL DEPOSITS 2,487,215 2,712,905
- ------------------------------------------------------------------------------------------------------------ --------------
Short-term borrowings:
Federal funds purchased and securities sold under agreements to repurchase 276,040 212,040
Other short-term borrowings 114,814 48,638
- ------------------------------------------------------------------------------------------------------------ --------------
TOTAL SHORT-TERM BORROWINGS 390,854 260,678
- ------------------------------------------------------------------------------------------------------------ --------------
Long-term debt and mandatorily redeemable securities 22,802 16,878
Subordinated notes 56,444 54,750
Accrued expenses and other liabilities 58,147 52,828
- ------------------------------------------------------------------------------------------------------------ --------------
TOTAL LIABILITIES 3,015,462 3,098,039
===========================================================================================================================
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 21,626,584 shares in 2003 and 21,619,622
shares in 2002, less unearned shares (246,100-- 2003 and 239,138-- 2002) 7,578 7,579
Capital surplus 214,001 214,001
Retained earnings 100,534 90,897
Cost of common stock in treasury (664,193 shares-- 2003 and 431,466 shares-- 2002) (9,777) (7,637)
Accumulated other comprehensive income 2,355 4,589
===========================================================================================================================
TOTAL SHAREHOLDERS' EQUITY 314,691 309,429
===========================================================================================================================
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $3,330,153 $3,407,468
===========================================================================================================================
The accompanying notes are a part of the consolidated financial statements.
26
CONSOLIDATED STATEMENTS OF INCOME
Year Ended December 31 (Dollars in thousands, except per share data) 2003 2002 2001
- ------------------------ ----------------------------------------------------------- ----------------- ---------
Interest income:
Loans $137,382 $ 171,029 $ 211,801
Investment securities, taxable 18,410 21,359 26,078
Investment securities, tax-exempt 5,614 6,037 6,867
Other 916 1,078 820
- ------------------------------------------------------------------------------------ ------------- ------------
TOTAL INTEREST INCOME 162,322 199,503 245,566
- ------------------------------------------------------------------------------------ ------------- ------------
Interest expense:
Deposits 49,153 71,084 108,069
Short-term borrowings 5,121 5,659 14,455
Subordinated notes 3,804 3,249 3,560
Long-term debt and mandatorily redeemable securities 992 825 873
- ------------------------------------------------------------------------------------ ------------- ------------
TOTAL INTEREST EXPENSE 59,070 80,817 126,957
- ------------------------------------------------------------------------------------ ------------- ------------
Net interest income 103,252 118,686 118,609
Provision for loan losses 17,361 39,657 25,745
- ------------------------------------------------------------------------------------ ------------- ------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 85,891 79,029 92,864
- ------------------------------------------------------------------------------------ ------------- ------------
Noninterest income:
Trust fees 10,664 10,252 9,672
Service charges on deposit accounts 15,532 14,947 11,714
Loan servicing and sale income 17,474 7,406 25,679
Equipment rental income 25,448 28,773 26,249
Other income 15,014 14,575 13,273
Investment securities and other investment (losses) gains (3,936) (2,836) 439
- ------------------------------------------------------------------------------------ ------------- ------------
TOTAL NONINTEREST INCOME 80,196 73,117 87,026
- ----------------------------------------------------------------- ------------------- ------------- -----------
Noninterest expense:
Salaries and employee benefits 69,457 67,398 62,614
Net occupancy expense 6,881 6,861 6,199
Furniture and equipment expense 10,363 10,719 9,428
Depreciation-- leased equipment 19,773 23,494 21,034
Supplies and communications 6,163 6,582 6,498
Loan collection and repossession expense 8,112 9,851 809
Other expense 18,155 15,836 15,101
- ----------------------------------------------------------------- ------------------- ------------- -----------
TOTAL NONINTEREST EXPENSE 138,904 140,741 121,683
- -------------------------------------------------------------- --------------------- ------------- ------------
Income before income taxes 27,183 11,405 58,207
Income taxes 8,029 1,366 19,709
- -------------------------------------------------------------- --------------------- ------------- ------------
NET INCOME $ 19,154 $ 10,039 $ 38,498
- -------------------------------------------------------------- --------------------- ----------------- --------
BASIC NET INCOME PER COMMON SHARE $ 0.92 $ 0.48 $ 1.85
- -------------------------------------------------------------- --------------------- ----------------- --------
DILUTED NET INCOME PER COMMON SHARE $ 0.91 $ 0.47 $ 1.82
==============================================================================================================
The accompanying notes are a part of the consolidated financial statements.
27
Accumulated
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Cost of Other
Common Capital Retained Common Stock Comprehensive
(Dollars in thousands, except per share data) Total Stock Surplus Earnings in Treasury Income(Loss),Net
- ------------------------------------------ ---------------- ----------------------- ------------ ----------- -----------
BALANCE AT JANUARY 1, 2001 $ 270,572 $ 7,227 $ 195,197 $ 80,881 $(14,954 $ 2,221
- ------------------------------------------ ---------------- ----------------------- ------------ ----------- -----------
Comprehensive income, net of tax:
Net income 38,498 - - 38,498 - -
Cumulative effect of change
in accounting principle 688 - - - - 688
Change in unrealized gains of
available-for-sale securities 2,701 - - - - 2,701
--------
Total comprehensive income 41,887 - - - - -
Issuance of 158,811 common shares under
stock based compensation plans,
including related tax effects 2,346 - - (1,325) 3,671 -
Cost of 71,514 shares of common
stock acquired for treasury (1,308) - - - (1,308) -
Cash dividends ($.351 per share) (7,297) - - (7,297) - -
5% common stock dividend
($10 cash paid in lieu of fractional shares) (10) 352 18,804 (19,166) - -
- ------------------------------------------ ---------------- ----------------------- ------------ ----------- ----------
BALANCE AT DECEMBER 31, 2001 $ 306,190 $ 7,579 $ 214,001 $ 91,591 $(12,591) $ 5,610
- ------------------------------------------ ---------------- ----------------------- ------------ ----------- ----------
Comprehensive income, net of tax:
Net income 10,039 - - 10,039 - -
Change in unrealized gains of
available-for-sale securities (1,021) - - - - (1,021)
--------
Total comprehensive income 9,018 - - - - -
Issuance of 289,854 common shares under
stock based compensation plans,
including related tax effects 4,261 - - (3,196) 7,457 -
Cost of 128,276 shares of common
stock acquired for treasury (2,503) - - - (2,503) -
Cash dividends ($.360 per share) (7,537) - - (7,537) - -
- ------------------------------------------ ---------------- ------------ --------------- --------------- ----------- ------
BALANCE AT DECEMBER 31, 2002 $ 309,429 $ 7,579 $ 214,001 $ 90,897 $ (7,637) $ 4,589
- ------------------------------------------ ---------------- ------------ --------------- --------------- ----------- ------
COMPREHENSIVE INCOME, NET OF TAX:
NET INCOME 19,154 - - 19,154 - -
CHANGE IN UNREALIZED GAINS OF
AVAILABLE-FOR-SALE SECURITIES (2,234) - - - - (2,234 )
--------
TOTAL COMPREHENSIVE INCOME 16,920 - - - - -
RECLASS OF 399,241 MANDATORILY
REDEEMABLE SHARES TO LIABILITIES (5,897) - - (955) (4,942) -
ISSUANCE OF 205,973 COMMON SHARES UNDER
STOCK BASED COMPENSATION PLANS,
INCLUDING RELATED TAX EFFECTS 2,598 (1) - (849) 3,448 -
COST OF 39,459 SHARES OF COMMON
STOCK ACQUIRED FOR TREASURY (646) - - - (646) -
CASH DIVIDENDS ($.370 PER SHARE) (7,713) (7,713) - -
- -------------------------------------------- -------------- ------------- -------------- -------------- ------------ ------
BALANCE AT DECEMBER 31, 2003 $ 314,691 $ 7,578 $ 214,001 $100,534 $ (9,777) $ 2,355
===========================================================================================================================
The accompanying notes are a part of the consolidated financial statements.
28
CONSOLIDATED STATEMENTS OF CASH FLOW
Year Ended December 31 (Dollars in thousands) 2003 2002 2001
- ------------------------------------------------------------------------------- ----------------- ---- ----------- -------------
Operating activities:
Net income $ 19,154 $ 10,039 $ 38,498
Adjustments to reconcile net income to net cash provided by operating
activities:
Provision for loan losses 17,361 39,657 25,745
Depreciation of premises and equipment 24,863 28,616 26,249
Amortization of investment security premiums and accretion of discounts, net 5,871 4,454 1,777
Amortization of mortgage servicing rights 8,168 6,306 4,382
Mortgage servicing asset impairment charges 581 7,328 -
Deferred income taxes (2,171) 14,803 418
Realized investment securities losses (gains) 3,936 2,836 (439)
Change in mortgages held for sale 86,425 26,875 (121,761)
Realized losses (gains) on securitized loans 289 (7,964) (8,532)
Change in trading account securities 13,347 (13,347) -
Deconsolidation of subsidiaries 1,694 - -
Change in interest receivable 1,245 4,465 3,607
Change in interest payable (3,810) (6,117) (9,184)
Change in other assets 6,727 (36,399) (11,137)
Change in other liabilities 12,642 (9,040) 3,031
Other 2,293 6,108 1,844
- ------------------------------------------------------------------------------- ----------------- ---- ----------- -------------
NET CASH FROM (USED BY) OPERATING ACTIVITIES 198,615 78,620 (45,502)
- ------------------------------------------------------------------------------- ----------------- ---- ----------- -------------
Investing activities:
Proceeds from sales and maturities of investment securities 351,747 329,324 345,544
Purchases of investment securities (481,565) (319,226) (408,611)
Net change in short-term investments 80,526 (64,843) (15,987)
Loans sold or participated to others 52,158 295,732 235,524
Net change in loans (110,241) (151,397) (323,191)
Purchase of loans in acquisition - - (29,641)
Net change in equipment owned under operating leases 3,815 (1,587) (48,788)
Purchases of premises and equipment (2,072) (6,363) (12,659)
Net cash paid in purchase acquisition - - (27,821)
- --------------------------------------------------------------------------- --------------------- --------------- --------------
NET CASH (USED IN) FROM INVESTING ACTIVITIES (105,632) 81,640 (285,630)
- --------------------------------------------------------------------------- --------------------- --------------- --------------
Financing activities:
Net change in demand deposits, NOW accounts and savings accounts (39,210) 81,220 82,696
Purchase of demand deposits and savings accounts - - 129,451
Net change in certificates of deposits (186,480) (251,121) 15,845
Purchase of certificates of deposits - - 192,090
Net change in short-term borrowings 130,175 (3,795) (68,917)
Proceeds from issuance of long-term debt 2,344 16,042 201
Payments on long-term debt (2,484) (11,103) (321)
Proceeds from issuance of trust-preferred securities - 10,000 -
Acquisition of treasury stock (646) (2,503) (1,308)
Cash dividends (7,789) (7,537) (7,297)
- --------------------------------------------------------------------------- --------------------- --------------- --------------
NET CASH (USED IN) FROM FINANCING ACTIVITIES (104,090) (168,797) 342,440
- --------------------------------------------------------------------------- --------------------- --------------- --------------
Net change in cash and cash equivalents (11,107) (8,537) 11,308
- --------------------------------------------------------------------------- --------------------- --------------- --------------
Cash and cash equivalents, beginning of year 120,894 129,431 118,123
- --------------------------------------------------------------------------- --------------------- --------------- --------------
Cash and cash equivalents, end of year $ 109,787 $ 120,894 $ 129,431
================================================================================================================================
Supplemental Information:
Cash paid (received) for:
Interest $ 55,259 $ 86,934 $ 132,580
Income taxes 2,655 (3,473) 19,739
================================================================================================================================
The accompanying notes are a part of the consolidated financial statements.
29
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A -- ACCOUNTING POLICIES
The principal line of business of 1st Source and subsidiaries is banking and
closely related activities. The following is a summary of significant accounting
policies followed in the preparation of the consolidated financial statements.
PRINCIPLES OF CONSOLIDATION -- The financial statements consolidate 1st
Source and its subsidiaries (principally the Bank and Trustcorp). All
significant intercompany balances and transactions have been eliminated. For
purposes of the parent company only financial information presented in Note Q,
investments in subsidiaries, are carried at 1st Source's equity in the
underlying net assets.
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS -- The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of income and expenses during the reporting
period. Actual results could differ from those estimates.
CASH FLOW -- For purposes of the consolidated and parent company only statements
of cash flows, 1st Source considers cash and due from banks as cash and cash
equivalents.
SECURITIES -- Securities that 1st Source has the ability and positive intent to
hold to maturity are classified as investment securities held-to-maturity.
Held-to-maturity investment securities, when present, are carried at amortized
cost. 1st Source holds no securities classified as held-to-maturity. Securities
that may be sold in response to, or in anticipation of, changes in interest
rates and resulting prepayment risk, or for other factors, are classified as
available-for-sale and carried at fair value. Unrealized gains and losses on
these securities are reported net of applicable taxes, as a separate component
of accumulated other comprehensive income in shareholders' equity. Debt and
equity securities that are purchased and held principally for the purpose of
selling them in the near term are classified as trading account securities and
are carried at fair value with unrealized gains and losses reported in earnings.
Realized gains and losses on the sales of all securities are reported in
earnings and computed using the specific identification cost basis.
LOANS -- Loans are reported at the principal amount outstanding, net of unearned
income. Interest on loans is included in interest income, using the accrual
method over the terms of the loans based upon principal balances outstanding.
Loan origination fees and direct loan origination costs are deferred and the net
amount amortized to interest income over the contractual life of the related
loan. Loan commitment fees are deferred and amortized into other income over the
commitment period.
The accrual of interest on loans is discontinued when a loan becomes
contractually delinquent for 90 days, except for residential mortgage loans that
are well secured and in the process of collection. Such residential mortgage
loans are placed in nonaccrual at the time the loan is placed in foreclosure.
When interest accruals are discontinued, interest credited to income in the
current year is reversed and interest accrued in the prior year is charged to
the reserve for loan losses. Management may elect to continue the accrual of
interest when the net realizable value of collateral is sufficient to cover the
principal and accrued interest. While a loan is classified as nonaccrual and the
future collectibility of the recorded loan balance is doubtful, collections on
interest and principal are applied as a reduction to principal outstanding.
A loan is considered impaired, based on current information and events, if it is
probable that 1st Source will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement. Interest on impaired loans, which are not classified as nonaccrual is
recognized on the accrual basis.
SECURITIZED ASSETS -- During December 2003, the Bank purchased the assets of
the 1st Source Master Trust, a qualified special purpose entity, from the
beneficial interest holders. The assets included $210.83 million in aircraft
loans, $15.19 million in auto rental loans and $4.39 million of loan related
assets. In addition, $24.53 million of the excess cash in the Master Trust was
returned to the Bank which resulted in the realization of the Bank's retained
interest in the securitization.
The Bank established a loss reserve of $6.82 million against the loans acquired,
which was deemed consistent with loss reserves maintained for its on-balance
sheet portfolios. The transaction, which closed in December, did not have a
significant impact on earnings for 2003. At December 31, 2003, the Bank had no
securitized assets.
The guidelines set forth in Statement of Financial Accounting Standards (SFAS)
No. 140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities," are followed when accounting for
securitizations. When 1st Source sold loans in securitizations, it retained
servicing rights and interest-only strips. The interest-only strips were
capitalized as retained interests in the securitized assets. Gain or loss on
sale of the loans depended in part on the previous carrying amount of the loans
sold, in proportion to their fair value. 1st Source estimated fair value based
on the present value of future cash flows expected under management's best
estimates of certain key assumptions. In conjunction with its securitization
activities, 1st Source sold $49.51 million of aircraft and auto loans in 2003
and $292.24 million of aircraft and auto loans in 2002. The securitization
generated total income of $5.73 million, $8.09 million, and $9.10 million, in
2003, 2002, and 2001 respectively. Of this amount, $3.21 million, $4.83 million,
and $5.71 million, representing gains on sale and servicing, for 2003, 2002, and
2001, respectively, were recorded in loan servicing and sale income. The balance
represents accretion of the discount on an effective yield basis. The accretion,
recorded as investment security income, for the years 2003, 2002, and 2001, was
$2.52 million, $3.26 million, and $3.39 million, respectively.
The recorded fair value of the retained interests was $21.46 million at year end
2002. Changes in fair value are recorded as a component of other comprehensive
income. In 2003, prior to the liquidation of the Master Trust, 1st Source
30
recorded an impairment charge of $2.99 million through investment security
losses caused by a reduction of the estimated discounted future cash flows
expected from the securitization. In 2002, 1st Source recorded an impairment
charge of $1.49 million due to decreased credit quality in the Master Trust.
As of December 31, 2002, there were $387.79 million outstanding auto and
aircraft loans in the contracted $400 million revolving securitization facility.
At year end 2002, 0.23% of the outstanding securitized loans were delinquent 60
or more days. Defaulted loans were $11.49 million at year end 2002. Prior to the
purchase of the securitized loans, charge-offs, net of recoveries were $5.68
million in 2003, compared to $9.60 million in 2002. Securitization guidelines
required that defaulted loans be charged off after 12 months, regardless of
collateral value.
MORTGAGE BANKING ACTIVITIES -- Loans for sale are primarily composed of
performing one-to-four family residential mortgage loans originated for resale
and carried at the lower of cost or fair value as determined on an aggregate
basis. Fair value is determined using available secondary market prices for
loans with similar coupons, maturities and credit quality.
1st Source recognizes the rights to service 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.
1st Source allocates a portion of the total cost of a mortgage loan to servicing
rights based on the relative fair value. The fair value of the servicing rights
is based on market prices, when available, or is determined by estimating the
present value of future net servicing income, taking into consideration market
loan prepayment speeds and discount rates. These assets are amortized as
reductions of mortgage servicing fee income over the estimated servicing period
in proportion to the estimated servicing income to be received. Gains and losses
on the sale of mortgage servicing rights are recognized as noninterest income in
the period in which such rights are sold.
Mortgage servicing assets are evaluated for impairment in accordance with SFAS
No. 140. 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. 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. 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.
Mortgage servicing assets are also reviewed for other-than-temporary impairment.
Other-than-temporary impairment exists when recoverability of a recorded
valuation allowance is determined to be remote taking into consideration
historical and projected interest rates and loan pay-off activity. When this
situation occurs, the unrecoverable portion of the valuation allowance is
applied as a direct write-down to the carrying value of the mortgage servicing
asset. Unlike a valuation allowance, a direct write-down permanently reduces the
carrying value of the mortgage servicing asset and the valuation allowance,
precluding subsequent recoveries.
RESERVE FOR LOAN LOSSES -- The reserve for loan losses is maintained at a
level believed to be adequate by management to absorb probable losses inherent
in the loan portfolio. The determination of the reserve requires significant
judgment reflecting management's best estimate of probable loan losses related
to specifically identified loans as well as probable losses in the remainder of
the various loan portfolios. The methodology for assessing the appropriateness
of the reserve consists of several key elements, which include: specific
reserves for identified special attention loans (classified loans and internal
watch list credits), percentage allocations for special attention loans without
specific reserves, formula reserves for each business lending division portfolio
including a higher percentage reserve allocation for special attention loans
without a specific reserve and reserves for pooled homogenous loans.
Management's evaluation is based upon a continuing review of these portfolios,
estimates of future customer performance, collateral values and disposition and
forecasts of future economic and geopolitical events, all of which are subject
to judgment and will change.
Specific reserves are established for certain business and specialty finance
credits based on a regular analysis of special attention loans. This analysis is
performed by the Credit Policy Committee, the Loan Review Department, Credit
Administration and the Loan Workout Departments. The specific reserves are based
on an analysis of underlying collateral values, cash flow considerations and, if
applicable, guarantor capacity.
The formula reserves determined for each business lending division portfolio are
calculated quarterly by applying loss factors to outstanding loans and certain
unfunded commitments based upon a review of historical loss experience and
qualitative factors, which include but are not limited to, economic trends,
current market risk assessment by industry, recent loss experience in particular
segments of the portfolios, movement in equipment values collateralizing
specialized industry portfolios, concentrations of credit, delinquencies, trends
in volume, experience and depth of relationship managers and division
management, and the effects of changes in lending policies and practices,
including changes in quality of the loan origination, servicing and risk
management processes. Special attention loans without specific reserves receive
a higher percentage allocation ratio than credits not considered special
attention.
Pooled loans are smaller credits and are homogenous in nature, such as consumer
credits and residential mortgages. Pooled loan loss reserves are based on
historical net charge-offs, adjusted for delinquencies, the effects of lending
practices and programs and current economic conditions and projected trends in
the geographic markets which we serve.
A comprehensive analysis of the reserve is performed by management on a
quarterly basis. Although management determines the amount of each element of
the reserve separately and relies on this process as an important credit
management tool, the entire reserve is available for the entire loan portfolio.
The actual amount of losses incurred can vary significantly from the estimated
amounts both positively and negatively. Management's methodology includes
several factors intended to minimize the difference between estimated and actual
losses. These factors allow management to adjust its estimate of losses based on
the most recent information available.
The reserve is reduced by charge-offs on loans deemed uncollectible, while
recoveries of amounts previously charged off are credited to the reserve. A
31
provision for loan losses is charged to operations based on management's
periodic evaluation of the factors previously mentioned, as well as other
pertinent factors.
LEASED ASSETS -- 1st Source finances various types of construction equipment,
medium and heavy duty trucks and automobiles under leases principally classified
as operating leases. Revenue consists of the contractual lease payments and is
recognized on a straight-line basis over the lease term. Lease terms range from
three to seven years. Leased assets are being depreciated on a straight-line
method over the lease term to the estimate of the equipment's fair market value
at lease termination, also commonly referred to as "residual" value. These
estimates are reviewed periodically to ensure realization.
OTHER REAL ESTATE -- Other real estate acquired through partial or total
satisfaction of nonperforming loans is included in other assets and recorded at
the estimated fair value less anticipated selling costs based upon the
property's appraised value at the date of transfer, with any difference between
the fair value of the property and the carrying value of the loan charged to the
reserve for loan losses. Subsequent changes in value are reported as adjustments
to the carrying amount and are recorded in noninterest expense on the income
statement. Gains or losses not previously recognized resulting from the sale of
other real estate are recognized on the date of sale. As of December 31, 2003,
and 2002, other real estate had carrying values of $4.62 million and $4.36
million, respectively.
REPOSSESSED ASSETS -- Repossessed assets consist of specialty finance equipment,
including aircraft, construction equipment and vehicles acquired through
foreclosure or in lieu of foreclosure. Repossessed assets are included in other
assets at the lower of cost or fair value of the equipment or vehicle. 1st
Source estimates fair value based on the best estimate of an orderly liquidation
value. Sources typically include vehicle and equipment dealers, valuation
guides, and other third parties, including appraisers. At the time of
foreclosure, the recorded amount of the loan is written down, if necessary, to
the fair value of the equipment or vehicle by a charge to the reserve for loan
losses. Subsequent write-downs are included in noninterest expense. Repossessed
assets totaled $6.26 million and $21.34 million, as of December 31, 2003, and
2002, respectively.
PREMISES AND EQUIPMENT -- Premises and equipment are stated at cost, less
accumulated depreciation and amortization. The provision for depreciation is
computed by the straight-line method, primarily with useful lives of 5, 7, 15
and 31 1/2 years. Maintenance and repairs are charged to expense as incurred,
while improvements, which extend the useful life, are capitalized and
depreciated over the estimated remaining life.
Long-lived depreciable assets are evaluated periodically for impairment when
events or changes in circumstances indicate the carrying amount may not be
recoverable. Impairment exists when the expected undiscounted future cash flows
of a long-lived asset are less than its carrying value. In that event, 1st
Source recognizes a loss for the difference between the carrying amount and the
estimated fair value of the asset based on a quoted market price, if applicable,
or a discounted cash flow analysis. Impairment losses are recorded in other
noninterest expense on the income statement.
GOODWILL AND INTANGIBLES -- Goodwill represents the excess of the cost of an
acquisition over the fair value of the net assets acquired. Other intangible
assets represent purchased assets that also lack physical substance but can be
distinguished from goodwill because of contractual or other legal rights or
because the asset is capable of being sold or exchanged either on its own or in
combination with a related contract, asset, or liability. On January 1, 2002,
1st Source adopted SFAS No. 142, "Goodwill and Other Intangible Assets." Under
the provisions of SFAS No. 142, goodwill is no longer ratably amortized into the
income statement over an estimated life but rather is tested at least annually
for impairment. Intangible assets which have finite lives continue to be
amortized over their estimated useful lives and also continue to be subject to
impairment testing. All of 1st Source's other intangible assets have finite
lives and are amortized on a straight-line basis over varying periods not
exceeding seven years. Prior to the adoption of SFAS No. 142, 1st Source's
goodwill was amortized on a straight-line basis over varying periods not
exceeding 25 years. 1st Source has performed the required annual impairment test
of goodwill and determined that no impairment exists.
At December 31, 2003, intangible assets consisted of goodwill of $18.55 million
and other intangible assets of $7.19 million, net of accumulated amortization
of $5.00 million. At December 31, 2002, intangible assets consisted of goodwill
of $18.55 million and other intangible assets of $9.35 million, net of
accumulated amortization of $2.26 million. Intangible asset amortization was
$2.75 million, $2.14 million, and $0.43 million for 2003, 2002, and 2001,
respectively. Amortization on other intangible assets is expected to total
$2.63 million, $2.61 million, $1.85 million, $0.15 million, and $0.05
million in 2004, 2005, 2006, 2007, and 2008, respectively.
VENTURE CAPITAL INVESTMENT -- Venture capital investments are carried at
estimated fair value with changes in fair value recognized in investment
securities and other investment (losses) gains. The fair values of publicly
traded investments are determined using quoted market prices. For other
investments, fair value is determined by the General Partner. All valuations are
approved by the Valuation Committee of the Advisory Board of the Partnership.
Venture capital investments in Partnerships are included in other assets on the
balance sheet. The balances as of December 31, 2003 and 2002 are $2.63 million
and $3.35 million, respectively.
SHORT-TERM BORROWINGS -- 1st Source's short-term borrowings consist of Federal
funds purchased, securities sold under agreement to repurchase, commercial
paper, U.S. Treasury demand notes and borrowings from non-affiliated banks.
Federal funds purchased, securities sold under agreements to repurchase, and
other short-term borrowings mature within 30 to 180 days of the transaction
date. Commercial paper matures within 30 to 270 days.
Securities purchased under agreements to resell and securities sold under
agreements to repurchase are treated as collateralized financing transactions
and are recorded at the amounts at which the securities were acquired or sold
plus accrued interest. U.S. government and Federal agency securities pledged as
collateral under these financing arrangements cannot be sold or repledged by the
secured party. The fair value of collateral either received from or provided to
a third party is continually monitored and additional collateral obtained or
requested to be returned to 1st Source as deemed appropriate.
TRUST FEES -- Trust fees are recognized on the accrual basis.
INCOME TAXES -- 1st Source and its subsidiaries file a consolidated Federal
income tax return. The provision for incomes taxes is based upon income in the
financial statements, rather than amounts reported on 1st Source's income tax
return.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
32
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized as income or
expense in the period that includes the enactment date.
NET INCOME PER COMMON SHARE -- Net income per common share is computed in
accordance with SFAS No. 128, "Earnings per Share." Basic earnings per share is
computed by dividing net income before interest expense on mandatorily
redeemable shares by the weighted-average number of shares of common stock
outstanding, which were as follows (in thousands): 2003, 20,859; 2002, 20,935;
and 2001, 20,767. Diluted earnings per share is computed by dividing net income
before interest expense on mandatorily redeemable shares by the weighted-average
number of shares of common stock outstanding, plus the dilutive effect of
outstanding stock options. The weighted-average number of common shares,
increased for the dilutive effect of stock options, used in the computation of
diluted earnings per share were as follows (in thousands): 2003, 21,150; 2002,
21,310; and 2001, 21,170. The computation of weighted-average number of shares
gives retroactive effect to a 5% stock dividend declared April 24, 2001.
At December 31, 2003, the company had six stock-based employee compensation
plans, which are described more fully in Note I. These include two stock option
plans, a stock option agreement, the Employee Stock Purchase Plan, the Executive
Incentive Plan and the Restricted Stock Award Plan. 1st Source accounts for
those plans under the recognition and measurement principles of Accounting
Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to
Employees," and related Interpretations. Stock-based employee compensation cost
under the Executive Incentive Plan and the Restricted Stock Award Plan is
reflected in net income. No stock-based employee compensation cost for the stock
option plans, the stock option agreement, or the Employee Stock Purchase Plan is
reflected in net income. All options granted under the stock option plans and
the stock option agreement had an exercise price equal to the market value of
the underlying common stock on the date of grant. Options granted under the
Employee Stock Purchase Plan had an exercise price based on the market value of
the underlying common stock on the date of grant as described more fully in Note
I. The following table illustrates the effect on net income and earnings per
share if the company had applied the fair value recognition provisions of SFAS
No. 123, "Accounting for Stock-Based Compensation," to stock-based employee
compensation.
Year Ended December 31 (Dollars in thousands, except per share data) 2003 2002 2001
- --------------------------------------------------------------------------------- ------------- ------------ ------------
Net income, as reported $19,154 $10,039 $38,498
Add:
Stock-based employee compensation expense included in reported net income,
net of related tax effects 1,360 - 1,832
Deduct:
Stock-based employee compensation expense determined under fair value based
method for all awards, net of related tax effects (1,590) (333) (2,124)
- --------------------------------------------------------------------------------- ------------- ------------ ------------
Pro forma net income $18,924 $ 9,706 $38,206
- --------------------------------------------------------------------------------- ------------- ------------ ------------
Earnings per share:
Basic-- as reported $ 0.92 $ 0.48 $ 1.85
Basic-- pro forma $ 0.91 $ 0.46 $ 1.84
- --------------------------------------------------------------------------------- ------------- ------------ ------------
Diluted-- as reported $ 0.91 $ 0.47 $ 1.82
Diluted-- pro forma $ 0.90 $ 0.46 $ 1.81
=========================================================================================================================
SEGMENT INFORMATION -- 1st Source's principal business is commercial banking and
mortgage banking conducted through its wholly-owned subsidiary, Trustcorp.
Trustcorp constitutes a segment by definition in accordance with SFAS No. 131,
"Disclosure about Segments of an Enterprise and Related Information," but does
not meet any of the materiality tests for disclosure.
DERIVATIVE FINANCIAL INSTRUMENTS -- 1st Source occasionally enters into
derivative financial instruments as part of its interest rate risk management
strategies. These derivative financial instruments consist primarily of interest
rate swaps. Under the guidance of SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities," as amended, all derivative instruments are
recorded on the balance sheet, as either an asset or liability, at their fair
value. The accounting for the gain or loss resulting from the change in fair
value depends on the intended use of the derivative. For a derivative used to
hedge changes in fair value of a recognized asset or liability, or an
unrecognized firm commitment, the gain or loss on the derivative will be
recognized in earnings together with the offsetting loss or gain on the hedged
item. This results in earnings recognition only to the extent that the hedge is
ineffective in achieving offsetting changes in fair value. For a derivative used
to hedge changes in cash flows associated with forecasted transactions, the gain
or loss on the effective portion of the derivative will be deferred, and
reported as accumulated other comprehensive income, a component of shareholders'
equity, until such time the hedged transaction affects earnings. For derivative
instruments not accounted for as hedges, changes in fair value are required to
be recognized in earnings.
RECENT ACCOUNTING PRONOUNCEMENTS -- ACCOUNTING FOR CERTAIN LOANS AND DEBT
SECURITIES ACQUIRED IN A TRANSFER: In December 2003, the American Institute of
Certified Public Accountants (AICPA) issued Statement of Position (SOP) 03-3,
"Accounting for Certain Loans and Debt Securities Acquired in a Transfer
(formerly known as Discounts Related to Credit Quality)." This SOP addresses
accounting differences between contractual cash flows and cash flows expected to
be collected from an investor's initial investment in loans or debt securities
(loans) acquired in a transfer if those differences are attributable, at least
in part, to credit quality. This SOP prohibits "carrying over" or creation of
valuation allowances in the initial accounting of all loans acquired in a
transfer that are within the scope of this SOP. The prohibition of the valuation
allowance carryover applies to the purchase of an individual loan, a pool of
loans, a group of loans, and loans acquired in a purchase business combination.
The provisions of SOP 03-3 are effective for loans acquired in fiscal years
beginning after December 15, 2004. Implementation of this statement is not
expected to have a material impact on 1st Source's results of operations,
financial position, or liquidity.
AMENDMENT OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES: In
April 2003, the Financial Accounting Standards Board (FASB) issued SFAS No. 149,
33
"Amendment of Statement 133 on Derivative Instruments and Hedging Activities."
This statement amends and clarifies financial accounting and reporting for
derivative instruments, including certain derivative instruments embedded in
other contracts. The provisions in this Statement require that contracts with
comparable characteristics be accounted for similarly. The provisions of SFAS
No. 149 are effective for contracts entered into or modified after June 30,
2003, and for hedging relationships designated after June 30, 2003. The
requirements of SFAS No. 149 did not have a material impact on the results of
operations or financial position of 1st Source.
ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH
LIABILITIES AND EQUITY: In May 2003, the FASB issued SFAS No. 150, "Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity." This Statement establishes standards on the classification and
measurement of certain financial instruments with characteristics of both
liability and equity. SFAS No. 150 is effective for all financial instruments
entered into or modified after May 31, 2003, and to all other instruments that
exist as of the beginning of the first interim period beginning after June 15,
2003. SFAS No. 150 requires the redemption value of mandatorily redeemable
securities to be classified as liabilities. As a result of the implementation of
SFAS No. 150, 1st Source reclassified $5.90 million of shareholder's equity to
mandatorily redeemable securities effective July 1, 2003. The mandatorily
redeemable securities are due to common stock issued under the 1st Source
Executive Incentive Plan. Awards under the plan include "book value" shares of
common stock. These shares are awarded annually based on weighted performance
criteria and vest over a period of five years. The plan shares may only be sold
to 1st Source and such sale is mandatory in the event of death, retirement,
disability or termination of employment. The adoption of SFAS No. 150 did not
have a material impact on the results of operations.
CONSOLIDATION OF VARIABLE INTEREST ENTITIES: In January 2003, the FASB issued
FASB Interpretation No. (FIN) 46, "Consolidation of Variable Interest Entities."
The objective of this interpretation is to provide guidance on how to identify a
variable interest entity (VIE) and determine when the assets, liabilities,
noncontrolling interests, and results of operations of a VIE need to be included
in a company's consolidated financial statements. FIN 46 requires a company that
holds variable interests in an entity to consolidate the entity if the company's
interest in the VIE is such that the company will absorb a majority of the VIE's
expected losses and/or receive a majority of the entity's expected residual
returns, if they occur. FIN 46 also requires additional disclosures by primary
beneficiaries and other significant variable interest holders. FIN 46, as
originally issued, was effective immediately for entities created after January
21, 2003, and applied to previously existing entities in quarters beginning
after June 15, 2003. On October 9, 2003, FASB issued a Staff Position deferring
the effective date for variable interests held prior to February 1, 2003,
however, early adoption was permitted.
1st Source early adopted FIN 46 on July 1, 2003. 1st Source determined that it
is not the primary beneficiary of its investment in 1st Source Capital Trust I,
II, and III (the Capital Trusts) and was required to deconsolidate the Capital
Trusts. 1st Source owns the common stock of the Capital Trusts, which issued
mandatorily redeemable preferred capital securities to third party investors.
The Capital Trusts' only assets, which totaled $56.44 million at July 1, 2003,
consisted of debentures which were acquired by the Capital Trusts using proceeds
from the issuance of the preferred securities and common stock. As a result of
the deconsolidation, the debentures are included in "subordinated notes" and
1st Source's equity interests in the Capital Trusts are included in "other
assets" on the balance sheet.
ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES: SFAS No. 146,
"Accounting for Costs Associated with Exit or Disposal Activities," was issued
in July 2002, and became effective for 1st Source beginning January 1, 2003.
This statement requires the cost associated with an exit or disposal activity,
such as the sale or termination of a line of business, the closure of business
activities in a particular location, or a change in management structure, be
recorded as a liability at fair value when it becomes probable the cost will be
incurred and no future economic benefit will be gained by 1st Source for such
cost. Applicable costs include employee termination benefits, contract
termination costs, and costs to consolidate facilities or relocate employees.
The adoption of this standard did not have a material impact on 1st Source's
results of operations, financial position, or liquidity.
GUARANTEES: In November 2002, the FASB issued FIN 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others." This interpretation expands the disclosures to be made
by a guarantor in its financial statements about its obligations under certain
guarantees and requires the guarantor to recognize a liability for the fair
value of an obligation assumed under a guarantee. The initial recognition and
measurement provisions of FIN 45 were applicable on a prospective basis to
guarantees issued or modified after December 31, 2002. The disclosure
requirements of FIN 45 were effective for financial statements of interim or
annual periods ending after December 15, 2002, and were adopted in 1st Source's
2002 Annual Report. Implementation of the remaining provisions of FIN 45 during
the first quarter of 2003 did not have a significant impact on the financial
statements. Significant guarantees that have been entered into by 1st Source are
disclosed in Note N.
ACCOUNTING FOR STOCK-BASED COMPENSATION: In December 2002, the FASB issued SFAS
No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure,"
which provides guidance on how to transition from the intrinsic value method of
accounting for stock-based employee compensation under APB 25 to SFAS No. 123's
fair value method of accounting, if a company so elects. 1st Source has not
adopted the fair value method of recording stock options under SFAS No. 123.
ACQUISITIONS OF CERTAIN FINANCIAL INSTITUTIONS: In October 2002, SFAS No. 147,
"Acquisitions of Certain Financial Institutions" was issued, which provides
guidance on the accounting for the acquisition of a financial institution and
supersedes the specialized accounting guidance provided in SFAS No. 72,
"Accounting for Certain Acquisitions of Banking or Thrift Institutions." SFAS
No. 147 was effective immediately and required companies to cease amortization
of unidentified intangible assets associated with certain branch acquisitions.
Upon adoption of SFAS No. 147, the amount of unidentifiable intangible assets
previously recorded was reclassified to goodwill. SFAS No. 147 also modifies
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets,"
to include in its scope long-term customer-relationship intangible assets and
thus subject those intangible assets to the same undiscounted cash flow
recoverability test and impairment loss recognition and measurement provisions
required for other long-lived assets. While SFAS No. 147 may affect how future
business combinations, if undertaken, are accounted for and disclosed in the
financial statements, the issuance of the new guidance currently has no effect
on 1st Source's result of operations, financial position, or liquidity.
RESCISSION OF SFAS NO. 4, 44, AND 64, AMENDMENT OF SFAS NO. 13 AND TECHNICAL
CORRECTIONS: In April 2002, SFAS No. 145 was issued, which updates, clarifies
and simplifies certain existing accounting pronouncements beginning at various
34
dates in 2002 and 2003. The statement rescinds SFAS No. 4 and SFAS No. 64, which
required net gains or losses from the extinguishments of debt to be classified
as an extraordinary item in the income statement. These gains and losses will
now be classified as extraordinary only if they meet the criteria for such
classification as outlined in APB Opinion 30, which allows for extraordinary
treatment if the item is material and both unusual and infrequent in nature. The
statement also rescinds SFAS No. 44 related to the accounting for intangible
assets for motor carriers and amends SFAS No. 13 to require certain lease
modifications that have economic effects similar to sale-leaseback transactions
to be accounted for as such. The changes required by SFAS No. 145 had no impact
on 1st Source's results of operations, financial position, or liquidity.
RECLASSIFICATIONS -- Certain amounts in the prior period consolidated financial
statements have been reclassified to conform with the current year presentation.
These reclassifications had no effect on total assets, shareholders' equity or
net income as previously reported.
NOTE B -- FAIR VALUES OF FINANCIAL INSTRUMENTS
The fair values of 1st Source's financial instruments as of December 31, 2003
and 2002 are summarized in the table below.
2003 2002
CARRYING OR Carrying or
CONTRACT VALUE FAIR VALUE Contract Value Fair Value
(Dollars in thousands)
- ------------------------------------------------------------- ------------------ ----------------- -------------- -------------
Assets:
Cash and due from banks $ 109,787 $ 109,787 $ 120,894 $ 120,894
Federal funds sold and interest bearing deposits with other banks 1,355 1,355 81,881 81,881
Investment securities, available-for-sale 763,763 763,763 647,617 647,617
Trading account securities - - 13,347 13,347
Mortgages held for sale 60,215 60,215 146,640 146,640
Loans, net of reserve for loan losses 2,160,955 2,192,329 2,120,234 2,174,830
- ------------------------------------------------------------- ------------------ ----------------- -------------- -------------
Liabilities:
Deposits 2,487,215 2,508,012 2,712,905 2,748,490
Short-term borrowings 390,854 390,854 260,678 260,678
Long-term debt and mandatorily redeemable securities 22,802 22,977 16,878 17,144
Subordinated notes 56,444 54,540 54,750 51,393
Interest rate swaps 4,103 4,103 - -
Off-balance-sheet instruments* - (620) - (696)
===============================================================================================================================
* Represents estimated cash outflows required to currently settle the
obligations at current market rates.
The following methods and assumptions were used by 1st Source in estimating the
fair value of its financial instruments:
CASH AND CASH EQUIVALENTS -- The carrying values reported in the consolidated
statements of financial condition for cash and due from banks, Federal funds
sold and interest bearing deposits with other banks approximate fair values for
these assets.
INVESTMENT SECURITIES -- Fair values for securities are based on quoted market
prices, where available. If quoted market prices are not available, fair values
are estimated based on quoted market prices of comparable investments. Retained
interests in securitized assets are generally valued using discounted cash flow
techniques.
LOANS -- For variable rate loans that reprice frequently and with no significant
change in credit risk, fair values are based on carrying values. The fair values
for certain real estate loans (e.g., one-to-four single family residential
mortgage loans) are based on quoted market prices of similar loans sold in
conjunction with securitization transactions, adjusted for differences in loan
characteristics. The fair values of all other loans are estimated using
discounted cash flow analyses which use interest rates currently being offered
for loans 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
approximate their fair values.
LONG-TERM DEBT AND MANDATORILY REDEEMABLE SECURITIES -- The fair values of 1st
Source's long-term debt are estimated using discounted cash flow analyses, based
on 1st Source's current estimated incremental borrowing rates for similar types
of borrowing arrangements. The carrying values of mandatorily redeemable
securities are based on approximate 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 quoted market prices of comparable securities.
INTEREST RATE SWAPS -- The carrying values of interest rate swaps are based on
approximate fair values.
GUARANTEES AND LOAN COMMITMENTS -- Contract and fair values for certain of 1st
Source's off-balance-sheet financial instruments (guarantees and loan
commitments) 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.
35
OFF-BALANCE-SHEET INSTRUMENTS -- Fair values for off-balance-sheet instruments
are based on the net amount necessary to currently settle the transaction.
LIMITATIONS -- Fair value estimates are made at a discrete point in time based
on relevant market information and information about the financial instruments.
Because no market exists for a significant portion of 1st Source's 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 are subjective in nature and involve uncertainties and matters
of significant judgment and therefore cannot be determined with precision.
Changes in assumptions could significantly affect the estimates. In addition,
the fair value estimates are based on existing on and off-balance-sheet
financial instruments without attempting to estimate the value of anticipated
future business and of the assets and liabilities which are not considered
financial instruments. For example, 1st Source has a substantial annual trust
net fee income. Trust operations are not considered financial instruments and
their value has not been incorporated into the fair value estimates.
Other significant assets and liabilities that are not considered financial
instruments include the mortgage banking operation, premises and equipment and
other assets. In addition, for investment and mortgage-backed securities, the
income tax ramifications related to the realization of unrealized gains and
losses can have a significant effect on fair value estimates and have not been
considered in many of the estimates. 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.
NOTE C -- INVESTMENT SECURITIES
Investment securities available-for-sale are as follows:
Gross Gross
Amortized Unrealized Unrealized
(Dollars in thousands) Cost Gains Losses Fair Value
DECEMBER 31, 2003
DEBT SECURITIES:
U.S. TREASURY AND AGENCY SECURITIES $439,295 $ 1,646 $ (1,373) $439,568
OBLIGATIONS OF STATES AND POLITICAL SUBDIVISIONS 168,383 3,295 (163) 171,515
MORTGAGE-BACKED SECURITIES 65,453 238 (537) 65,154
OTHER SECURITIES 14,404 76 (131) 14,349
- ---------------------------------------------------------- -------------- ----------- ---------------- ------------
TOTAL DEBT SECURITIES 687,535 5,255 (2,204) 690,586
EQUITY SECURITIES 72,410 3,479 (2,712) 73,177
- ---------------------------------------------------------- -------------- ----------- ---------------- ------------
TOTAL INVESTMENT SECURITIES $759,945 $ 8,734 $ (4,916) $763,763
- ---------------------------------------------------------- -------------- ----------- ---------------- ------------
December 31, 2002
Debt securities:
U.S. Treasury and agency securities $321,798 $ 5,389 $ (1) $327,186
Obligations of states and political subdivisions 152,001 4,054 (45) 156,010
Mortgage-backed securities 63,880 597 (10) 64,467
Other securities 29,996 58 (2,112) 27,942
- ---------------------------------------------------------- -------------- ----------- ---------------- ------------
Total debt securities 567,675 10,098 (2,168) 575,605
Equity securities 72,549 1,503 (2,040) 72,012
- ---------------------------------------------------------- -------------- ----------- ---------------- ------------
Total investment securities $640,224 $11,601 $ (4,208) $647,617
===================================================================================================================
The contractual maturities of investments in debt securities available-for-sale
at December 31, 2003, 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.
Amortized
(Dollars in thousands) Cost Fair Value
- --------------------------------------------------------------------------------
Due in one year or less $ 91,520 $ 92,401
Due after one year through five years 506,145 508,506
Due after five years through ten years 19,270 19,375
Due after ten years 5,147 5,149
Mortgage-backed securities 65,453 65,155
- ---------------------------------------------------------------- ------------
TOTAL DEBT SECURITIES $687,535 $690,586
================================================================================
Other equity securities classified as available-for-sale at December 31, 2003
and 2002, include securities such as Federal Reserve Bank and Federal Home Loan
Bank stock, which are not traded on established exchanges and have only
redemption capabilities. Fair values for such equity securities are considered
to approximate cost.
36
Gross losses of $3.02 million were recognized during 2003 on investment
securities available-for-sale. The gross loss in 2003 includes a $2.99 million
impairment charge on the securitization retained interest. Realized and
unrealized gains of $0.60 million, and $0.56 million, and $0, on trading account
securities were included in earnings in 2003, 2002, and 2001, respectively.
At December 31, 2003 and 2002, investment securities with carrying values of
$332.18 million and $284.53 million, respectively, were pledged as collateral to
secure government and public deposits, and for other purposes.
The mortgage-backed securities held by 1st Source consist primarily of FNMA,
GNMA and FHLMC pass-through certificates which are guaranteed by those
respective agencies of the United States government.
1st Source's available-for-sale investment portfolio contains preferred stock of
two Government Agency securities of which the market values have been below book
value for a period longer than twelve months. The securities are floating rate
preferred stock that reprice every two years with the next repricing to occur in
2004. Due to a change in interest rates during the course of the year and the
fact that the interest rate on the securities is below current market levels,
the market value is below the book value. It is anticipated that the impairment
will continue until the securities reprice in 2004 at the then current market
rate. The following table summarizes 1st Source's temporarily impaired
securities as of December 31, 2003:
Less than 12 Months 12 months or Longer Total
-------------------- --------------------- -------------------
Fair Unrealized Fair Unrealized Fair Unrealized
(Dollars in thousands) Value Losses Value Losses Value Losses
Debt securities:
U.S. Treasury and agency securities $191,475 $ (1,373) $ - $ - $191,475 $ (1,373)
Obligations of states and political subdivisions 24,076 (156) 501 (7) 24,577 (163)
Mortgage-backed securities 45,774 (536) 123 (1) 45,897 (537)
Other securities 3,425 (131) - - 3,425 (131)
- --------------------------------------------- --------------- ------------ ---------- -------- ------------- ----------
Total debt securities 264,750 (2,196) 624 (8) 265,374 (2,204)
Equity securities 13,807 (840) 13,815 (1,872) 27,622 (2,712)
- --------------------------------------------- --------------- ------------ ----------- --------- ------------- ----------
TOTAL TEMPORARILY IMPAIRED SECURITIES $278,557 $ (3,036) $14,439 $(1,880) $292,996 $(4,916)
============================================================================================================================
NOTE D -- LOANS TO RELATED PARTIES
1st Source and its subsidiaries have extended, and expect to extend in the
future, loans to officers, directors, and principal holders of equity securities
of 1st Source and its subsidiaries and to their associates. In the opinion of
management, these loans are made on substantially the same terms, including
interest rates and collateral, as those prevailing at the time for comparable
transactions with other parties and are consistent with sound banking practices
and within applicable regulatory and lending limitations. The aggregate dollar
amount of these loans was $29.98 million and $22.83 million at December 31, 2003
and 2002, respectively. During 2003, $14.48 million of new loans were made and
repayments and other reductions totaled $7.33 million.
NOTE E -- RESERVE FOR LOAN LOSSES
At December 31, 2003 and 2002, nonaccrual and restructured loans, substantially
all of which are collateralized, were $27.09 million and $35.66 million,
respectively. Interest income for the years ended December 31, 2003, 2002, and
2001, would have increased by approximately $2.64 million, $2.63 million and
$2.82 million, respectively, if these loans had earned interest at their full
contract rate.
As of December 31, 2003 and 2002, impaired loans totaled $60.04 million and
$60.10 million, respectively, of which $9.74 million and $27.35 million had
corresponding specific reserves for loan losses totaling $5.18 million and
$10.04 million, respectively. The remaining balances of impaired loans had no
specific reserves for loan losses associated with them. As of December 31, 2003,
a total of $27.15 million of the impaired loans were nonaccrual loans. For 2003,
2002, and 2001 the average recorded investment in impaired loans was $60.36
million, $64.30 million and $45.69 million, respectively, and interest income
recognized on impaired loans totaled $2.63 million, $2.84 million and $3.40
million, respectively.
Changes in the reserve for loan losses for each of the three years ended
December 31 are shown below.
(Dollars in thousands) 2003 2002 2001
Balance, beginning of year $ 59,218 $ 57,624 $ 44,644
Provision for loan losses 17,361 39,657 25,745
Charge-offs, net of recoveries of $4,181 in 2003, $3,658 in 2002, and $971 in 2001 (13,357) (38,063) (13,361)
Reserves related to loans acquired 6,823 - 596
- ---------------------------------------------------------------------------------- --------- --------- ---------
BALANCE, END OF YEAR $ 70,045 $ 59,218 $ 57,624
============================================================================================================================
37
NOTE F -- PREMISES AND EQUIPMENT
Premises and equipment as of December 31 consisted of the following:
(Dollars in thousands) 2003 2002
- -------------------------------------------------------------- ------------
Land $ 6,759 $ 6,905
Buildings and improvements 40,205 39,756
Furniture and equipment 32,437 32,548
- -------------------------------------------------------------- ------------
Total premises and equipment 79,401 79,209
Accumulated depreciation and amortization (40,970) (38,310)
- -------------------------------------------------------------- ------------
NET PREMISES AND EQUIPMENT $ 38,431 $ 40,899
===========================================================================
NOTE G - MORTGAGE SERVICING ASSETS
The unpaid principal balance of residential mortgage loans serviced for third
parties was $2.09 billion at December 31, 2003, compared to $2.01 billion at
December 31, 2002, and $1.34 billion at December 31, 2001.
Changes in the carrying value of mortgage servicing assets and the associated
valuation allowance follow:
Year Ended December 31 (Dollars in thousands) 2003 2002
- ------------------------------------------------------------------------------------------ ------------
Mortgage servicing assets:
Balance at beginning of period $ 28,086 $ 20,092
Additions 18,372 19,567
Amortization (8,168) (6,306)
Application of valuation allowance to directly write-down servicing assets (4,633) -
Sales (6,056) (5,267)
- ------------------------------------------------------------------------------------------ ------------
Carrying value before valuation allowance at end of period 27,601 28,086
- ------------------------------------------------------------------------------------------ ------------
Valuation allowance:
Balance at beginning of period (7,328) -
Impairment charges (581) (7,328)
Application of valuation allowance to directly write-down servicing assets 4,633 -
- ------------------------------------------------------------------------------------------ ------------
Balance at end of period $ (3,276) $ (7,328)
- ---------------------------------------------------------------------------------------------- ---------
Net carrying value of mortgage servicing assets at end of period $ 24,325 $ 20,758
- ---------------------------------------------------------------------------------------------- ---------
FAIR VALUE OF MORTGAGE SERVICING ASSETS AT END OF PERIOD $ 24,936 $ 21,480
========================================================================================================
Mortgage servicing assets are evaluated for impairment and a valuation allowance
is established through a charge to income when the carrying value of the
mortgage servicing assets exceeds the fair value and the impairment is
determined to be temporary. Other-than-temporary impairment is recognized when
the recoverability of a recorded valuation allowance is determined to be remote
taking into consideration historical and projected interest rates and loan
pay-off activity. When this situation occurs, the unrecoverable portion of the
valuation allowance is applied as a direct write-down to the carrying value of
the mortgage servicing asset. Unlike a valuation allowance, a direct write-down
permanently reduces the carrying value of the mortgage servicing asset and the
valuation allowance, precluding subsequent recoveries. During 2003, management
determined that $4.63 million of previously established valuation allowance was
not recoverable and reduced both the asset and the valuation allowance. At
December 31, 2003, the fair value of mortgage servicing assets exceeded the
carrying value reported in the consolidated balance sheet by $0.61 million. This
difference represents increases in the fair value of certain mortgage servicing
assets accounted for under SFAS No. 140 that could not be recorded above cost
basis.
Funds held in trust at 1st Source for the payment of principal, interest, taxes
and insurance premiums applicable to mortgage loans being serviced for others,
aggregated were approximately $41.19 million and $86.57 million at December 31,
2003 and December 31, 2002, respectively.
NOTE H -- LONG-TERM DEBT AND MANDATORILY REDEEMABLE SECURITIES
Details of long-term debt and mandatorily redeemable securities as of December
31 are as follows:
(Dollars in thousands) 2003 2002
- -------------------------------------------------------------------------- --------------
Term loan * $ 15,000 $ 15,000
Federal Home Loan Bank borrowings (5.04%-6.98%) 1,027 1,209
Mandatorily redeemable securities 6,064 -
Other long-term debt 711 669
- -------------------------------------------------------------------------- --------------
TOTAL LONG-TERM DEBT AND MANDATORILY REDEEMABLE SECURITIES $ 22,802 $ 16,878
=========================================================================================
*Fixed rate at December 31, 2003 and 2002, was 4.76% and 4.76%, respectively.
Variable rate at December 31, 2003 was 2.57%.
38
Annual maturities of long-term debt outstanding at December 31, 2003, for the
next five years beginning in 2004, are as follows (in thousands): $258; $225;
$131; $15,076 and $70.
At December 31, 2003, the term loan included $10.00 million contractually based
on a fixed interest rate of 4.76% and $5.00 million contractually based on a
variable interest rate. Interest is payable quarterly with principal due at the
October 31, 2007, maturity. The Term Loan Agreement contains, among other
provisions, certain covenants relating to existence and mergers, capital
structure, and financial requirements.
At December 31, 2003, the Federal Home Loan Bank borrowings represent a source
of funding for certain residential mortgage activities and consist of five fixed
rate notes with maturities ranging from 2006 to 2022. These notes are
collateralized by $1.64 million of certain real estate loans.
Mandatorily redeemable securities as of December 31, 2003, of $6.06 million were
recorded for "book value" shares under the 1st Source Executive Incentive Plan.
See "Executive Incentive Plan" section of Note I for additional information on
this plan. Dividends paid on these shares and increases in book value per share
are recorded as other interest expense. Total interest expense recorded for 2003
was $0.24 million.
NOTE I -- COMMON STOCK
1st Source has adopted SFAS No. 123, "Accounting for Stock-Based Compensation,"
on a disclosure basis only. The disclosure requirements include reporting the
pro forma effect on net income and net income per share of compensation expense
attributable to the fair value of stock options and other stock-based
compensation which have been issued to employees under the Stock Option Plans
and the Employee Stock Purchase Plan. 1st Source is following APB No. 25 in
accounting for these plans. In addition, the Executive Incentive Plan (including
annual and special long-term awards) and the Restricted Stock Award Plan are
also accounted for under the provisions of APB No. 25. Compensation cost charged
against income for these plans was $2.19 million, $0 and $2.95 million for the
years ended December 31, 2003, 2002, and 2001, respectively.
STOCK OPTION PLANS -- 1st Source's incentive stock option plans include the 1992
Stock Option Plan (the "1992 Plan"), the 2001 Stock Option Plan (the "2001
Plan") and a certain other stock option agreement which became effective January
1, 1992. As of December 31, 2003, an aggregate 2,686,544 shares of common stock
were reserved for issuance under the above plans. Under the 2001 Plan, the
exercise price of each option equals the market price of 1st Source stock on the
date of grant, and an option's term is ten years, except for reload options,
which are given the remaining term of the original grant. Options under the 2001
Plan vest in one to eight years from date of grant. Options are granted on a
discretionary basis by the Executive Compensation Committee (the "Committee") of
the 1st Source Board of Directors.
The fair value of each option on the date of grant was estimated using the
Black-Scholes option pricing model. The following weighted-average assumptions
were used in the option pricing model for options granted in each of the last
three years: a risk-free interest rate of 3.39% for 2003, 3.61% for 2002, and
4.91% for 2001; an expected dividend yield of 2.32% for 2003, 1.74% for 2002,
and 1.77% for 2001; an expected volatility factor of 37.02% for 2003, 35.32% for
2002, and 30.63% for 2001, and an expected option life of 6.39 years for 2003,
5.29 years for 2002, and 6.51 years for 2001. The weighted-average grant date
fair value of options granted for 2003, 2002, and 2001 was $4.94, $6.81, and
$8.43, respectively.
The following table is a summary of the activity with respect to 1st Source's
stock option plans for the years ended December 31, 2001, 2002 and 2003:
Number of Weighted-Average
Shares Exercise Price
Options outstanding, January 1, 2001 967,180 $ 17.47
- ------------------------------------------------------------- --------------
Options granted 53,608 21.85
Options exercised (40,928) 9.09
Options forfeited (2,212) 10.60
- ------------------------------------------------------------- --------------
Options outstanding, December 31, 2001 977,648 18.07
- ------------------------------------------------------------- --------------
Options granted 23,673 19.93
Options exercised (175,039) 7.59
Options forfeited - -
- ------------------------------------------------------------- --------------
Options outstanding, December 31, 2002 826,282 20.34
- ------------------------------------------------------------- --------------
Options granted 20,000 13.24
Options exercised (71,528) 8.71
Options forfeited (4,235) 19.24
- ------------------------------------------------------------- --------------
OPTIONS OUTSTANDING, DECEMBER 31, 2003 770,519 21.24
- ------------------------------------------------------------- --------------
OPTIONS EXERCISABLE, DECEMBER 31, 2003 720,553 $21.45
============================================================================
39
The following table summarizes information about stock options outstanding at
December 31, 2003:
Options Outstanding Options Exercisable
---------------------- ---------------------
Weighted-Average
Number of Remaining Contractual Weighted-Average Number of Weighted-Average
Range of Exercise Prices Shares Life (Years) Exercise Price Shares Exercise Price
- ------------------------------------------- ---------------------- --------------------------------- -----------------
$ 5.00 to $ 11.99 133,089 0.97 $ 6.12 133,089 $ 6.12
$ 12.00 to $ 29.99 279,058 4.45 15.77 229,092 15.24
$ 30.00 to $ 31.99 358,372 4.55 31.12 358,372 31.12
======================================================================================================================
EMPLOYEE STOCK PURCHASE PLAN -- 1st Source also has an employee stock purchase
plan for substantially all employees with at least two years of service on the
effective date of an offering under the plan. Eligible employees may elect to
purchase any dollar amount of stock, so long as such amount does not exceed 25%
of their base rate of pay and the aggregate stock accrual rate for all offerings
does not exceed $25,000 in any calendar year. The purchase price for shares
offered is the lower of the closing market bid price for the offering date or
the average market bid price for the five business days preceding the offering
date. The purchase price and discount to the actual market closing price for the
2003, 2002, and 2001 offerings were $16.47 (4.96%), $22.85 (0.17%), and $19.38
(2.86%), respectively. Payment for the stock is made through payroll deductions
over the offering period, and employees may discontinue the deductions at any
time and exercise the option or take the funds out of the program. The most
recent offering began June 2, 2003 and runs through May 31, 2005, with $353,100
in stock value to be purchased at $16.47 per share. The fair value of the
employees' purchase rights for the 2003, 2002, and 2001 offerings was estimated
using the Black-Scholes model. The following assumptions were used in the model
in each of the last three years: a risk-free interest rate of 1.38% for 2003 and
3.19% for 2002, and 4.22% for 2001; an expected dividend yield of 2.72% for 2003
and 1.52% for 2002, and 1.86% for 2001; an expected volatility factor of 49.56%
for 2003 and 43.07% for 2002, and 40.69% for 2001; and an expected life of 2.00
years for 2003, 2002, and 2001. The fair value for shares offered in 2003, 2002,
and 2001 was $4.61, $5.58, and $4.65, respectively.
Pro forma net income and diluted net income per common share, reported as if
compensation expense had been recognized under the fair value provisions of SFAS
No. 123 for the stock option and employee stock purchase plans, are as follows:
2003 2002 2001
- --------------------------------------------------------------------------------
Net income (dollars in thousands):
As reported $19,154 $10,039 $38,498
Pro forma 18,924 9,706 38,206
Diluted net income per common share:
As reported $ 0.91 $ 0.47 $ 1.82
Pro forma 0.90 0.46 1.81
================================================================================
EXECUTIVE INCENTIVE PLAN -- 1st Source's Executive Incentive Plan is also
administered by the Committee. Awards under the plan include "book value" shares
of common stock. These shares are awarded annually based on weighted performance
criteria and vest over a period of five years. The plan shares may only be sold
to 1st Source and such sale is mandatory in the event of death, retirement,
disability or termination of employment. Grants under the plan for 2003, 2002,
and 2001 are summarized as follows:
2003 2002 2001
- --------------------------------------------------------------------------------
Number of shares 13,776 59,824 51,168
Weighted-average grant-date fair value $14.77 $14.73 $13.07
================================================================================
SPECIAL LONG-TERM INCENTIVE AWARD -- During February 2001 and February 1996, 1st
Source granted special long-term incentive awards, including 1st Source common
stock, to participants in the Executive Incentive Plan. Shares granted under the
plan vest over a period of ten years. The first 10% was vested at the time of
the grants. Subsequent vesting requires (i) the participant to remain an
employee of 1st Source and (ii) that 1st Source be profitable on an annual
basis, based on the determination of the Committee. The number of shares granted
under the Plan for 2001 was 46,353, and the weighted average grant date fair
value was $17.38.
RESTRICTED STOCK AWARD PLAN -- 1st Source also has a restricted stock award plan
for key employees. Awards under the plan are made to employees recommended by
the Chief Executive Officer and approved by the Committee. Shares granted under
the plan vest over a five to ten-year period and vesting is based upon meeting
certain criteria, including continued employment by 1st Source. Grants under the
plan for 2003, 2002, and 2001 are summarized below:
2003 2002 2001
- --------------------------------------------------------------------------------
Number of shares 15,158 1,000 22,737
Weighted-average grant-date fair value $19.37 $22.89 $22.13
================================================================================
40
NOTE J --SUBORDINATED NOTES
1st Source has sponsored three trusts, 1st Source Capital Trust I, II and III
(Capital Trusts) of which 100% of the common equity is owned by 1st Source. The
Capital Trusts were formed for the purpose of issuing corporation-obligated
mandatorily redeemable capital securities (the capital securities) to
third-party investors and investing the proceeds from the sale of the capital
securities solely in junior subordinated debt securities of 1st Source (the
subordinated notes). The subordinated notes held by each Capital Trust are the
sole assets of that Capital Trust. Distributions on the capital securities
issued by each Capital Trust are payable semi-annually at a rate per annum equal
to the interest rate being earned by the Capital Trust on the subordinated notes
held by that Capital Trust. The capital securities are subject to mandatory
redemption, in whole or in part, upon repayment of the subordinated notes. 1st
Source has entered into agreements which, taken collectively, fully and
unconditionally guarantee the capital securities subject to the terms of each of
the guarantees.
During 2003, as a result of applying the provisions of FIN 46, which
represents new accounting guidance governing when an equity interest should be
consolidated, 1st Source was required to deconsolidate the Capital Trusts from
its financial statements. The deconsolidation of the net assets and results of
operations of the Capital Trusts had virtually no impact on 1st Source's
financial statements or liquidity position since 1st Source continues to be
obligated to repay the subordinated notes held by the Capital Trusts and
guarantees repayment of the capital securities issued by the Capital Trusts. The
consolidated debt obligation related to the Capital Trusts increased from $54.75
million to $56.44 million upon deconsolidation with the difference representing
1st Source's common ownership interest in the Capital Trusts.
The capital securities held by the Capital Trusts qualify as Tier 1 capital for
1st Source under Federal Reserve Board guidelines. As a result of the issuance
of FIN 46, the Federal Reserve Board is currently evaluating whether
deconsolidation of the Capital Trusts will affect the qualification of the
capital securities as Tier 1 capital. If in the future it is determined that the
capital securities can no longer qualify as Tier 1 capital, 1st Source would
still be well capitalized.
The subordinated notes are summarized as follows, at December 31, 2003:
Amount of
Subordinated Interest Maturity
(Dollars in thousands) Notes Rate Date
- -------------------------------------------------------- ------------ ----------
March 1997 issuance-fixed rate $28,351 9.00% 03/31/27
March 1997 issuance-floating rate 17,783 3.41% 03/31/27
November 2002 issuance-floating rate 10,310 6.95% 11/15/32
- -------------------------------------------------------- ------------ ----------
TOTAL $56,444
================================================================================
The March 1997 floating rate issuance interest rate is equal to the sum of the
three-month Treasury adjusted to a constant maturity, plus 2.25%. The November
2002 issuance interest rate is fixed at 6.95% until November 15, 2007, at which
time it will become floating at an interest rate equal to LIBOR, plus 3.35%.
NOTE K -- EMPLOYEE BENEFIT PLANS
1st Source maintains a defined contribution money purchase pension plan covering
the majority of its employees. Contributions to the plan are based on 2% of
participants' eligible compensation. For the years ended December 31, 2003,
2002, and 2001, total pension expense for this plan amounted to $0.87 million,
$0.70 million, and $0.60 million, respectively.
1st Source also maintains a defined contribution profit sharing and savings plan
covering the majority of its employees. The plan allows eligible employees to
make contributions by salary reduction pursuant to Section 401(k) of the
Internal Revenue Code. 1st Source is required under the plan to match 100% of
participant contributions up to 4% of compensation and one-half of any
additional participant contributions up to 6% of compensation, provided that 1st
Source is profitable for the respective plan year. 1st Source may also make
discretionary contributions to the plan, depending on its profitability.
Contribution expense for this plan for the years ended December 31, 2003, 2002,
and 2001, amounted to $1.99 million, $1.88 million, and $1.89 million,
respectively.
Trustcorp contributes to a defined contribution plan for all of its employees
who meet the general eligibility requirements of the plan. Contribution expense
for this plan for the years ended December 31, 2003, 2002, and 2001, amounted to
$0.16 million, $0.15 million, and $0.32 million, respectively.
In addition to the pension and profit sharing plans, 1st Source provides certain
health care and life insurance benefits for substantially all of its retired
employees. All of 1st Source's full-time employees become eligible for these
retiree benefits upon reaching age 55 with 20 years of credited service. The
medical plan pays a stated percentage of eligible medical expenses reduced for
any deductibles and payments made by government programs and other group
coverage. The lifetime maximum benefit payable under the medical plan is $15,000
and $3,000 for life insurance.
1st Source's accrued postretirement benefit cost and net periodic postretirement
benefit cost recognized in the consolidated financial statements for the years
ended December 31, 2003, 2002, and 2001 were not material.
41
NOTE L -- INCOME TAXES
Income tax expense is comprised of the following:
(Dollars in thousands) 2003 2002 2001
- --------------------------------------------- ----------- ----------
Current:
Federal $ 9,226 $ (12,133) $ 14,714
State 2,315 (1,952) 2,736
- --------------------------------------------- ----------- ----------
Total current 11,541 (14,085) 17,450
- --------------------------------------------- ----------- ----------
Deferred:
Federal (2,697) 13,616 2,128
State (815) 1,835 131
- --------------------------------------------- ----------- ----------
Total deferred (3,512) 15,451 2,259
- --------------------------------------------- ----------- ----------
TOTAL PROVISION $ 8,029 $ 1,366 $ 19,709
====================================================================
Deferred tax assets and liabilities as of December 31, 2003 and 2002 consisted
of the following:
(Dollars in thousands) 2003 2002
- --------------------------------------------------------------------------------------
Deferred tax assets:
Reserve for loan losses $ 27,075 $ 28,041
Accruals for employee benefits 3,884 3,379
Asset securitization 1,414 (4,085)
Other 596 590
- ---------------------------------------------------------------------------------------
TOTAL DEFERRED TAX ASSETS 32,969 27,925
- --------------------------------------------------------------------------------------
Deferred tax liabilities:
Differing depreciable bases in premises and leased equipment 36,824 33,897
Mortgage servicing 8,154 7,961
Net unrealized gains on securities available-for-sale 1,463 2,804
Differing bases in assets related to acquisitions 809 839
Other 62 279
- --------------------------------------------------------------------------------------
TOTAL DEFERRED TAX LIABILITIES 47,312 45,780
- --------------------------------------------------------------------------------------
NET DEFERRED TAX LIABILITY $ 14,343 $ 17,855
======================================================================================
The reasons for the difference between income tax expense and the amount
computed by applying the statutory federal income tax rate (35%) to income
before income taxes are as follows:
2003 2002 2001
PERCENT OF Percent of Percent of
PRETAX Pretax Pretax
Year Ended December 31(Dollars in thousands) AMOUNT INCOME Amount Income Amount Income
- ---------------------------------------------------- ----------- ----------- --------------- ----------- ------------- ----
Statutory federal income tax $ 9,514 35.0% $ 3,992 35.0% $20,372 35.0%
(Decrease) increase in income taxes resulting from:
Tax-exempt interest income (1,969) (7.3) (2,069) (18.1) (2,195) (3.8)
State taxes, net of federal income tax benefit 975 3.6 (76) (0.7) 1,863 3.2
Other (491) (1.8) (481) (4.2) (331) (0.5)
- ---------------------------------------------------- ----------- ----------- --------------- ----------- ------------- ----
TOTAL $ 8,029 29.5% $ 1,366 12.0% $19,709 33.9%
===========================================================================================================================
The tax expense (benefit)applicable to securities gains and losses for the
years 2003, 2002 and 2001 was $(1,508,000),$(1,076,000) and $166,000,
respectively.
42
The following is a summary of the income tax effect allocated to other
comprehensive income:
2003 2002 2001
BEFORE- Before- Before-
Year Ended December 31 TAX TAX NET-OF-TAX Tax Tax Net-of-Tax Tax Tax Net-of-Tax
(Dollars in thousands) AMOUNT EXPENSE AMOUNT Amount Expense Amount Amount Expense Amount
- ------------------------------------------ -------- ---------- --------- ------- --------- --------- --------- --------- ---------
Unrealized gains on available-for-sale
securities (including effect of change
in accounting principle) $ 360 $ 134 $ 226 $ 977 $ 440 $ 537 $5,958 $2,299 $3,659
Less, reclassification adjustment for
losses realized in net income 3,936 1,476 2,460 2,836 1,278 1,558 439 169 270
- ------------------------------------------ ----------------------------- -------- -------- ---------- --------- ---------- --------
OTHER COMPREHENSIVE (LOSSES) INCOME $(3,576) $(1,342) $(2,234) $(1,859) $ (838) $(1,021) $5,519 $2,130 $3,389
===================================================================================================================================
NOTE M -- LEASES
1st Source and its subsidiaries are obligated under operating leases for certain
office premises and equipment. The headquarters building is leased for a
remaining term of eight years with options to renew for up to 15 additional
years. Approximately 30% of the facility is subleased to other tenants.
Future minimum rental commitments for all noncancellable operating leases total
approximately, $2.44 million in 2004, $1.77 million in 2005, $1.58 million in
2006, $1.44 million in 2007, $1.27 million in 2008, and $4.61 million
thereafter. As of December 31, 2003, future minimum rentals to be received under
noncancellable subleases totaled $3.43 million.
Rental expense of office premises and equipment and related sublease income were
as follows:
Year Ended December 31 (Dollars in thousands) 2003 2002 2001
- -------------------------------------------------------- ----------------- ------------
Gross rental expense $ 3,216 $ 3,184 $ 2,866
Sublease rental income (1,502) (1,479) (1,340)
- -------------------------------------------------------- ----------------- ------------
NET RENTAL EXPENSE $ 1,714 $ 1,705 $ 1,526
=======================================================================================
NOTE N -- FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
To meet the financing needs of its customers, 1st Source and its subsidiaries
are parties to financial instruments with off-balance-sheet risk in the normal
course of business. These off-balance-sheet financial instruments include
commitments to originate, purchase and sell loans and standby letters of credit.
The instruments involve, to varying degrees, elements of credit and interest
rate risk in excess of the amount recognized in the consolidated statements of
financial condition.
1st Source's 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. 1st Source uses
the same credit policies and collateral requirements in making commitments and
conditional obligations as it does for on-balance-sheet instruments.
Loan commitments have fixed expiration dates or other termination clauses and
may require payment of a fee. Since many of the commitments are expected to
expire without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements.
Trustcorp and the Bank grant 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.
Letters of credit are conditional commitments issued by 1st Source to guarantee
the performance of a customer to a third party. The credit risk involved and
collateral obtained in issuing letters of credit is essentially the same as that
involved in extending loan commitments to customers.
As of December 2003 and 2002, 1st Source and its subsidiaries had commitments
outstanding to originate and purchase mortgage loans aggregating $143.92 million
and $364.12 million, respectively. Outstanding commitments to sell loans
aggregated $99.53 million at December 31, 2003, and $240.41 million at December
31, 2002. Standby letters of credit totaled $101.26 million and $117.21 million
at December 31, 2003 and 2002, respectively. Standby letters of credit have
terms ranging from six months to one year.
NOTE O -- REGULATORY MATTERS
1st Source is subject to various regulatory capital requirements administered by
the federal banking agencies. Failure to meet minimum capital requirements can
result in certain mandatory and possible additional discretionary actions by
regulators that, if undertaken, could have a material effect on 1st Source's
43
financial statements. Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, 1st Source must meet specific capital
guidelines that involve quantitative measures of 1st Source's assets,
liabilities, and certain off-balance-sheet items as calculated under regulatory
accounting practices. 1st Source's capital amounts and classification are
subject to qualitative judgments by the regulators about components, risk
weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require 1st Source to maintain minimum amounts and ratios of total capital and
Tier I capital to risk-weighted assets and of Tier I capital to average assets.
Management believes, as of December 31, 2003, that 1st Source meets all capital
adequacy requirements to which it is subject.
As of December 31, 2003, the most recent notification from the federal bank
regulators categorized the Bank, the largest of 1st Source's subsidiaries, as
"well capitalized" under the regulatory framework for prompt corrective action.
To be categorized as "well capitalized" 1st Source must maintain minimum total
risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the
table below. There are no conditions or events since that notification that
management believes will have changed the institution's category.
As discussed in Note J, the capital securities held by the 1st Source subsidiary
trusts qualify as Tier 1 capital for 1st Source under Federal Reserve board
guidelines. As a result of the issuance of FIN 46, the Federal Reserve Board is
currently evaluating whether deconsolidation of the Capital Trusts will affect
the qualification of the capital securities as Tier 1 capital. If in the future
it is determined that the capital securities can no longer qualify as Tier 1
capital, 1st Source would still meet all capital adequacy requirements to which
it is subject.
The actual capital amounts and ratios of 1st Source and its largest subsidiary,
the Bank, as of December 31, 2003, are presented in the table below:
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):
Consolidated $376,578 14.00% $215,218 8.00% $269,022 10.00%
1st Source Bank 347,226 13.26 209,506 8.00 261,883 10.00
Tier I Capital (to Risk-Weighted Assets):
Consolidated 341,346 12.69 107,609 4.00 161,413 6.00
1st Source Bank 313,685 11.98 104,753 4.00 157,130 6.00
Tier I Capital (to Average Assets):
Consolidated 341,346 10.83 126,072 4.00 157,591 5.00
1st Source Bank 313,685 10.24 122,543 4.00 153,178 5.00
======================================================================================================================
The Bank is required to maintain noninterest bearing cash balances with the
Federal Reserve Bank. The average balance of these deposits for the years ended
December 31, 2003 and 2002, were approximately $6.36 million and $4.37 million,
respectively.
Dividends that may be paid by a subsidiary bank to the parent company are
subject to certain legal and regulatory limitations and also may be affected by
capital needs, as well as other factors. Without regulatory approval, the Bank
can pay dividends in 2004 of $47.60 million, plus an additional amount equal to
its net profits for 2004, as defined by statute, up to the date of any such
dividend declaration.
NOTE P -- COMMITMENTS AND CONTINGENT LIABILITIES
1st Source and its subsidiaries are defendants in various legal proceedings
arising in the normal course of business. In the opinion of management, based
upon present information including the advice of legal counsel, the ultimate
resolution of these proceedings will not have a material effect on 1st Source's
consolidated financial position or results of operation.
On May 16, 2001, Airmotive, Inc., by and through the Official Unsecured
Creditors' Committee of Airmotive, Inc. (the "Plaintiff"), commenced an
adversary proceeding against the Bank and other entities and individuals. The
proceeding was commenced in connection with the chapter 11 bankruptcy case of
Airmotive, Inc. pending in the U.S. Bankruptcy Court, Central District of
California. Other defendants in the proceeding are Airmotive Capital Group,
Inc., Pacific Aerospace Finance Co., Aviation Finance Corp., Craig Garrick and
Glenn Golenberg.
The Plaintiff alleges that the Bank and other defendants were the recipients of
payments over approximately a four-year period made by Airmotive, Inc. while it
was insolvent and for which it did not receive anything of reasonable equivalent
value in return. Plaintiff also seeks recovery of such payments, or
alternatively, damages equal to the aggregate amount of all unpaid creditor
claims against the bankruptcy estate, on the basis that the Bank and other
defendants exerted control over Airmotive, Inc. to the detriment of its
creditors and also that the Bank aided and abetted Messrs. Garrick and Golenberg
in the breach of their fiduciary duties to Airmotive, Inc. Plaintiff seeks
recovery of an unspecified amount for the payments made to the Bank over the
period, or alternatively, in excess of $10 million which it alleges represents
the aggregate of all unpaid creditor claims against the bankruptcy estate.
The Bank has denied the substantive allegations as without merit and is
defending the proceeding vigorously. The Bank also has filed counter and
cross-claims against Plaintiff and the corporate defendants. Since commencement
of the proceeding, the parties have engaged in substantial discovery and the
44
discovery phase remains ongoing. Based upon the currently available information,
management believes the ultimate resolution of the matter will not have any
material adverse effect on 1st Source's consolidated financial position or
results of operations, but there can be no assurance thereof. Absent a
negotiated resolution, management expects that the discovery phase will conclude
and a trial of the proceeding will be scheduled during 2004.
NOTE Q-- 1ST SOURCE CORPORATION (PARENT COMPANY ONLY) FINANCIAL INFORMATION
STATEMENTS OF FINANCIAL CONDITION
December 31 (Dollars in thousands) 2003 2002
- --------------------------------------------------------------------------------
ASSETS
Cash $ 70 $ 2
Short-term investments with bank subsidiary 3,153 5,079
Investment securities,available-for-sale
(amortized cost of $25,245 and $26,884 at
December 31, 2003 and 2002, respectively) 27,081 27,595
Investments in:
Bank subsidiaries 338,514 328,124
Non-bank subsidiaries 10,437 10,700
Loan receivables:
Non-bank subsidiaries 6,715 5,000
Premises and equipment, net 2,349 4,288
Other assets 6,627 5,903
- --------------------------------------------------------------------------------
TOTAL ASSETS $394,946 $386,691
================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
Commercial paper borrowings $ 982 $ 3,437
Other liabilities 1,562 2,130
Long-term debt and
mandatorily redeemable securities 77,711 71,695
- --------------------------------------------------------------------------------
Total liabilities 80,255 77,262
Shareholders' equity 314,691 309,429
- --------------------------------------------------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $394,946 $386,691
================================================================================
STATEMENTS OF INCOME
Year Ended December 31 (Dollars in thousands) 2003 2002 2001
- ---------------------------------------------------------------------------------------------
Income:
Dividends from bank and non-bank subsidiaries $ 8,715 $ 7,578 $ 17,593
Rental income from subsidiaries 2,668 2,763 2,697
Other 1,306 647 1,759
- ---------------------------------------------------------------------------------------------
TOTAL INCOME 12,689 10,988 22,049
- ---------------------------------------------------------------------------------------------
Expenses:
Interest on long-term debt
and mandatorily redeemable securities 4,725 4,078 4,430
Interest on commercial paper and other
short-term borrowings 26 66 537
Rent expense 1,059 1,059 1,065
Other 1,998 1,666 1,998
- ---------------------------------------------------------------------------------------------
TOTAL EXPENSES 7,808 6,869 8,030
- ---------------------------------------------------------------------------------------------
Income before income tax benefit and
equity in undistributed income of subsidiaries 4,881 4,119 14,019
Income tax benefit 1,386 1,332 1,508
- ---------------------------------------------------------------------------------------------
Income before equity in undistributed
income of subsidiaries 6,267 5,451 15,527
Equity in undistributed income of subsidiaries:
Bank subsidiaries 13,285 10,158 21,978
Non-bank subsidiaries (398) (5,570) 993
- ---------------------------------------------------------------------------------------------
NET INCOME $ 19,154 $ 10,039 $ 38,498
=============================================================================================
45
STATEMENTS OF CASH FLOWS
Year Ended December 31 (Dollars in thousands) 2003 2002 2001
- ------------------------ ------------------------------------------------------ ---------------------- -----------------
Operating activities:
NET INCOME $ 19,154 $ 10,039 $ 38,498
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in undistributed income of subsidiaries (12,887) (4,588) (22,971)
Depreciation of premises and equipment 338 346 341
Realized and unrealized investment securities losses 1,092 1,349 645
Other 1,778 3,949 1,545
- ------------------------------------------------------------------------------- -------------- --------------------------
NET CASH FROM OPERATING ACTIVITIES 9,475 11,095 18,058
- ------------------------------------------------------------------------------- -------------- --------------------------
Investing activities:
Proceeds from sales and maturities of investment securities 1,895 6,625 2,829
Purchases of investment securities (313) (19,425) (3,325)
Net change in premises and equipment (262) 184 (281)
Decrease (increase) in short-term investments with bank subsidiary 1,926 (667) 1,991
(Increase) decrease in loans made to subsidiaries, net (1,715) 4,096 (14)
Capital contributions to subsidiaries - (5,501) (1,000)
- ------------------------------------------------------------------------------- -------------- --------------------------
NET CASH FROM (USED IN) INVESTING ACTIVITIES 1,531 (14,688) 200
- ------------------------------------------------------------------------------- -------------- --------------------------
Financing activities:
Net (decrease) increase in commercial paper and other short-term borrowings (2,456) (1,555) (9,763)
Proceeds from issuance of subordinated notes - 10,310 -
Proceeds from issuance of long-term debt 47 15,048 217
Payments on long-term debt (94) (10,169) (101)
Acquisition of treasury stock (646) (2,504) (1,308)
Cash dividends (7,789) (7,537) (7,298)
Other - - (10)
- ------------------------------------------------------------------------------- ---------------------- ------------- ----
NET CASH (USED IN) FROM FINANCING ACTIVITIES (10,938) 3,593 (18,263)
- ------------------------------------------------------------------------------- ---------------------- ------------- ----
Net change in cash and cash equivalents 68 0 (5)
Cash and cash equivalents, beginning of year 2 2 7
Cash and cash equivalents, end of year $ 70 $ 2 $ 2
=========================================================================================================================
46
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Shareholders of 1st Source Corporation:
We have audited the accompanying consolidated statements of financial condition
of 1st Source Corporation and Subsidiaries as of December 31, 2003 and 2002, and
the related consolidated statements of income, shareholders' equity, and cash
flows for each of the three years in the period ended December 31, 2003. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of 1st Source
Corporation and Subsidiaries at December 31, 2003 and 2002, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2003, in conformity with accounting principles
generally accepted in the United States.
/s/Ernst & Young LLP
--------------------
Columbus, Ohio
January 29, 2004
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None
ITEM 9A. CONTROLS AND PROCEDURES
1st Source carried out an evaluation, under the supervision and with the
participation of 1st Source's management, including 1st Source's Chief Executive
Officer and Chief Financial Officer, of the effectiveness of the design and
operation of 1st Source's disclosure controls and procedures pursuant to
Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive
Officer and Chief Financial Officer concluded that, at December 31, 2003, 1st
Source's disclosure controls and procedures are effective in accumulating and
communicating to management (including such officers) the information relating
to 1st Source (including its consolidated subsidiaries) required to be included
in 1st Source's periodic SEC filings.
47
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information under the caption "Proposal Number 1: Election of Directors" and
"Section 16(a) Beneficial Ownership Reporting Compliance" of the 2004 Proxy
Statement is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION.
The information under the caption "Remuneration of Executive Officers" of the
2004 Proxy Statement is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information under the caption "Voting Securities and Principal Holders
Thereof" and "Proposal Number 1: Election of Directors" of the 2004 Proxy
Statement is incorporated herein by reference.
Equity Compensation Plan Information:
(a) (b) (c)
Number of Securities
Remaining Available
for Future Issuance
Number of Securities to be Weighted-average Under Equity
Issued upon Exercise of Exercise Price of Compensation Plans
Outstanding Options, Outstanding Options, [excluding securities
Warrants and Rights Warrants and Rights reflected in column
[(a)]
EQUITY COMPENSATION PLANS
APPROVED BY SHAREHOLDERS
1992 stock option plan 577,960 $ 24.45 -
2001 stock option plan 83,975 19.56 1,916,025
1997 employee stock purchase plan 28,261 18.81 181,289
1982 executive incentive plan - - 100,000 (1)(2)
1982 restricted stock award plan - - 184,842 (1)
- ---------------------------------------------- ------------------------------- ----------------------------- -----------------------
Total plans approved by shareholders 690,196 $ 23.62 2,382,156
- ---------------------------------------------- ------------------------------- ----------------------------- -----------------------
EQUITY COMPENSATION PLANS
NOT APPROVED BY SHAREHOLDERS
Stock option agreement effective
January 1, 1992 108,584 $ 5.48 -
- --------------------------------------------- -------------------------------- ----------------------------- -----------------------
TOTAL EQUITY COMPENSATION PLANS 798,780 $ 21.16 2,382,156
====================================================================================================================================
(1)Amount is to be awarded by grants administered by the Executive
Compensation Committee of the 1st Source Board of Directors.
(2)Amount includes market value stock only. Book value shares used for annual
awards may only be sold to 1st Source.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Theinformation under the caption "Proposal Number 1: Election of Directors"
of the 2004 Proxy Statement is incorporated herein by reference
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
The information under the caption "Relationship with Independent Public
Accountants" of the 2004 Proxy Statement is incorporated herein by reference.
48
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Financial Statements and Schedules:
The following Financial Statements and Supplementary Data are filed as part
of this annual report:
Consolidated statements of financial condition
-- December 31, 2003 and 2002
Consolidated statements of income
-- Years ended December 31, 2003, 2002, and 2001
Consolidated statements of shareholders' equity
-- Years ended December 31, 2003, 2002, and 2001
Consolidated statements of cash flows
-- Years ended December 31, 2003, 2002, and 2001
Notes to consolidated financial statements
-- December 31, 2003, 2002, and 2001
Report of Ernst & Young LLP, Independent Auditors
Financial statement schedules required by Article 9 of Regulation S-X are
not required under the related instructions, or are inapplicable and,
therefore, have been omitted.
(b) Reports on Form 8-K --
1. Purchase of Securitization Portfolio Form 8-K, dated December 17, 2003.
2. Earnings press release Form 8-K, dated October 30, 2003.
(c) Exhibits (numbered in accordance with Item 601 of Regulation S-K):
3(a)Articles of Incorporation of Registrant, as amended April 30, 1996,
and filed as exhibit to Form 10-K, dated December 31, 1996,
and incorporated herein by reference.
3(b) By-Laws of Registrant, as amended January 29, 2004, filed as exhibit to
Form 10-K, dated December 31, 2003, and attached hereto.
4(a) Form of Common Stock Certificates of Registrant filed as exhibit to
Registration Statement 2-40481 and incorporated herein by reference.
4(b)(1) Form of 9% Cumulative Trust Preferred Securities Indenture,
dated March 21, 1997, filed as exhibit to Form 10-K, dated
December 31, 1997, and incorporated herein by reference.
4(b)(2) Form of 9% Cumulative rust Preferred Securities Trust Agreement,
dated March 21, 1997, filed as exhibit to Form 10-K, dated
December 31, 1997, and incorporated herein by reference.
4(b)(3) Form of 9% Cumulative Trust Preferred Securities Guarantee
Agreement, dated March 21, 1997, filed as exhibit to Form 10-K,
dated December 31, 1997, and incorporated herein by reference.
4(c)(1) Form of Floating Rate Cumulative Trust Preferred Securities
Indenture, dated March 21, 1997, filed as exhibit to Form 10-K,
dated December 31, 1997, and incorporated herein by reference.
4(c)(2) Form of Floating Rate Cumulative Trust Preferred Securities Trust
Agreement, dated March 21, 1997, filed as exhibit to Form 10-K,
dated December 31, 1997, and incorporated herein by reference.
4(c)(3) Form of Floating Rate Cumulative Trust Preferred Securities
Guarantee Agreement, dated March 21, 1997, filed as exhibit to
Form 10-K, dated December 31, 1997, and incorporated herein by
reference.
4(d) Agreement to Furnish Long-term Debt Instruments, dated
February 11, 2003, filed as an exhibit to Form 10-K, dated
December 31, 2002, and incorporated herein by reference.
10(a)(1) Employment Agreement of Christopher J. Murphy III, dated
April 16, 1998, filed as exhibit to Form 10-K, dated
December 31, 1998, and incorporated herein by reference.
10(a)(2) Employment Agreement of Wellington D. Jones III, dated
April 16, 1998, filed as exhibit to Form 10-K, dated
December 31, 1998, and incorporated herein by reference.
10(a)(3) Employment Agreement of Allen R. Qualey, dated April 16, 1998,
filed as exhibit to Form 10-K, dated December 31, 1998, and
incorporated herein by reference.
10(a)(4) Employment Agreement of Larry E. Lentych, dated April 16, 1998,
filed as exhibit to Form 10-K, dated December 31, 1998, and
incorporated herein by reference.
10(a)(5) Employment Agreement of Richard Q. Stifel, dated April 16, 1998,
filed as exhibit to Form 10-K, dated December 31, 1998, and
incorporated herein by reference.
10(a)(6) Employment Agreement of John B. Griffith, dated March 31,
2001, filed as exhibit to Form 10-K, dated December 31, 2002,
and incorporated herein by reference.
10(b) 1st Source Corporation Employee Stock Purchase Plan dated
April 17, 1997, filed as exhibit to Form 10-K, dated
December 31, 1997, and incorporated herein by reference.
49
10(c) 1st Source Corporation 1982 Executive Incentive Plan, amended
January 17, 2003, and filed as exhibit to Form 10-K, dated
December 31, 2003, and attached hereto.
10(d) 1st Source Corporation 1982 Restricted Stock Award Plan, amended
January 17, 2003, and filed as exhibit to Form 10-K, dated
December 31, 2003, and attached hereto.
10(e) 1st Source Corporation 2001 Stock Option Plan, filed as an exhibit to
1st Source Corporation Proxy Statement dated March 7, 2001,
and incorporated herein by reference.
10(f) 1st Source Corporation Non-Qualified Stock Option Agreement with
Christopher J. Murphy III, dated January 1, 1992, as amended
December 11, 1997, filed as an exhibit to Form 10-K, dated
December 31, 1997, and incorporated herein by reference.
10(g)(1) 1st Source Corporation 1992 Stock Option Plan, dated
April 23, 1992, as amended December 11, 1997, filed as exhibit to
Form 10-K, dated December 31, 1997, and incorporated herein by
reference.
10(g)(2) An amendment to 1st Source Corporation 1992 Stock Option Plan,
dated July 18, 2000, and filed as exhibit to Form 10-K, dated
December 31, 2000, and incorporated herein by reference.
10(h) 1st Source Corporation 1998 Performance Compensation Plan, dated
February 19, 1998, filed as exhibit to Form 10-K, dated
December 31, 1998, and incorporated herein by reference.
10(i) Consulting Agreement of Ernestine M. Raclin, dated April 14, 1998,
filed as exhibit to Form 10-K, dated December 31, 1998, and
incorporated herein by reference.
21 Subsidiaries of Registrant (unless otherwise indicated, each
subsidiary does business under its own name):
Name Jurisdiction
-----------------
1st Source Bank Indiana
SFG Equipment Leasing, Inc. * Indiana
1st Source Insurance, Inc. * Indiana
1st Source Specialty Finance, Inc. * Indiana
FBT Capital Corporation (Inactive) Indiana
1st Source Leasing, Inc. Indiana
1st Source Capital Corporation * Indiana
Trustcorp Mortgage Company Indiana
1st Source Capital Trust I Delaware
1st Source Capital Trust II Delaware
1st Source Capital Trust III Delaware
Michigan Transportation Finance Corporation * Michigan
1st Source Intermediate Holding, LLC Delaware
1st Source Funding, LLC Delaware
1st Source Corporation Investment Advisors, Inc. * Indiana
SFG Commercial Aircraft Leasing, Inc. * Indiana
SFG Equipment Leasing Corporation I* Indiana
Capstone 557 (Proprietary) Limited South Africa
*Wholly-owned subsidiaries of 1st Source Bank
23 Consent of Ernst & Young LLP, Independent Auditors.
31.1 Certification of Christopher J. Murphy III, Chief Executive Officer
(Rule 13a-14(a)).
31.2 Certification of Larry E. Lentych, Chief Financial Officer
(Rule 13a-14(a)).
32.1 Certification of Christopher J. Murphy III, Chief Executive Officer.
32.2 Certification of Larry E. Lentych, Chief Financial Officer.
(d) Financial Statement Schedules -- None.
50
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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
By /s/ CHRISTOPHER J. MURPHY III
--------------------------------
Christopher J. Murphy III, Chairman of the Board,
President and Chief Executive Officer Date:
February 19, 2004
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant
and in the capacities and on the dates indicated.
Signature Title Date
/s/ CHRISTOPHER J. MURPHY III Chairman of the Board, February 19, 2004
- ----------------------------- President and
Christopher J. Murphy III Chief Executive Officer
/s/ WELLINGTON D. JONES III Executive Vice Presid February 19, 2004
- ------------------------------ and Director
Wellington D. Jones III
/s/ LARRY E. LENTYCH Treasurer, February 19, 2004
- ------------------------------ Chief Financial Officer
Larry E. Lentych and Principal Accounting Officer
/s/ JOHN B. GRIFFITH Secretary February 19, 2004
- ----------------------------- and General Counsel
John B. Griffith
/s/ DAVID C. BOWERS Director February 19, 2004
- -----------------------------
David C. Bowers
/s/ DANIEL B. FITZPATRICK Director February 19, 2004
- -----------------------------
Daniel B. Fitzpatrick
/s/ LAWRENCE E. HILER Director February 19, 2004
- -----------------------------
Lawrence E. Hiler
/s/ WILLIAM P. JOHNSON Director February 19, 2004
- -----------------------------
William P. Johnson
/s/ REX MARTIN Director February 19, 2004
- -----------------------------
Rex Martin
/s/ DANE A. MILLER Director February 19, 2004
- -----------------------------
Dane A. Miller
/s/ TIMOTHY K. OZARK Director February 19, 2004
- -----------------------------
Timothy K. Ozark
/s/ TOBY S. WILT Director February 19, 2004
- -----------------------------
Toby S. Wilt
51
(C) 2004 1st Source Corporation All rights reserved