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, 2005
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:
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 if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act. Yes [ ] No [x]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [x]
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. [x]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large Accelerated filer [ ] Accelerated filer [x] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Act). Yes [ ] No [x]
The aggregate market value of the voting common stock held by non-affiliates of
the registrant as of June 30, 2005 was $239,529,019.
The number of shares outstanding of each of the registrant's classes of stock as
of February 24, 2006:
Common Stock, without par value 20,705,899 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the annual proxy statement for the 2006 annual meeting of
shareholders to be held April 27, 2006, are incorporated by reference into Part
III.
TABLE OF CONTENTS
Part I
Item 1. Business..............................................................3
Item 1A. Risk Factors......................................................... 7
Item 1B. Unresolved Staff Comments.............................................9
Item 2. Properties............................................................9
Item 3. Legal Proceedings.....................................................9
Item 4. Submission of Matters to a Vote of Security Holders...................9
Part II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities ..........................9
Item 6. Selected Financial Data..............................................10
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations..........................................10
Item 7A. Quantitative and Qualitative Disclosures About Market Risk...........24
Item 8. Financial Statements and Supplementary Data..........................25
Reports of Independent Registered Public Accounting Firm
Consolidated Statements of Financial Condition
Consolidated Statements of Income
Consolidated Statements of Shareholders' Equity
Consolidated Statements of Cash Flow
Notes to Consolidated Financial Statements
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure...........................................49
Item 9A. Controls and Procedures..............................................49
Item 9B. Other Information....................................................49
Part III
Item 10. Directors and Executive Officers of the Registrant..................50
Item 11. Executive Compensation..............................................50
Item 12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters...................................50
Item 13. Certain Relationships and Related Transactions......................50
Item 14. Principal Accounting Fees and Services..............................50
Part IV
Item 15. Exhibits and Financial Statement Schedules..........................51
Signatures........................... ........................................53
PART I
ITEM 1. BUSINESS.
1st SOURCE CORPORATION
- ----------------------
1st Source Corporation, an Indiana corporation incorporated in 1971, is a bank
holding company headquartered in South Bend, Indiana that provides, through its
subsidiaries (collectively referred to as "1st Source"), a broad array of
financial products and services. 1st Source, through its principal subsidiary
1st Source Bank ("Bank"), offers commercial and consumer banking services, as
well as trust and investment management, and insurance, to individual and
business clients through 64 banking locations (two new banking centers were
opened in 2005 and two banking centers were relocated) in 15 counties in the
Northern Indiana-Southwestern Michigan regional market area and 23 locations
nationwide for the 1st Source Specialty Finance Group. Through these 23
locations the Bank offers specialized financing services for new and used
private and cargo aircraft, automobiles and light trucks for leasing and rental
agencies, medium and heavy duty trucks, construction equipment, and
environmental equipment. 1st Source is not dependent upon any single industry or
client. At December 31, 2005, 1st Source had consolidated total assets of $3.51
billion, loans and leases of $2.46 billion, deposits of $2.75 billion, and total
shareholders' equity of $345.58 million.
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). 1st Source will provide a printed
copy of any of the aforementioned documents to any requesting shareholder.
1st SOURCE BANK
- ---------------
1st Source Bank, is a wholly owned subsidiary of 1st Source Corporation that
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 Bank provides
commercial and agriculture loans to corporations and other business clients
primarily located within 1st Source's regional market area. Loans are made for a
wide variety of general corporate purposes, including financing for industrial
and commercial properties, financing for equipment, inventories and accounts
receivable, and acquisition financing. Other services include commercial leasing
and cash management services.
CONSUMER SERVICES -- 1st Source Bank provides a full range of consumer banking
services, including checking accounts, on-line banking, savings programs,
installment and real estate loans, home equity loans and lines of credit,
drive-in and night deposit services, safe deposit facilities, automated teller
machines, overdraft facilities, and brokerage services.
TRUST SERVICES -- 1st Source Bank provides a wide range of trust, investment,
agency, and custodial services for individual and corporate clients. These
services include the administration of estates and personal trusts, as well as
the management of investment accounts for individuals, employee benefit plans,
and charitable foundations.
SPECIALTY FINANCE GROUP SERVICES -- 1st Source Bank, through its 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 four areas: auto, light truck, and environmental
equipment financing; medium and heavy duty truck financing; aircraft financing;
and construction equipment financing.
Auto, light truck, and environmental equipment financing consists of financings
to automobile rental and leasing companies, light truck rental and leasing
companies, and environmental equipment companies. Auto, light truck, and
environmental equipment finance receivables generally range from $50,000 to $15
million with fixed or variable interest rates and terms of two to seven years.
Medium and heavy duty truck financing consists of financings for highway
tractors and trailers and delivery trucks to the commercial trucking industry.
Medium and heavy duty truck 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 for new and used aircraft for
individual and corporate aircraft users, aircraft dealers, charter operators,
and air cargo carriers. Aircraft finance receivables generally range from
$100,000 to $15 million with fixed or variable interest rates and terms of two
to ten years.
Construction equipment financing includes financing of equipment (i.e., asphalt
and concrete plants, bulldozers, excavators, cranes, and loaders, etc.) to the
construction industry. Construction equipment finance receivables generally
range from $100,000 to $15 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 trucks, and other equipment to clients through
operating leases.
SPECIALTY FINANCE GROUP SUBSIDIARIES
- ------------------------------------
The Specialty Finance Group also consists of separate wholly owned
subsidiaries of 1st Source Bank which include: Michigan Transportation Finance
Corporation, 1st Source Specialty Finance, Inc., SFG Equipment Leasing, Inc.,
1st Source Intermediate Holding, LLC, 1st Source Commercial Aircraft Leasing,
Inc., and SFG Equipment Leasing Corporation I.
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TRUSTCORP MORTGAGE COMPANY
- --------------------------
Trustcorp Mortgage Company (Trustcorp), is a mortgage banking company with five
offices in Indiana and Ohio and a wholly owned subsidiary of 1st Source
Corporation. Trustcorp provides real estate mortgage loan services primarily in
the one-to-four family residential housing market. Most of the residential
mortgages originated and/or purchased are sold into the secondary market and
serviced by Trustcorp.
1st SOURCE INSURANCE, INC.
- --------------------------
1st Source Insurance, Inc., is a wholly owned subsidiary of 1st Source Bank that
provides insurance services to individuals and businesses covering corporate and
personal property products, casualty insurance products, and group health and
life insurance products.
1st SOURCE CORPORATION INVESTMENT ADVISORS, INC.
- ------------------------------------------------
1st Source Corporation Investment Advisors, Inc., is a wholly owned
subsidiary of 1st Source Bank that provides investment advisory services to
trust and investment clients of 1st Source Bank and to the 1st Source Monogram
Funds. 1st Source Corporation Investment Advisors, Inc., is registered as an
investment advisor under the Securities Exchange Investment Advisors Act of
1940. 1st Source Corporation Investment Advisors, Inc., serves strictly in an
advisory capacity and, as such, does not hold any client securities.
OTHER CONSOLIDATED SUBSIDIARIES
- -------------------------------
1st Source has various other subsidiaries that are not significant to the
consolidated entity.
1st SOURCE CAPITAL TRUST II, III, AND IV
- ----------------------------------------
1st Source's unconsolidated subsidiaries include, 1st Source Capital Trust II,
III, and IV (1st Source Capital Trust I was dissolved on May 26, 2005). These
subsidiaries were created for the purposes of issuing $17.25 million, $10.00
million, and $30.00 million of trust preferred securities, respectively, and
lending the proceeds to 1st Source. 1st Source guarantees, on a limited basis,
payments of distributions on the trust preferred securities and payments on
redemption of the trust preferred securities.
1st Source Capital Trust II, III, and IV are variable interest entities (VIEs)
for which 1st Source is not the primary beneficiary, as defined in Financial
Accounting Standards Board Interpretation (FIN) No. 46, "Consolidation of
Variable Interest Entities." In accordance with FIN 46, which 1st Source adopted
early on July 1, 2003, the accounts of 1st Source Capital Trust II, III, and IV
are not included in 1st Source's consolidated financial statements. At December
31, 2005, the balance of 1st Source's total issuance of trust preferred
securities was $57.25 million. The subordinated loans from 1st Source Capital
Trust II, III, and IV are included in 1st Source's consolidated balance sheet in
"subordinated notes" and 1st Source's equity interests in the 1st Source Capital
Trust II, III, and IV are included in "other assets" on the balance sheet. See
1st Source's accounting policy related to consolidation in Item 8. Financial
Statements and Supplementary Data -- Note A - Accounting Policies of the Notes
to Consolidated Financial Statements.
COMPETITION
- -----------
The activities in which 1st Source and the Bank engage are highly competitive.
These activities and the geographic markets served involve competition with
other banks, some of which are affiliated with large bank holding companies
headquartered outside of 1st Source's principal market. 1st Source generally
competes on the basis of client service and responsiveness to client needs,
available loan and deposit products, the rates of interest charged on loans and
leases, the rates of interest paid for funds, other credit and service charges,
the quality of services rendered, the convenience of banking facilities, and in
the case of loans and leases 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 service companies, 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 a full
array of products and highly personalized services. 1st Source also relies on a
history in its core market dating back to 1863, relationships that long-term
colleagues have with 1st Source's clients, and the capacity for quick local
decision-making.
EMPLOYEES
- ---------
At December 31, 2005, 1st Source had approximately 1,200 employees 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. 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.
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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 Federal
Deposit Insurance Corporation (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 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
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. At December 31, 2005,
the Bank was categorized as "well capitalized," meaning that its total
risk-based capital ratio exceeded 10.00%, its Tier 1 risk-based capital ratio
exceeded 6.00%, its leverage ratio exceeded 5.00%, and it was not subject to a
regulatory order, agreement, or directive to meet and maintain a specific
capital level for any capital measure.
FEDERAL DEPOSIT INSURANCE REFORM ACT -- On February 1, 2006, Congress approved
the Federal Deposit Insurance Reform Act of 2005 (FDIRA). Among other things,
the FDIRA provides for the merger of the Bank Insurance Fund with the Savings
Association Insurance Fund and for an immediate increase in Federal deposit
insurance for certain retirement accounts up to $250,000. The statute further
provides for the indexing of the maximum deposit insurance coverage for all
types of deposit accounts in the future to account for inflation. The FDIRA also
requires the FDIC to provide certain banks and thrifts that were in existence
prior to December 31, 1996 with one-time credits against future premiums based
on the amount of their payments to the Bank Insurance Fund or Savings
Association Insurance Fund prior to that date.
SECURITIES AND EXCHANGE COMMISSION (SEC) AND NATIONAL ASSOCIATION OF SECURITIES
DEALERS AUTOMATED QUOTATIONS (NASDAQ) -- 1st Source is under the jurisdiction of
the SEC and certain state securities commissions for matters relating to the
offering and sale of its securities. 1st Source is subject to the disclosure and
regulatory requirements of the Securities Act of 1933, as amended, and the
Securities Exchange Act of 1934, as amended, as administered by the SEC. 1st
Source is listed on the NASDAQ Stock Market under the trading symbol "SRCE," and
is subject to the rules of NASDAQ for listed companies.
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. Among other things, 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 (GLBA) 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 GLBA
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 GLBA 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 GLBA 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 activities that are not financial in nature, 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 GLBA 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 GLBA, including those relating to
CRA and privacy, regardless of whether 1st Source elects to become a financial
5
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.
FINANCIAL PRIVACY -- In accordance with the GLBA, Federal banking regulators
adopted rules that limit the ability of banks and other financial institutions
to disclose non-public information about customers to nonaffiliated third
parties. These limitations require disclosure of privacy policies to consumers
and, in some circumstances, allow consumers to prevent disclosure of certain
personal information to a nonaffiliated third party. The privacy provisions of
the GLBA affect how consumer information is transmitted through diversified
financial companies and conveyed to outside vendors.
USA PATRIOT ACT OF 2001 -- The USA Patriot Act of 2001 (USA Patriot Act) was
signed into law primarily as a result of the terrorist attacks of September 11,
2001. The USA Patriot Act is comprehensive anti-terrorism legislation that,
among other things, substantially broadened the scope of anti-money laundering
laws and regulations by imposing significant new compliance and due diligence
obligations on financial institutions.
The regulations adopted by the United States Treasury Department under the USA
Patriot Act impose new obligations on financial institutions to maintain
appropriate policies, procedures and controls to detect, prevent and report
money laundering, and terrorist financing. Additionally, the regulations require
that 1st Source, upon request from the appropriate Federal regulatory agency,
provide records related to anti-money laundering, perform due diligence of
private banking and correspondent accounts, establish standards for verifying
customer identity, and perform other related duties.
Failure of a financial institution to comply with the USA Patriot Act's
requirements could have serious legal and reputational consequences for the
institution.
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 Q 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. Federal banking regulators are required to
consider a financial institution's performance in these areas as they review
applications filed by the institution to engage in mergers or acquisitions or 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, certain
regulations of the Federal Reserve, state laws and many other Federal laws
govern the extensions of credit and 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 3.00% must be maintained against net transaction accounts
greater than $7.00 million and less than $47.6 million (subject to adjustment by
the Federal Reserve) and reserves of 10.00% must be maintained against that
portion of net transaction accounts in excess of $47.6 million.
DIVIDENDS -- The ability of the Bank to pay dividends and management fees is
limited by various state and Federal laws, by certain covenant agreements, 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
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 and leases 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.
SARBANES-OXLEY ACT OF 2002 -- On July 30, 2002, the Sarbanes-Oxley Act of 2002
(SOA) was signed into law. The SOA's stated goals include enhancing corporate
responsibility, increasing penalties for accounting and auditing improprieties
at publicly traded companies and protecting investors by improving the accuracy
and reliability of corporate disclosures pursuant to the securities laws. The
SOA generally applies to all companies that file or are required to file
periodic reports with the SEC under the Securities Exchange Act of 1934
(Exchange Act.)
6
Among other things, the SOA creates the Public Company Accounting Oversight
Board as an independent body subject to SEC supervision with responsibility for
setting auditing, quality control, and ethical standards for auditors of public
companies. The SOA also requires public companies to make faster and
more-extensive financial disclosures, requires the chief executive officer and
the chief financial officer of public companies to provide signed certifications
as to the accuracy and completeness of financial information filed with the SEC,
and provides enhanced criminal and civil penalties for violations of the Federal
securities laws.
The SOA also addresses functions and responsibilities of audit committees of
public companies. The statute makes the audit committee directly responsible for
the appointment, compensation, and oversight of the work of the company's
outside auditor, and requires the auditor to report directly to the audit
committee. The SOA authorizes each audit committee to engage independent counsel
and other advisors, and requires a public company to provide the appropriate
funding, as determined by its audit committees, to pay the company's auditors
and any advisors that its audit committee retains. The SOA also requires public
companies to include an internal control report and assessment by management,
along with an attestation to this report prepared by the company's registered
public accounting firm, in their annual reports to stockholders.
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.
ITEM 1A. RISK FACTORS.
An investment in 1st Source's common stock is subject to risks inherent to 1st
Source's business. The material risk and uncertainties that management believes
affect 1st Source are described below. Additional risks and uncertainties that
management is not aware of or focused on or that management currently deems
immaterial may also impair 1st Source's business operations.
FLUCTUATIONS IN INTEREST RATES COULD REDUCE 1st SOURCE'S PROFITABILITY AND
AFFECT THE VALUE OF ITS ASSETS -- Like other financial institutions, 1st Source
is subject to interest rate risk. 1st Source's primary source of income is net
interest income, which is the difference between interest earned on loans and
leases and investments, and interest paid on deposits and borrowings. 1st Source
expects that it will periodically experience imbalances in the interest rate
sensitivities of its assets and liabilities and the relationships of various
interest rates to each other. Over any defined period of time, 1st Source's
interest-earning assets may be more sensitive to changes in market interest
rates than its interest-bearing liabilities, or vice-versa. In addition, the
individual market interest rates underlying 1st Source's loan and lease and
deposit products may not change to the same degree over a given time period. In
any event, if market interest rates should move contrary to 1st Source's
position, earnings may be negatively affected. In addition, loan and lease
volume and quality and deposit volume and mix can be affected by market interest
rates as can the businesses of 1st Source's clients. Changes in levels of market
interest rates could have a material adverse affect on 1st Source's net interest
spread, asset quality, origination volume, and overall profitability.
Until recently, interest rates have been at historically low levels. However,
since June 30, 2004, the Federal Reserve has increased its target for Federal
funds rate numerous times. While these short-term market interest rates (which
are used as a guide for pricing deposits) have increased, longer-term market
interest rates (which are used as a guide for pricing longer-term loans and
leases) have not. This "flattening" of the market yield curve has had a negative
impact on 1st Source's interest rate spread and net interest margin to date. If
short-term interest rates continue to rise, and if rates on its deposits and
borrowings continue to reprice upwards faster than the rates on long-term loans
and leases and investments, 1st Source could experience compression of its
interest rate spread and net interest margin, which could have a negative effect
on 1st Source's profitability.
1st Source principally manages interest rate risk by managing the volume and mix
of its earning assets and funding liabilities. In a changing interest rate
environment, 1st Source may not be able to manage this risk effectively. If 1st
Source is unable to manage interest rate risk effectively, its business,
financial condition and results of operations could be materially harmed.
Changes in the level of interest rates also may negatively affect 1st Source's
ability to originate loans and leases, the value of its assets and its ability
to realize gains from the sale of its assets, all of which ultimately could
affect 1st Source's earnings.
FUTURE EXPANSION INVOLVES RISKS -- In the future, 1st Source may acquire all or
part of other financial institutions and 1st Source may establish de novo branch
offices. There could be considerable costs involved in executing 1st Source's
growth strategy. For instance, new branches generally require a period of time
to generate sufficient revenues to offset their costs, especially in areas in
which 1st Source does not have an established presence. Accordingly, any new
branch expansion could be expected to negatively impact earnings for some period
of time until the branch reaches certain economies of scale. Acquisitions and
mergers involve a number or risks, including the risk that:
o 1st Source may incur substantial costs identifying and evaluating potential
acquisitions and merger partners, or in evaluating new markets, hiring
experienced local managers, and opening new offices;
o 1st Source's estimates and judgments used to evaluate credit, operations,
management, and market risks relating to target institutions may not be
accurate;
o There may be substantial lag-time between completing an acquisition or
opening a new office and generating sufficient assets and deposits to
support costs of the expansion;
o 1st Source may not be able to finance an acquisition, or the financing 1st
Source obtains may have an adverse effect on its operating results or
dilution of its existing shareholders;
o 1st Source's management's attention in negotiating a transaction and
integrating the operations and personnel of the combining businesses may be
diverted from its existing business;
o 1st Source may enter new markets where it lacks local experience;
o 1st Source may incur goodwill in connection with an acquisition, or the
goodwill it incurs may become impaired, which results in adverse short-term
effects on 1st Source's operating results; or
o 1st Source may lose key employees and clients.
7
COMPETITION FROM OTHER FINANCIAL SERVICES PROVIDERS COULD ADVERSELY IMPACT
1st SOURCE'S RESULTS OF OPERATIONS -- The banking and financial services
business is highly competitive. 1st Source faces competition in making loans and
leases, attracting deposits and providing insurance, investment, trust, and
other financial services. Increased competition in the banking and financial
services businesses may reduce 1st Source's market share, impair its growth or
cause the prices 1st Source charges for its services to decline. 1st Source's
results of operations may be adversely impacted in future periods depending upon
the level and nature of competition it encounters in its various market areas.
1st SOURCE IS DEPENDENT UPON THE SERVICES OF ITS MANAGEMENT TEAM -- 1st Source's
future success and profitability is substantially dependent upon the management
and banking abilities of its senior executives. 1st Source believes that its
future results will also depend in part upon its ability to attract and retain
highly skilled and qualified management. 1st Source is especially dependent on a
limited number of key management personnel, many of whom do not have employment
agreements with 1st Source. The loss of the chief executive officer and other
senior management and key personnel could have a material adverse impact on 1st
Source's operations because other officers may not have the experience and
expertise to readily replace these individuals. Many of these senior officers
have primary contact with 1st Source's clients and are extremely important in
maintaining personalized relationships with 1st Source's client base. The
unexpected loss of services of one or more of these key employees could have a
material adverse effect on 1st Source's operations and possibly result in
reduced revenues if 1st Source was unable to find suitable replacements
promptly. Competition for senior personnel is intense, and 1st Source may not be
successful in attracting and retaining such personnel. Changes in key personnel
and their responsibilities may be disruptive to 1st Source's business and could
have a material adverse effect on 1st Source's business, financial condition,
and results of operations.
TECHNOLOGY SECURITY BREACHES COULD EXPOSE 1st SOURCE TO POSSIBLE LIABILITY AND
DAMAGE ITS REPUTATION -- Any compromise of 1st Source's security also could
deter clients from using 1st Source's internet banking services that involve the
transmission of confidential information. 1st Source relies on standard internet
security systems to provide the security and authentication necessary to effect
secure transmission of data. These precautions may not protect 1st Source's
systems from compromises or breaches of its security measures that could result
in damage to 1st Source's reputation and business.
FAILURE TO PROPERLY MANAGE THE REPLACEMENT OF THE MAJORITY OF 1st SOURCE'S CORE
AND ANCILLARY DATA PROCESSING SYSTEMS COULD ADVERSELY IMPACT 1st SOURCE'S
RESULTS OF OPERATIONS -- 1st Source is in the process of replacing the majority
of its core and ancillary data processing systems. 1st Source and its affiliates
are licensing integrated core technology and ancillary systems. The core
technology licensing includes a loan system, deposit system, general ledger
system, and customer information file system. The target period for completion
of the installation of the technology is March 2007. Failure to meet this
deadline may be disruptive to 1st Source's business and could have a material
adverse effect on 1st Source's financial condition and results of operations.
1st SOURCE IS SUBJECT TO CREDIT RISKS RELATING TO ITS LOAN AND LEASE PORTFOLIOS
- -- 1st Source has certain lending policies and procedures in place that are
designed to maximize loan and lease income within an acceptable level of risk.
Management reviews and approves these policies and procedures on a regular
basis. A reporting system supplements the review process by providing management
with frequent reports related to loan and lease production, loan quality,
concentrations of credit, loan and lease delinquencies, and nonperforming and
potential problem loans and leases. Diversification in the loan and lease
portfolios is a means of managing risk associated with fluctuations and economic
conditions.
1st Source maintains an independent loan review department that reviews and
validates the credit risk program on a periodic basis. Results of these reviews
are presented to management. The loan and lease review process complements and
reinforces the risk identification and assessment decisions made by lenders and
credit personnel, as well as 1st Source's policies and procedures.
In the financial services industry, there is always a risk that certain
borrowers may not repay borrowings. 1st Source's reserve for loan and lease
losses may not be sufficient to cover the loan and lease 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, particularly in its
local business loan and lease portfolio. Changes in national economic conditions
could also adversely affect the quality of its loan and lease portfolio and
negate, to some extent, the benefits of national diversification through its
Specialty Finance Group's portfolio.
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 underlying assets, 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. 1st Source obtains financial information and performs credit risk
analysis on its customers. Credit criteria may include, but are not limited to,
assessments of income, cash flows, and net worth; asset ownership; bank and
trade credit reference; credit bureau report; and operational history.
Commercial real estate or equipment loans are underwritten after evaluating and
understanding the borrower's ability to operate profitably and generate positive
cash flows. 1st Source's management examines current and projected cash flows of
the borrower to determine the ability of the borrower to repay their obligations
as agreed. Underwriting standards are designed to promote relationship banking
rather than transactional banking. Most commercial and industrial loans are
secured by the assets being financed or other business assets; however, some
loans may be made on an unsecured basis. 1st Source's credit policy sets
different maximum exposure limits both by business sector and its current and
historical relationship and previous experience with each customer.
1st Source offers both fixed-rate and adjustable-rate consumer mortgage loans
secured by 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; however, 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. Additionally, most residential mortgages are sold into the secondary
market and serviced by 1st Source's mortgage subsidiary, Trustcorp.
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.
The 1st Source Specialty Finance Group loan and lease portfolio consists of
commercial loans and leases secured by construction and transportation
equipment, including aircraft, autos, trucks, and vans. Finance receivables for
this Group generally provide for monthly payments and may include prepayment
penalty provisions.
8
1st Source's construction and transportation related businesses could be
adversely affected by slow downs in the economy. Clients who rely on the use of
assets financed through the Specialty Finance Group to produce income could be
negatively affected, and 1st Source could experience substantial loan and lease
losses. By the nature of the businesses these clients operate in, 1st Source
could be adversely affected by continued rapid increases of fuel costs. Since
some of the relationships in these industries are large (up to $15 million), a
slow down could have a significant adverse impact on 1st Source's performance.
1st Source's construction and transportation related businesses could be
adversely impacted by the negative effects caused by high fuel costs, terrorist
attacks, potential attacks, and other destabilizing events. These factors could
contribute to the deterioration of the quality of 1st Source's loan and lease
portfolio, as they could have a negative impact on the travel sensitive
businesses for which 1st Source's specialty finance businesses provide
financing.
In addition, 1st Source's leasing and equipment financing activity is subject to
the risk of cyclical downturns, industry concentration and clumping, 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, construction, and
transportation industries.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
None
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. Also, in 1982, 1st Source sold the
building and entered into a leaseback agreement with the purchaser for a term of
30 years. The 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% subleased to unrelated tenants.
At December 31, 2005, 1st Source also owned property and/or buildings on which
46 of the Bank subsidiary's 64 banking centers were 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 an operations center,
training facility, warehouse, and its former headquarters building, which is
utilized for additional business operations. The Bank leases additional property
and/or buildings from third parties under lease agreements negotiated at
arms-length.
ITEM 3. LEGAL PROCEEDINGS.
1st Source and its subsidiaries are involved in various 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
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
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.
2005 Sales Price Cash Dividends 2004 Sales Price Cash Dividends
Common Stock Prices (quarter ended) High Low Paid High Low Paid
- -------------------------------------------------------------------------------------------------------------------------
March 31 $ 25.84 $ 20.39 $ .120 $ 24.90 $ 20.96 $ .100
June 30 23.80 19.41 .120 25.50 20.35 .100
September 30 25.89 22.06 .120 26.04 22.30 .110
December 31 26.10 20.92 .130 28.09 25.15 .110
=========================================================================================================================
As of December 31, 2005, there were 1,071 holders of record of 1st Source common
stock.
9
The following table summarizes share repurchase activity of 1st Source during
the three months ended December 31, 2005.
Issuer Purchases of Equity Securities
(a) (b) (c) (d)
Total Number of Maximum Number(or Approximate
Shares Purchased as Dollar Value) of Shares that
Total Number of Average Price Part of Publicly Announced may yet be Purchased Under
Period Shares Purchased Paid Per Share Plans or Programs* the Plans or Program
- ------------------ --------------------------- --------------------- ---------------------- -- --- ---- ----------------------------
October 01-31, 2005 - $ - - 538,078
November 01-30, 2005 894 24.80 894 537,184
December 01-31, 2005 - - - 537,184
====================================================================================================================================
* 1st Source maintains a stock repurchase plan that was authorized by the
Board of Directors on October 23, 2001. Under the terms of the plan, 1st
Source may repurchase up to 1,038,990 shares of its common stock when
favorable conditions exist on the open market or through private
transactions at various prices from time to time. Since the inception of
the plan, 1st Source has repurchased a total of 501,806 shares.
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 Q 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)
2005 2004 2003 2002 2001
- ---------------------------------------------- --------------------------------------------------------------------
Interest income $ 168,532 $ 151,437 $ 162,322 $ 199,503 $ 245,566
Interest expense 70,104 52,749 59,070 80,817 126,957
- ---------------------------------------------- --------------------------------------------------------------------
Net interest income 98,428 98,688 103,252 118,686 118,609
(Recovery of) provision
for loan and lease losses (5,855) 229 17,361 39,657 25,745
- ---------------------------------------------- --------------------------------------------------------------------
Net interest income after (recovery of)
provision for loan and lease losses 104,283 98,459 85,891 79,029 92,864
Noninterest income 68,533 62,733 80,196 73,117 87,026
Noninterest expense 123,439 127,091 138,904 140,741 121,683
- -------------------------------------------- ----------------------------------------------------------------------
Income before income taxes 49,377 34,101 27,183 11,405 58,207
Income taxes 15,626 9,136 8,029 1,366 19,709
- -------------------------------------------- ----------------------------------------------------------------------
Net income $ 33,751 $ 24,965 $ 19,154 $ 10,039 $ 38,498
- -------------------------------------------- ----------------------------------------------------------------------
Assets at year-end $ 3,511,277 $ 3,563,715 $ 3,330,153 $ 3,407,468 $ 3,562,691
Long-term debt and mandatorily redeemable
securities at year-end 23,237 17,964 22,802 16,878 11,939
Shareholders' equity at year-end 345,576 326,600 314,691 309,429 306,190
Basic net income per common share * 1.63 1.21 0.92 0.48 1.85
Diluted net income per common share * 1.61 1.19 0.91 0.47 1.82
Cash dividends per common share* .490 .420 .370 .360 .351
Dividend payout ratio 30.43% 35.29% 40.66% 76.60% 19.29%
Return on average assets 1.00% 0.75% 0.59% 0.29% 1.14%
Return on average common equity 10.12% 7.81% 6.12% 3.23% 13.14%
Average common equity to average assets 9.89% 9.55% 9.60% 8.95% 8.69%
====================================================================================================================
* All per share amounts have been restated for stock dividends.
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.
Forward-looking statements include statements with respect to 1st Source's
beliefs, plans, objectives, goals, expectations, anticipations, assumptions,
estimates, intentions, and future performance, and involve known and unknown
risks, uncertainties and other factors, which may be beyond 1st Source's
control, and which may cause actual results, performance or achievements to be
materially different from future results, performance or achievements expressed
or implied by such forward-looking statements.
10
All statements other than statements of historical fact are statements that
could be forward-looking statements. Words such as "believe", "contemplate",
"seek", "estimate", "plan", "project", "anticipate", "assume", "expect",
"intend", "targeted", "continue", "remain", "will", "should", "indicate",
"would", "may" and other similar expressions are intended to identify
forward-looking statements but are not the exclusive means of identifying such
statements. Forward-looking statements provide current expectations or forecasts
of future events and are not guarantees of future performance, nor should they
be relied upon as representing management's views as of any subsequent date. The
forward-looking statements are based on 1st Source's expectations and are
subject to a number of risks and uncertainties.
All written or oral forward-looking statements that are made by or attributable
to 1st Source are expressly qualified in their entirety by this cautionary
notice. 1st Source has no obligation and does not undertake to update, revise,
or correct any of the forward-looking statements after the date of this report,
or after the respective dates on which such statements otherwise are made. 1st
Source has expressed its expectations, beliefs, and projections in good faith
and 1st Source believes they have a reasonable basis. However, 1st Source makes
no assurances that its expectations, beliefs, or projections will be achieved or
accomplished. These forward-looking statements may not be realized due to a
variety of factors, including, without limitation, the following:
o Local, regional, national, and international economic conditions and the
impact they may have on 1st Source and its clients and 1st Source's
assessment of that impact.
o Changes in the level of nonperforming assets and charge-offs.
o Changes in estimates of future cash reserve requirements based upon the
periodic review thereof under relevant regulatory and accounting
requirements.
o The effects of and changes in trade and monetary and fiscal policies and
laws, including the interest rate policies of the Federal Reserve Board.
o Inflation, interest rate, securities market, and monetary fluctuations.
o Political instability.
o Acts of war or terrorism.
o Substantial increases in the cost of fuel.
o The timely development and acceptance of new products and services and
perceived overall value of these products and services by others.
o Changes in consumer spending, borrowings, and savings habits.
o Changes in the financial performance and/or condition of 1st Source's
borrowers.
o Technological changes.
o Acquisitions and integration of acquired businesses.
o The ability to increase market share and control expenses.
o Changes in the competitive environment among bank holding companies.
o The effect of changes in laws and regulations (including laws and
regulations concerning taxes, banking, securities, and insurance) with
which 1st Source and its subsidiaries must comply.
o The effect of changes in accounting policies and practices and auditing
requirements, as may be adopted by the regulatory agencies, as well as the
Public Company Accounting Oversight Board, the Financial Accounting
Standards Board, and other accounting standard setters.
o Changes in 1st Source's organization, compensation, and benefit plans.
o The costs and effects of legal and regulatory developments including the
resolution of legal proceedings or regulatory or other governmental
inquires and the results of regulatory examinations or reviews.
o Greater than expected costs or difficulties related to the integration of
new products and lines of business.
o 1st Source's success at managing the risks described in Item 1A. Risk
Factors.
CRITICAL ACCOUNTING POLICIES
- ----------------------------
1st Source's consolidated financial statements are prepared in accordance with
U. S. generally accepted accounting principles 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), 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 of 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 and lease losses, the valuation of
mortgage servicing rights, and the valuation of securities. 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 AND LEASE LOSSES -- The reserve for loan and lease losses
represents management's estimate of probable losses inherent in the loan and
lease 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 and
lease portfolio, estimates of future customer performance, collateral values,
11
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 and lease 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 and Lease Losses."
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."
VALUATION OF SECURITIES -- 1st Source's available-for-sale security portfolio is
reported at fair value. The fair value of a security is determined based on
quoted market prices. If quoted market prices are not available, fair value is
determined based on quoted prices of similar instruments. Available-for-sale and
held-to-maturity securities are reviewed quarterly for possible
other-than-temporary impairment. The review includes an analysis of the facts
and circumstances of each individual investment such as length of time the fair
value has been below cost, the expectation for that security's performance, the
credit worthiness of the issuer, and 1st Source's intent and ability to hold the
security for a time necessary to recover the amortized cost. A decline in value
that is considered to be other-than-temporary is recorded as investment
securities and other investment losses in the Consolidated Statements of Income.
The valuation of securities is discussed further in Note A under the heading
"Securities."
EARNINGS SUMMARY
- ----------------
Net income in 2005 was $33.75 million, up from $24.97 million in 2004 and up
from $19.15 million in 2003. Diluted net income per common share was $1.61 in
2005, $1.19 in 2004, and $0.91 in 2003. Return on average total assets was 1.00%
in 2005 compared to 0.75% in 2004, and 0.59% in 2003. Return on average common
shareholders' equity was 10.12% in 2005 versus 7.81% in 2004, and 6.12% in 2003.
Net income in 2005 was favorably affected by a recovery in the provision for
loan and lease losses, a reduction in loan and lease collection and repossession
expense, and decreased professional fee expense. In addition, income from
deposit fees increased and losses on investment securities decreased notably
from 2004 and 2003. Equipment rental income decreased and depreciation on leased
equipment decreased accordingly in 2005 from 2004. Net income included $0.61
million, $4.78 million, and $0 of other-than-temporary impairment on investment
securities, for 2005, 2004, and 2003, respectively. Net income continued to be
unfavorably affected by decreased net interest margins primarily due to the
interest rate environment.
Dividends paid on common stock in 2005 amounted to $0.49 per share, compared to
$0.42 per share in 2004, and $0.37 per share in 2003. 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.
REPLACEMENT OF CORE AND ANCILLARY DATA PROCESSING SYSTEMS -- On December 1,
2005, 1st Source Bank, entered into a license and service agreement with Fiserv
Solutions, Inc.(Fiserv), a subsidiary of Fiserv, Inc. The agreement was an
integral part of the decision by 1st Source to replace the majority of its core
and ancillary data processing systems. 1st Source expects the implementation of
this project will increase the effectiveness and efficiency of its operations
and facilitate future growth. 1st Source also expects that, over time, this
investment in its core systems will be offset by elimination of current costs
for ongoing support of the current technology platform.
Under the agreement, 1st Source and its affiliates are licensing integrated core
technology and ancillary systems from Fiserv. The core technology licensing
includes a loan system, deposit system, general ledger system, and customer
information file system. Fiserv is obligated to provide professional services
for installation of the technology and training, and maintenance support
services. The agreement provides an initial five year maintenance period to
begin no later than March 2007, the target period for completion of the
installation of the technology. The agreement provides for automatic renewal of
the maintenance period, after the initial five year term, unless either party
notifies the other of its intent not to renew. 1st Source is subject to
termination fees for early termination of the maintenance period. 1st Source
expects the cost will be approximately $6.0 million for the technology licenses,
professional fees for installation and training, and hardware delivered under
the Fiserv agreement.
SECURITIZED LOAN PORTFOLIO PURCHASE -- In December 2003, the Bank purchased its
securitized loan portfolio for $226.0 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 autos for the
rental car industry, 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.
The portfolio purchased included $210.83 million in aircraft loans, $15.19
million in automobile 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 transaction did not have a
material impact on the results of operations in 2003.
12
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 remained relatively stable in 2005 following a 4.56% decrease
in 2004.
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 3.21% in 2005 compared to 3.25% in 2004, and
3.56% in 2003. The Federal Reserve Board influences the general market rates of
interest, including the deposit and loan rates offered by many financial
institutions. The Federal funds rate has increased 325 basis points since June
2004. The continued rise in short-term interest rates has resulted in a
flattened yield curve for the years ended 2005 and 2004. Compression of the net
interest margin during 2005 and 2004 largely resulted from decreases in the net
interest rate spread associated with increases in rates paid across deposit and
other funding categories, continued mix shifts within the deposit base to higher
cost time deposits, and the prolonged and significant flattening of the yield
curve. Additionally, 1st Source's focus on loan portfolio credit quality coupled
with increased competition for deposits across all markets were contributing
factors leading to the decline in the net interest margin for 2005 and 2004.
The average yield on earning assets in 2005 was 5.43%, compared to 4.94% in
2004, and 5.54% in 2003. Average earning assets in 2005 remained relatively
stable, following a 4.71% increase in 2004. The effective rate on interest
bearing liabilities was 2.71% in 2005 compared to 2.04% in 2004, and 2.38% for
2003.
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. Yields/rates are
computed on a tax-equivalent basis, using a 35% rate. Nonaccrual loans and
leases are included in the average loan and lease balance outstanding.
2005 2004 2003
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 $ 515,992 $ 14,777 2.86% $ 590,786 $ 16,361 2.77% $ 535,233 $ 18,410 3.44%
Tax-exempt 186,614 7,682 4.12 171,600 7,502 4.37 167,740 8,306 4.95
Mortgages held for sale 82,174 4,779 5.82 69,964 3,868 5.53 112,157 6,496 5.79
Net loans and leases 2,348,690 143,295 6.10 2,240,055 125,469 5.60 2,091,004 131,186 6.27
Other investments 18,765 666 3.55 49,585 952 1.92 75,488 916 1.21
- ---------------------------- ------------- ---------- --------- -------------- ---------- -------- ------------- ---------- --------
Total earning assets 3,152,235 171,199 5.43 3,121,990 154,152 4.94 2,981,622 165,314 5.54
Cash and due from banks 84,517 81,334 86,483
Reserve for loan and
lease losses (61,072) (69,567) (63,123)
Other assets 197,457 215,607 253,192
- ---------------------------- ------------- ---------- --------- -------------- ---------- -------- ------------- ---------- --------
Total assets $ 3,373,137 $ 3,349,364 $ 3,258,174
====================================================================================================================================
LIABILITIES AND
- ---------------
SHAREHOLDERS' EQUITY
--------------------
Interest bearing deposits $ 2,217,923 $ 56,341 2.54% $ 2,105,013 $ 41,698 1.98% $ 2,145,467 $ 49,153 2.29%
Short-term borrowings 295,271 8,628 2.92 405,192 6,079 1.50 256,628 5,121 2.00
Subordinated notes 59,022 4,008 6.79 57,198 3,863 6.75 55,604 3,804 6.84
Long-term debt and
mandatorily redeemable
securities 18,270 1,127 6.17 22,921 1,109 4.84 20,132 992 4.93
- ----------------------------- ------------- ---------- --------- -------------- ---------- -------- ------------- ---------- -------
Total interest bearing
liabilities 2,590,486 70,104 2.71 2,590,324 52,749 2.04 2,477,831 59,070 2.38
Noninterest bearing
deposits 392,475 384,157 413,794
Other liabilities 56,553 55,146 53,756
Shareholders' equity 333,623 319,737 312,793
- ----------------------------- ------------- ---------- --------- -------------- ---------- -------- ------------- ---------- -------
Total liabilities and
shareholders' equity $ 3,373,137 $ 3,349,364 $ 3,258,174
====================================================================================================================================
Net interest income $101,095 $101,403 $106,244
====================================================================================================================================
Net interest margin on a
tax equivalent basis 3.21% 3.25% 3.56%
====================================================================================================================================
13
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. 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
- --------------------------------------------------------- ----------- ---------------- --------
2005 compared to 2004
Interest earned on:
Investment securities:
Taxable $ (2,139) $ 555 $ (1,584)
Tax-exempt 534 (354) 180
Mortgages held for sale 700 211 911
Net loans and leases 6,273 11,553 17,826
Other investments 781 (1,067) (286)
- --------------------------------------------------------- ----------- ---------------- --------
Total earning assets $ 6,149 $ 10,898 $ 17,047
===============================================================================================
Interest paid on:
Interest bearing deposits $ 2,323 $ 12,320 $ 14,643
Short-term borrowings (1,020) 3,569 2,549
Subordinated notes 122 23 145
Long-term debt and mandatorily redeemable securities (51) 69 18
- --------------------------------------------------------------------- ---------------- --------
Total interest bearing liabilities $ 1,374 $ 15,981 $ 17,355
===============================================================================================
Net interest income $ 4,775 $ (5,083) $ (308)
===============================================================================================
2004 compared to 2003
Interest earned on:
Investment securities:
Taxable $ 2,332 $ (4,381) $ (2,049)
Tax-exempt 196 (1,000) (804)
Mortgages held for sale (2,348) (280) (2,628)
Net loans and leases 11,260 (16,977) (5,717)
Other investments (51) 87 36
- --------------------------------------------------------------------- ---------------- --------
Total earning assets $ 11,389 $ (22,551) $(11,162)
===============================================================================================
Interest paid on:
Interest bearing deposits $ (914) $ (6,541) $ (7,455)
Short-term borrowings 1,681 (723) 958
Subordinated notes 108 (49) 59
Long-term debt and mandatorily redeemable securities 135 (18) 117
- --------------------------------------------------------------------- ---------------- --------
Total interest bearing liabilities $ 1,010 $ (7,331) $ (6,321)
===============================================================================================
Net interest income $ 10,379 $ (15,220) $ (4,841)
===============================================================================================
NONINTEREST INCOME -- Noninterest income for the most recent three years
ended December 31 was as follows:
(Dollars in thousands) 2005 2004 2003
- --------------------------------------------------------------------- ----------------- -------------
Noninterest income:
Trust fees $ 12,877 $ 12,361 $ 10,664
Service charges on deposit accounts 17,775 16,228 15,532
Mortgage banking 10,868 9,553 19,635
Securitization income - - 3,206
Insurance commissions 4,133 3,695 3,047
Equipment rental income 16,067 18,856 25,448
Other income 6,463 6,759 6,600
Investment securities and other investment gains (losses) 350 (4,719) (3,936)
- --------------------------------------------------------------------- ----------------- -------------
Total noninterest income $ 68,533 $ 62,733 $ 80,196
=====================================================================================================
14
Noninterest income increased 9.25% in 2005 over 2004 mainly due to recoveries of
mortgage servicing rights impairment, decreased charges for other-than-temporary
impairment of securities, and gains on partnership investments. These increases
were partially offset by decreases in equipment rental income. Noninterest
income decreased 21.78% in 2004 from 2003 primarily due to decreased mortgage
banking income, equipment rental income, securitization income, and increased
investment securities losses. These decreases were partially offset by growth in
trust and deposit fees and insurance commission income.
During 2005, the Bank and Trustcorp together produced $826.63 million in new
mortgages -- $139.06 million through the Bank; $214.05 million through
Trustcorp; and $473.52 million purchased from wholesale production sources.
Mortgage banking income increased 13.77% in 2005 over 2004, compared to a
decrease of 51.35% in 2004 from 2003. The increase in 2005 was primarily the
result of a recovery of impairment on mortgage servicing assets of $2.27 million
versus impairment recoveries of $0.28 million, and impairment charges of $0.58
million during 2004 and 2003, respectively. During 2005, 1st Source determined
that no direct write-down was necessary for previously recorded impairment on
mortgage servicing assets. During 2004 and 2003, 1st Source determined that
$0.70 million and $4.63 million, respectively, of previously recorded impairment
was unrecoverable and was recorded as a direct write-down to the carrying value
of the asset.
Due to the December 2003 purchase of securitized loans by the Bank, there was no
securitization income in 2004 or 2005. In the first half of 2003, 1st Source
made a strategic decision to liquidate the Master Trust 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 the
securitization. Servicing income was $3.50 million and losses on loan sales were
$0.30 million in 2003.
Trust fees (which includes investment management fees, estate
administration fees, mutual fund annuity fees, and fiduciary fees) increased by
4.17% in 2005 from 2004 compared to an increase of 15.91% in 2004 over 2003.
Trust fees are largely based on the size of client relationships and the market
value and mix of assets under management. The market value of trust assets under
management at December 31, 2005 and 2004, were $2.66 billion and $2.41 billion,
respectively. At December 31, 2005, these trust assets were comprised of $1.32
billion of personal and agency trusts, $816.00 million of employee benefit plan
assets, $333.67 million of estate administration assets, and $188.63 million of
custody assets. A weaker stock and bond market slowed the growth of trust fees
in 2005 from 2004 as compared to 2004 over 2003.
Service charges on deposit accounts increased 9.53% in 2005 from 2004 compared
to an increase of 4.48% in 2004 from 2003. The increases in service charges on
deposit accounts in 2005, 2004, and 2003, were attributed primarily to increased
debit card fees and consumer overdraft fees.
Insurance commissions continued to grow and were up 11.85% in 2005 from 2004
compared to an increase of 21.27% in 2004 from 2003. The increases for 2005 and
2004 were mainly attributed to new business sales growth.
Equipment rental income generated from operating leases declined by 14.79%
during 2005 from 2004 compared to a decrease of 25.90% in 2004 from 2003.
Revenues from operating leases for construction equipment, various trucks, and
other equipment declined primarily due to portfolio maturities in 2005. Revenues
for 2004 and 2003 were negatively affected as clients in these industries opted
to take advantage of the tax benefits available for purchases of equipment
versus equipment rental.
Other income decreased 4.38% in 2005 from 2004 compared to an increase of 2.41%
in 2004 from 2003. The decline in other income was primarily the result of lower
standby letter of credit fee income which decreased by $0.17 million and
miscellaneous fee income which decreased by $0.31 million in 2005. The increase
in 2004 over 2003 was primarily the result of increased income on bank owned
life insurance of $0.18 million.
Investment securities and other investment gains totaled $0.35 million for the
year ended 2005. Gains on venture capital investments were partially offset by
other-than-temporary impairment of $0.61 million for 2005. In 2004, investment
securities and other investment losses totaled $4.72 million, of this amount
$4.58 million was comprised of other-than-temporary impairment charges on
investments in Federal National Mortgage Association (FNMA) and the Federal Home
Loan Mortgage Corporation (FHLMC) preferred stock. Investment securities and
other investment losses in 2003 total $3.94 million, of this amount $2.99
million was impairment charges on the securitization retained asset.
NONINTEREST EXPENSE -- Noninterest expense for the recent three years ended
December 31 was as follows:
(Dollars in thousands) 2005 2004 2003
- ---------------------------------------------------------------------- ---------------- -------------
Noninterest expense:
Salaries and employee benefits $ 69,767 $ 63,083 $ 69,457
Net occupancy expense 7,749 7,196 6,881
Furniture and equipment expense 11,418 10,290 10,363
Depreciation -- leased equipment 12,895 15,315 19,773
Professional fees 3,362 6,563 2,925
Supplies and communication 5,462 5,708 6,163
Business development and marketing expense 3,630 3,613 3,481
Intangible asset amortization 2,663 2,631 2,748
Loan and lease collection and repossession expense (1,094) 4,946 8,112
Other expense 7,587 7,746 9,001
- ---------------------------------------------------------------------- ---------------- -------------
Total noninterest expense $ 123,439 $ 127,091 $ 138,904
=====================================================================================================
1st Source experienced a decrease in noninterest expense of 2.87% in 2005 from
2004 compared to a decrease of 8.50% in 2004 from 2003 . The leading factors
contributing to the decrease in noninterest expense in 2005 were reduced
expenses for professional fees, decreased depreciation on leased equipment, and
a decline in loan and lease collection and repossession expenses which were
partially offset by an increase in salaries and employee benefits.
Salaries and employee benefits increased 10.60% in 2005 from 2004, following a
9.18% decrease in 2004 from 2003. Salaries increased 2.88% in 2005 compared to a
decrease of 9.61% in 2004. The increase in salaries in 2005 was primarily the
result of merit-based and market-driven salary increases and increased
commissions due to higher insurance revenues. The largest component of the 2004
decrease was the impact of the capitalization of an additional $3.21 million in
salaries and benefits in connection with the deferral of loan origination costs.
In addition, commission expense decreased $2.20 million in 2004 as mortgage
originations slowed due to lower origination volume than that experienced in
2003.
15
Employee benefits increased 39.21% in 2005, following a 7.52% decrease in 2004.
The increase in 2005 was primarily due to increased executive incentives and
group insurance expense. In 2004, employee benefits decreased due to a reduction
in pension and profit sharing expense and lower group insurance expense.
Occupancy expense increased 7.68% in 2005 from 2004, compared to a 4.58%
increase in 2004 from 2003. The increase in 2005 was primarily due to higher
leasehold improvements and repair of premises expenses. Also, during the first
quarter of 2005, 1st Source reviewed its lease accounting practices in light of
the views expressed by the Office of the Chief Accountant of the SEC in a
February 7, 2005 letter to the American Institute of Certified Public
Accountants. As a result of its review, 1st Source recorded a one-time, net
charge of $0.27 million to correct its accounting for straight-line rent and
depreciation of leasehold improvements. During 2004, real estate property taxes
increased as the Indiana state wide property reassessment was finalized.
Furniture and equipment expense, including depreciation, increased in 2005 over
2004 by 10.96%, compared to a 0.70% decrease in 2004 from 2003. The leading
causes for the increase in 2005 were increased third-party processing charges
and desktop computer upgrades. The decrease in 2004 was due to reduced equipment
depreciation and repair expense which were offset by increased software expense.
The decrease in 2003 was the result of reduced equipment repair costs offset by
increased computer processing charges.
Depreciation on operating leases decreased 15.80% in 2005 from 2004, following a
22.55% decrease in 2004 from 2003. Depreciation on operating leases declined in
conjunction with the decline in noninterest income from equipment owned under
operating leases due to maturities in the operating lease portfolio during 2005
and clients who opted to take advantage of the tax benefits available for
purchases of equipment versus equipment rental during 2004 and 2003.
Professional fees decreased 48.77% in 2005 from 2004, compared to a 124.38%
increase in 2004 from 2003. The decrease in 2005 was mainly due to the
settlement, during the fourth quarter of 2004, of the lawsuit described in the
2003 Form 10-K Item 3, Legal Proceedings and a reduction in the associated legal
fees. The increase in 2004 was primarily due to increased legal fees relating,
in part, to defense of the lawsuit described in the 2003 Form 10-K Item 3, Legal
Proceedings. Also, during 2004 professional fees increased due to the costs of
implementing new internal control evaluation procedures in order to comply with
the provisions of Section 404 of the Sarbanes-Oxley Act and fees incurred due to
long-term projects involving operations improvements and system upgrades.
Supplies and communications expense decreased 4.31% in 2005 from 2004, compared
to a 7.38% decrease in 2004 from 2003. The decrease in 2005 was primarily due to
lower charges for postage and freight and telephone service. The decrease in
2004 was due to lower charges for printing and supplies and reduced
communication expense.
Business development and marketing expense remained relatively flat for the year
2005 from 2004, compared to an increase of 3.79% in 2004 from 2003. During 2005,
2004, and 2003, 1st Source continued to engage in effective target advertising
and marketing campaigns, while keeping expenses for these items under control.
Intangible asset amortization increased 1.22% in 2005 from 2004 compared to a
4.26% decrease in 2004 from 2003. The increase in 2005 was due to amortization
related to an insurance agency acquisition made during the year. The reduction
in 2004 was due to lower amortization of intangibles related to insurance agency
acquisitions.
Loan and lease collection and repossession expenses decreased 122.12% or $6.04
million in 2005 from 2004, compared to a 39.03% or $3.17 million decrease in
2004 from 2003. In 2005 and 2004, valuation adjustments on repossessed assets
continued to decrease along with a decrease in legal and collection expenses.
Over the last three years, 1st Source took back 72 aircraft in repossession and
all of these repossessed aircraft, except for one, had been disposed of as of
December 31, 2005. The 2004 decreases were partially offset by valuation
adjustments on equipment owned under operating leases.
A decrease of 2.05% occurred in other expenses during 2005, compared to a 13.94%
decrease in 2004 from 2003. Lower insurance cost was the primary factor for the
decline for 2005. Other factors affecting other expenses were increases in
forgery and miscellaneous losses, which were mostly offset by lower gains on
sales of operating lease equipment in 2005. Additionally, 2004 decreases were
offset by the write-off of capitalized debt issuance costs related to the
redemption of the 1st Source Capital Trust I trust preferred securities.
INCOME TAXES -- 1st Source recognized income tax expense in 2005 of $15.63
million, compared to $9.14 million in 2004, and $8.03 million in 2003. The
effective tax rate in 2005 was 31.65% compared to 26.79% in 2004, and 29.54% in
2003. The effective tax rate increased in 2005 due to an increase in pre-tax
income and a decrease in the dividend received deduction. For detailed analysis
of 1st Source's income taxes see Part II, Item 8, Financial Statements and
Supplementary Data -- Note N of the Notes to Consolidated Financial Statements.
FINANCIAL CONDITION
- -------------------
LOAN AND LEASE PORTFOLIO -- The following table shows 1st Source's loan and
lease distribution at the end of each of the last five years as of December 31:
(Dollars in thousands) 2005 2004 2003 2002 2001
- --------------------------------------------------- ---------------- ---------------- ----------------- -------------
Commercial and agricultural loans $ 453,197 $ 425,018 $ 402,905 $ 428,367 $ 460,373
Auto, light truck and environmental 310,786 263,637 269,490 247,883 212,781
equipment
Medium and heavy duty truck 302,137 267,834 221,562 197,312 131,233
Aircraft financing 459,645 444,481 489,155 323,802 514,573
Construction equipment financing 224,230 196,516 219,562 303,126 328,004
Loans secured by real estate 601,077 583,437 533,749 567,950 586,580
Consumer loans 112,359 99,245 94,577 111,012 128,305
- --------------------------------------------------- ----------------- ---------------- ----------------- -------------
Total loans and leases $ 2,463,431 $ 2,280,168 $ 2,231,000 $ 2,179,452 $ 2,361,849
======================================================================================================================
At December 31, 2005, 16.0%, and 10.9% of total loans and leases were
concentrated with borrowers in trucking and truck leasing and construction end
users, respectively.
16
Average loans and leases, net of unearned discount, increased 4.85% and
7.13% in 2005 and 2004, respectively. Loans and leases, net of unearned
discount, at December 31, 2005, were $2.46 billion and were 70.16% of total
assets, compared to $2.28 billion and 63.98% of total assets at December 31,
2004.
Commercial and agricultural lending, excluding those loans secured by real
estate, increased 6.63% in 2005 over 2004. Commercial and agricultural lending
outstandings were $453.20 million and $425.02 million at December 31, 2005 and
December 31, 2004, respectively. This increase was mainly due to increased sales
activity within the commercial loan and small business loan areas coupled with
improved market conditions.
Loans secured by real estate increased 3.02% during 2005 over 2004. Loans
secured by real estate outstanding at December 31, 2005, were $601.08 million
and $583.44 million at December 31, 2004. The primary focus of this lending area
is commercial real estate ($386.30 million at December 31, 2005, the majority of
which is owner occupied) and residential mortgage lending ($214.78 million at
December 31, 2005) in the regional market area. This increase was mostly due to
business clients' continued investment in real estate for expansion or
relocation of their commercial facilities and 1st Source's ability to meet those
funding needs.
Auto, light truck, and environmental equipment financing increased 17.88% in
2005 over 2004. At December 31, 2005, auto, light truck, and environmental
equipment financing had outstandings of $310.79 million and $263.64 million at
December 31, 2004. The increase in this portfolio was primarily in the auto
rental industry due to reduced competition in this market area, along with 1st
Source's ability to provide personalized service to its clients in this business
sector.
Medium and heavy duty truck loans and leases experienced growth of $34.30
million, or an increase of 12.81%, in 2005. Medium and heavy duty truck
financing at December 31, 2005 and 2004, had outstandings of $302.14 million and
$267.83 million, respectively. Much of this increase can be attributed to
improved overall market conditions, rigorous sales efforts, and the ability of
the sales staff to continue to produce in the available market for medium and
heavy duty trucks.
Aircraft financing at year-end 2005 increased 3.41% from year-end 2004. Aircraft
financing at December 31, 2005 and 2004, had outstandings of $459.65 million and
$444.48 million, respectively. This increase was mainly due to growth in the
corporate aircraft portfolio which was largely offset by intentional reduction
of the operator business portfolio.
Construction equipment financing increased 14.10% in 2005 over 2004.
Construction equipment financing at December 31, 2005, had outstandings of
$224.23 million, compared to outstandings of $196.52 million at December 31,
2004. The increase was mainly the result of an improving economy and greater
funding availability at both the state and Federal levels for roads, bridges,
and general transportation projects upon which 1st Source's client base relies
for business. The continued strong housing market and improvements in the
commercial building segment also contributed to the higher level of construction
equipment loan and lease portfolio activity.
Consumer loans increased 13.21% in 2005 over 2004. Consumer loans outstanding at
December 31, 2005, were $112.36 million and $99.25 million at December 31, 2004.
Successful marketing to new and established clients coupled with competitive
rates on consumer loans was the main factor in the increase.
The following table shows the maturities of loans and leases in the categories
of commercial and agriculture, auto, light truck and environmental equipment,
medium and heavy duty truck, aircraft and construction equipment outstanding as
of December 31, 2005. 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 $ 265,278 $ 167,257 $ 20,662 $ 453,197
Auto, light truck and environmental equipment 153,679 156,708 399 310,786
Medium and heavy duty truck 92,501 203,526 6,110 302,137
Aircraft financing 139,998 272,403 47,244 459,645
Construction equipment financing 68,658 154,254 1,318 224,230
- ------------------------------------------------------- ----------- ---------------- ----------------- -------------
Total $ 720,114 $ 954,148 $ 75,733 $ 1,749,995
=====================================================================================================================
Rate Sensitivity (Dollars in thousands) Fixed Rate Variable Rate Total
- ------------------------------------------------------- ----------- ---------------- ----------------- -------------
1 - 5 Years $ 650,254 $ 303,894 $ 954,148
Over 5 Years 12,853 62,880 75,733
- ------------------------------------------------------- ----------- ---------------- ----------------- -------------
Total $ 663,107 $ 366,774 $ 1,029,881
=====================================================================================================================
Most of the Bank's 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 $67.22 million at December 31,
2005 and were $55.71 million at December 31, 2004.
CREDIT EXPERIENCE
- -----------------
RESERVE FOR LOAN AND LEASE LOSSES -- 1st Source's reserve for loan and lease
losses is provided for by direct charges to operations. Losses on loans and
leases 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 and leases over a
fixed-dollar amount ($100,000) 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 and leases, estimated losses on pools of
homogeneous loans and leases based on historical loss experience, and
consideration of economic trends, all of which may be susceptible to significant
and unforeseen changes. Management of 1st Source reviews the status of the loan
and lease 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 and lease
losses.
17
The reserve for loan and lease losses at December 31, 2005 totaled $58.70
million and was 2.38% of loans and leases, compared to $63.67 million or 2.79%
of loans and leases at December 31, 2004 and $70.05 million or 3.14% of loans
and leases at December 31, 2003. It is management's opinion that the reserve for
loan and lease losses was adequate to absorb losses inherent in the loan and
lease portfolio as of December 31, 2005.
The recovery of provision for loan and lease losses for 2005 was $5.86 million,
compared to the provision for loan and lease losses of $0.23 million in 2004 and
$17.36 million in 2003. The recovery of the provision was consistent with 1st
Source's improved credit quality of the loan and lease portfolio. Net
(recoveries)/charge-offs in 2005, 2004, and 2003, to aircraft dealers and
operators were ($0.20) million, ($1.27) million and $5.25 million, respectively.
The reserve for loan and lease losses increased $6.82 million in 2003 for
reserves acquired in acquisitions.
The following table summarizes 1st Source's loan and lease loss experience for
each of the last five years ended December 31:
(Dollars in thousands) 2005 2004 2003 2002 2001
- ---------------------------------------------------------------------------------------------------------------------------
Amounts of loans and leases outstanding
at end of period $ 2,463,431 $ 2,280,168 $ 2,231,000 $ 2,179,452 $ 2,361,849
- ---------------------------------------------------------------------------------------------------------------------------
Average amount of net loans and leases
outstanding during period $ 2,348,690 $ 2,240,055 $ 2,091,004 $ 2,332,992 $ 2,347,746
- ---------------------------------------------------------------------------------------------------------------------------
Balance of reserve for loan and lease losses
at beginning of period $ 63,672 $ 70,045 $ 59,218 $ 57,624 $ 44,644
- ---------------------------------------------------------------------------------------------------------------------------
Charge-offs:
Commercial and agricultural loans 1,478 6,104 1,187 2,376 4,916
Auto, light truck and environmental equipment 630 2,408 2,789 6,380 753
Medium and heavy duty truck 15 352 69 771 -
Aircraft financing 2,424 3,585 6,877 27,401 5,584
Construction equipment financing - 686 4,712 2,326 762
Loans secured by real estate 167 456 344 340 215
Consumer loans 858 1,090 1,560 2,127 2,102
- ---------------------------------------------------------------------------------------------------------------------------
Total charge-offs 5,572 14,681 17,538 41,721 14,332
- ---------------------------------------------------------------------------------------------------------------------------
Recoveries:
Commercial and agricultural loans 1,308 1,312 519 1,311 328
Auto, light truck and environmental equipment 1,140 1,277 1,182 616 71
Medium and heavy duty truck 174 14 - - -
Aircraft financing 2,255 4,460 1,698 759 92
Construction equipment financing 1,065 547 248 465 129
Loans secured by real estate 89 107 11 26 -
Consumer loans 421 362 523 481 351
- ---------------------------------------------------------------------------------------------------------------------------
Total recoveries 6,452 8,079 4,181 3,658 971
- ---------------------------------------------------------------------------------------------------------------------------
Net (recoveries) charge-offs (880) 6,602 13,357 38,063 13,361
(Recoveries) provisions charged to operating
expense (5,855) 229 17,361 39,657 25,745
Reserves acquired in acquisitions - - 6,823 - 596
- ---------------------------------------------------------------------------------------------------------------------------
Balance at end of period $ 58,697 $ 63,672 $ 70,045 $ 59,218 $ 57,624
===========================================================================================================================
Ratio of net (recoveries) charge-offs to
average net loans and leases outstanding (0.04)% 0.29 % 0.64 % 1.63 % 0.57 %
===========================================================================================================================
Net (recoveries) charge-offs as a percentage of average loans and leases by
portfolio type follow:
2005 2004 2003 2002 2001
- ----------------------------------------------------------------------------------------------------------------------
Commercial and agricultural loans 0.04 % 1.14% 0.16% 0.23% 0.96%
Auto, light truck and environmental equipment (0.17) 0.43 0.62 2.27 0.29
Medium and heavy duty truck (0.06) 0.14 0.03 0.47 -
Aircraft financing 0.04 (0.19) 1.73 6.40 1.03
Construction equipment financing (0.51) 0.07 1.67 0.55 0.21
Loans secured by real estate 0.01 0.06 0.06 0.05 0.04
Consumer loans 0.41 0.77 1.04 1.39 1.37
- ---------------------------------------------------------------------------------------------------------------------
Total net charge-offs to average portfolio
loans and leases (0.04)% 0.29% 0.64% 1.63% 0.57%
======================================================================================================================
18
The reserve for loan and lease losses has been allocated according to the amount
deemed necessary to provide for the possibility of losses being incurred within
the categories of loans and leases set forth in the table below. The amount of
such components of the reserve at December 31 and the ratio of such loan and
lease categories to total outstanding loan and lease balances, are as follows
(for purposes of this analysis, auto, light truck and environmental equipment
and medium and heavy duty truck loans and leases have been consolidated into the
category truck and automobile financing):
2005 2004 2003 2002 2001
Percent of Percent of Percent of Percent of Percent of
Loans and Loans and Loans and Loans and Loans and
Leases Leases Leases Leases Leases
in Each in Each in Each in Each in Each
Category Category Category Category Category
to Total to Total to Total to Total to Total
Reserve Loans and Reserve Loans and Reserve Loans and Reserve Loans and Reserve Loans and
(Dollars in thousands) Amount Leases Amount Leases Amount Leases Amount Leases Amount Leases
- ---------------------- -------------- --------- ---------- ---------- --------- ---------- --------- ---------- ---------- ---------
Commercial and
agricultural loans $ 15,472 18.40% $ 13,612 18.64% $ 9,589 18.06% $ 11,163 19.65% $ 14,247 19.49%
Truck and automobile 13,008 24.88 12,633 23.31 13,966 22.01 11,006 20.43 9,924 14.57
financing
Aircraft financing 19,583 18.66 26,475 19.49 31,733 21.93 21,603 14.86 19,987 21.79
Construction equipment 4,235 9.10 4,502 8.62 9,061 9.84 9,394 13.91 6,463 13.89
financing
Loans secured by real estate 4,058 24.40 4,187 25.59 3,798 23.92 3,656 26.06 4,268 24.84
Consumer loans 2,341 4.56 2,263 4.35 1,898 4.24 2,396 5.09 2,735 5.42
- ---------------------------- --------- ---------- --------- ---------- --------- ---------- --------- ---------- --------- ---------
Total $ 58,697 100.00% $ 63,672 100.00% $ 70,045 100.00% $ 59,218 100.00% $ 57,624 100.00%
====================================================================================================================================
NONPERFORMING ASSETS -- 1st Source's policy is to discontinue the accrual of
interest on loans and leases 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 and consumer loans that
are both well secured and in the process of collection. Nonperforming assets
amounted to $22.04 million at December 31, 2005, compared to $33.21 million at
December 31, 2004, and $36.83 million at December 31, 2003. Impaired loans and
leases totaled $18.53 million, $47.22 million, and $60.04 million at December
31, 2005, 2004, and 2003, respectively. During 2005, interest income that would
have been recorded on nonaccrual loans and leases under their original terms was
$2.19 million, compared to $3.21 million in 2004. Interest income that was
recorded on nonaccrual loans and leases was $0.81 million and $0.94 million in
2005 and 2004, respectively.
Overall decreases in nonperforming assets for 2005 were realized across the
entire loan and lease portfolio with the exception of loans secured by real
estate which experienced a marginal increase.
Nonperforming assets at December 31 (Dollars in thousands) 2005 2004 2003 2002 2001
- ------------------------------------------------------------------------------------------------------------------------
Loans past due over 90 days $ 245 $ 481 $ 212 $ 154 $ 453
Nonaccrual loans and leases and restructured loans:
Commercial and agricultural loans 3,701 6,928 2,795 4,819 6,580
Auto, light truck and environmental equipment 812 2,336 2,419 4,730 3,746
Medium and heavy duty truck 17 179 1,823 1,384 -
Aircraft financing 7,641 10,132 12,900 12,281 16,365
Construction equipment financing 2,513 4,097 4,663 9,844 5,126
Loans secured by real estate 1,475 1,141 1,786 2,191 3,349
Consumer loans 393 440 699 415 659
- ------------------------------------------------------------------------------------------------------------------------
Total nonaccrual loans and leases and restructured loans 16,552 25,253 27,085 35,664 35,825
- ------------------------------------------------------------------------------------------------------------------------
Total nonperforming loans and leases 16,797 25,734 27,297 35,818 36,278
- ------------------------------------------------------------------------------------------------------------------------
Other real estate 960 1,307 3,010 4,362 3,137
Repossessions:
Commercial and agricultural loans - - 34 - -
Auto, light truck and environmental equipment 128 1,112 847 1,364 2,590
Medium and heavy duty truck - - - - -
Aircraft financing 4,073 3,037 4,551 19,242 770
Construction equipment financing - 183 753 681 53
Consumer loans 83 50 78 56 96
- ------------------------------------------------------------------------------------------------------------------------
Total repossessions 4,284 4,382 6,263 21,343 3,509
- ------------------------------------------------------------------------------------------------------------------------
Operating leases - 1,785 257 2,594 369
- ------------------------------------------------------------------------------------------------------------------------
Total nonperforming assets $ 22,041 $ 33,208 $ 36,827 $ 64,117 $ 43,293
========================================================================================================================
Nonperforming loans and leases to loans and leases,
net of unearned discount 0.68% 1.13% 1.22% 1.64% 1.54%
========================================================================================================================
Nonperforming assets to loans and leases and operating
leases, net of unearned discount 0.87% 1.42% 1.59% 2.79% 1.74%
========================================================================================================================
19
POTENTIAL PROBLEM LOANS AND LEASES -- At December 31, 2005, the Bank had a
$3.32 million standby letter of credit outstanding which supported bond
indebtedness of a customer. If this standby letter of credit is funded, due to
the current financial condition of the customer, the Bank likely will foreclose
on the real estate securing the customer's reimbursement obligation. This likely
will result in an increase in other real estate for approximately the same
amount as the funding.
At December 31, 2005, management was not aware of any potential problem loans or
leases that would have a material effect on loan and lease delinquency or loan
and lease charge-offs. 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 2005 decreased 19.30% from 2004, following a 4.01%
increase from year-end 2003 to year-end 2004. Securities at December 31, 2005
were $637.88 million or 18.17% of total assets, compared to $790.40 million or
22.18% of total assets at December 31, 2004.
The amortized cost of securities available-for-sale as of December 31 are
summarized as follows:
(Dollars in thousands) 2005 2004 2003
- ----------------------------------------------------------------------------------------------------------------------------------
U.S. Treasury and government agencies, including agency mortgage-backed securities $ 415,793 $ 552,949 $ 504,748
States and political subdivisions 179,797 171,338 168,383
Other securities 42,288 66,117 86,814
- ----------------------------------------------------------------------------------------------------------------------------------
Total securities available-for-sale $ 637,878 $ 790,404 $ 759,945
==================================================================================================================================
Yields on tax-exempt obligations are calculated on a fully tax equivalent basis
assuming a 35% tax rate. The following table shows the maturities of securities
available-for-sale at December 31, 2005, at the amortized costs and the weighted
average yields of such securities:
(Dollars in thousands) Amount Yield
- ----------------------------------------------------------------------------------------------------------------------------------
U.S. Treasury and government agencies, including agency mortgage-backed securities
Under 1 year $ 217,350 3.14%
1 - 5 years 141,025 2.82
5 - 10 years 533 6.94
Over 10 years 56,885 4.67
- ----------------------------------------------------------------------------------------------------------------------------------
Total U.S. Treasury and government agencies, including agency mortgage-backed securities 415,793 3.25
- ----------------------------------------------------------------------------------------------------------------------------------
States and political subdivisions
Under 1 year 34,345 4.03
1 - 5 years 115,691 4.05
5 - 10 years 26,261 5.03
Over 10 years 3,500 4.03
- ----------------------------------------------------------------------------------------------------------------------------------
Total states and political subdivisions 179,797 4.19
- ----------------------------------------------------------------------------------------------------------------------------------
Other securities
Under 1 year 75 6.20
1 - 5 years 4,000 2.99
5 - 10 years 75 6.55
Over 10 years - -
Marketable equity securities 38,138 4.56
- ----------------------------------------------------------------------------------------------------------------------------------
Total other securities 42,288 4.42
- ----------------------------------------------------------------------------------------------------------------------------------
Total securities available-for-sale $ 637,878 3.59%
==================================================================================================================================
20
DEPOSITS
- --------
The average daily amounts of deposits and rates paid on such deposits are
summarized as follows:
2005 2004 2003
(Dollars in thousands) Amount Rate Amount Rate Amount Rate
- ---------------------------------------------------------------------------------------------------------
Noninterest bearing demand deposits $ 392,475 -% $ 384,157 -% $ 413,794 -%
Interest bearing demand deposits 784,366 1.78 707,168 0.88 645,131 0.79
Savings deposits 210,151 0.30 228,836 0.29 233,737 0.53
Other time deposits 1,223,406 3.41 1,169,009 2.98 1,266,599 3.38
- ---------------------------------------------------------------------------------------------------------
Total $ 2,610,398 $ 2,489,170 $ 2,559,261
=========================================================================================================
The amount of certificates of deposit of $100,000 or more and other time
deposits of $100,000 or more outstanding at December 31, 2005, by time remaining
until maturity is as follows:
(Dollars in thousands)
- -----------------------------------------
Under 3 months $ 133,527
4 - 6 months 49,706
7 - 12 months 58,197
Over 12 months 149,497
- -----------------------------------------
Total $ 390,927
=========================================
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
- ------------------------------------------------------------------ ------------- ------------- --------------- ------------
2005
Balance at December 31, 2005 $ 230,756 $ 4,600 $ 42,113 $ 277,469
Maximum amount outstanding at any month-end 273,428 5,552 122,038 401,018
Average amount outstanding 214,199 2,054 79,018 295,271
Weighted average interest rate during the year 2.55% 3.36% 3.91% 2.92%
Weighted average interest rate for outstanding amounts at
December 31, 2005 3.86% 3.88% 2.76% 3.70%
- ------------------------------------------------------------------ ------------- ------------- --------------- ------------
2004
Balance at December 31, 2004 $ 216,751 $ 836 $ 82,075 $ 299,662
Maximum amount outstanding at any month-end 411,812 1,152 113,958 526,922
Average amount outstanding 295,172 815 109,205 405,192
Weighted average interest rate during the year 1.15% 1.23% 2.46% 1.50%
Weighted average interest rate for outstanding amounts at
December 31, 2004 2.09% 1.72% 2.09% 2.09%
- ------------------------------------------------------------------ ------------- ------------- --------------- ------------
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%
===========================================================================================================================
21
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 2005, average core deposits equaled 67.60% of
average total assets, compared to 66.97% in 2004 and 70.83% in 2003. The
effective cost rate of core deposits in 2005 was 1.96%, compared to 1.59% in
2004 and 1.81% in 2003.
Average demand deposits (noninterest bearing core deposits) increased 2.17%
in 2005 compared to a decrease of 7.16% in 2004. These represented 17.21% of
total core deposits in 2005, compared to 17.13% in 2004, and 17.93% in 2003.
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 2005, 1st Source's
reliance on purchased funds decreased to 18.55% of average total assets from
19.45% in 2004.
SHAREHOLDERS' EQUITY -- Average shareholders' equity equated to 9.89% of average
total assets in 2005 compared to 9.55% in 2004. Shareholders' equity was 9.84%
of total assets at year-end 2005, compared to 9.16% at year-end 2004. 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 (loss) which is a component of
shareholders' equity. While regulatory capital adequacy ratios exclude
unrealized gain (loss), it does impact 1st Source's equity as reported in the
audited financial statements. The unrealized loss on available-for-sale
securities, net of income taxes, was $3.24 million and $0.30 million at December
31, 2005 and 2004, 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 ALCO 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.
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 at December 31,
2005. The aggregate hypothetical increase in pre-tax earnings was estimated to
be $2.00 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 was
estimated to be $3.10 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. The earnings simulation model excludes the earnings
dynamics related to how fee income and noninterest expense may be affected by
changes 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. At December 31, 2005, the impact of these
hypothetical fluctuations in interest rates on 1st Source's derivative holdings
was not significant, and, as such, separate disclosure is not presented.
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 O of the Notes to Consolidated
Financial Statements.
OFF-BALANCE SHEET ARRANGEMENTS AND 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, determinable, and estimated
contractual obligations, by payment date, at December 31, 2005, except for
obligations associated with short-term borrowing arrangements. Payments for
borrowings do not include interest. Further discussion of the nature of each
obligation is included in the referenced note to the consolidated financial
statements.
22
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 - $ 1,515,676 $ - $ - $ - $ - $1,515,676
Certificates of deposit - 631,668 516,483 67,186 14,574 - 1,229,911
Long-term debt and mandatorily
redeemable securities J 265 15,538 226 110 7,098 23,237
Subordinated notes L - - - 59,022 - 59,022
Operating leases O 2,868 4,141 2,912 2,093 - 12,014
Purchase obligations - 25,532 3,898 1,534 50 - 31,014
- ------------------------------ -------- -------------- ---- ---------- ----- --------- ----- --------- ----- ---------- ------------
Total contractual obligations $ 2,176,009 $ 540,060 $ 71,858 $ 75,849 $ 7,098 $2,870,874
====================================================================================================================================
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. 1st Source made a
diligent effort to account for such payments and penalties, where applicable.
Additionally, where necessary, 1st Source has made reasonable estimates as to
certain purchase obligations as of December 31, 2005. Management has used the
best information available to make the estimations necessary to value the
related purchase obligations. 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 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, 2005 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.
Assets under management and assets under custody are held in fiduciary or
custodial capacity for 1st Source's clients. These assets are not included in
1st Source's balance sheet, in accordance with U. S. generally accepted
accounting principles.
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
clients. 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 O 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
- -------------------------------------------------------------- ---------------------- ---------- --------------- ------
2005
Interest income $ 38,796 $ 40,843 $ 43,657 $ 45,236
Interest expense 15,192 16,641 18,358 19,913
Net interest income 23,604 24,202 25,299 25,323
(Recovery of) provision for loan and lease losses (421) (3,411) (1,304) (719)
Investment securities and other investment gains (losses) 904 5 (559) -
Income before income taxes 10,046 12,385 14,186 12,760
Net income 6,944 8,227 9,481 9,099
Diluted net income per common share 0.33 0.39 0.45 0.43
- -------------------------------------------------------------- ---------------------- ---------- --------------- ------
2004
Interest income $ 38,125 $ 37,314 $ 37,220 $ 38,778
Interest expense 12,363 11,980 12,997 15,409
Net interest income 25,762 25,334 24,223 23,369
Provision for loan and lease losses 101 482 237 (591)
Investment securities and other investment losses (252) (38) (3,744) (685)
Income before income taxes 7,338 13,128 2,018 11,617
Net income 5,079 8,718 3,308 7,860
Diluted net income per common share 0.24 0.42 0.16 0.37
=======================================================================================================================
23
Net income was $9.10 million for the fourth quarter of 2005 compared to the
$7.86 million of net income reported for the fourth quarter of 2004. Diluted net
income per common share for the fourth quarter of 2005 amounted to $0.43,
compared to $0.37 per common share reported in the fourth quarter of 2004.
1st Source's recovery of provision for loan and lease losses was $0.72 million
in the fourth quarter of 2005 compared to a recovery of provision for loan and
lease losses of $0.59 million in the fourth quarter of 2004. 1st Source's
reserve for loan and lease losses as of December 31, 2005, was 2.38% of total
loans and leases, compared to 2.79% as of December 31, 2004. Net recoveries were
$0.87 million for the fourth quarter 2005, compared to net charge-offs of $3.93
million one year ago. The ratio of nonperforming assets to net loans and leases
was 0.87% on December 31, 2005, compared to 1.42% on December 31, 2004.
Noninterest income for the fourth quarter of 2005 was $17.57 million, down 2.84%
from the fourth quarter of 2004. Lower recoveries of mortgage servicing rights
impairment in the fourth quarter of 2005, as compared to the same quarter of
2004, was the predominate factor behind the decrease. Other income and deposit
fee income increased marginally during the fourth quarter of 2005.
Noninterest expense for the fourth quarter of 2005 was relatively flat at
$30.86 million as compared to the $30.43 million reported for fourth quarter of
2004. Reductions in collection and repossession expense, a decline in
professional fees, and lower depreciation expense on leased equipment were the
significant factors behind the decrease. These decreases were partially offset
by increases in salaries and employee benefits.
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.
24
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
REPORTS OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
- ---------------------------------------------------------------------------
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of 1st Source Corporation:
We have audited management's assessment, included in the accompanying Report of
Management, that 1st Source Corporation maintained effective internal control
over financial reporting as of December 31, 2005, based on criteria established
in Internal Control--Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (the COSO criteria). 1st Source
Corporation's management is responsible for maintaining effective internal
control over financial reporting and for its assessment of the effectiveness of
internal control over financial reporting. Our responsibility is to express an
opinion on management's assessment and an opinion on the effectiveness of the
company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
In our opinion, management's assessment that 1st Source Corporation maintained
effective internal control over financial reporting as of December 31, 2005, is
fairly stated, in all material respects, based on the COSO criteria. Also, in
our opinion, 1st Source Corporation maintained, in all material respects,
effective internal control over financial reporting as of December 31, 2005,
based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated statements of
financial condition of 1st Source Corporation as of December 31, 2005 and 2004,
and the related consolidated statements of income, shareholders' equity and cash
flow for each of the three years in the period ended December 31, 2005 and our
report dated March 2, 2006 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Chicago, Illinois
March 2, 2006
25
Report of Independent Registered Public Accounting Firm
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, 2005 and 2004, and
the related consolidated statements of income, shareholders' equity and cash
flow for each of the three years in the period ended December 31, 2005. 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 the standards of the Public Company
Accounting Oversight Board (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 consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of 1st
Source Corporation and subsidiaries at December 31, 2005 and 2004, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2005, in conformity with U.S.
generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of 1st Source
Corporation's internal control over financial reporting as of December 31, 2005,
based on criteria established in Internal Control--Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission and our
report dated March 2, 2006 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Chicago, Illinois
March 2, 2006
26
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
- -----------------------------------------------
December 31 (Dollars in thousands) 2005 2004
- ------------------------------------------------------------------------------------------------------------------------------------
ASSETS
- ------
Cash and due from banks $ 124,817 $ 78,255
Federal funds sold and interest bearing deposits with other banks 68,578 220,131
Investment securities, available-for-sale
(amortized cost of $637,878 and $790,404 at December 31, 2005 and 2004, respectively) 632,625 789,923
Mortgages held for sale 67,224 55,711
Loans and leases, net of unearned discount:
Commercial and agricultural loans 453,197 425,018
Auto, light truck and environmental equipment 310,786 263,637
Medium and heavy duty truck 302,137 267,834
Aircraft financing 459,645 444,481
Construction equipment financing 224,230 196,516
Loans secured by real estate 601,077 583,437
Consumer loans 112,359 99,245
- ------------------------------------------------------------------------------------------------ --------------------- -------------
Total loans and leases 2,463,431 2,280,168
Reserve for loan and lease losses (58,697) (63,672)
- ------------------------------------------------------------------------------------------------ --------------------- -------------
Net loans and leases 2,404,734 2,216,496
Equipment owned under operating leases, net 58,250 47,257
Net premises and equipment 37,710 37,314
Accrued income and other assets 117,339 118,628
- ------------------------------------------------------------------------------------------------ --------------------- -------------
Total assets $ 3,511,277 $ 3,563,715
====================================================================================================================================
LIABILITIES
- -----------
Deposits:
Noninterest bearing $ 393,494 $ 378,867
Interest bearing 2,352,093 2,428,136
- ------------------------------------------------------------------------------------------------ --------------------- -------------
Total deposits 2,745,587 2,807,003
- ------------------------------------------------------------------------------------------------ --------------------- -------------
Short-term borrowings:
Federal funds purchased and securities sold under agreements to repurchase 230,756 216,751
Other short-term borrowings 46,713 82,911
- ------------------------------------------------------------------------------------------------ --------------------- -------------
Total short-term borrowings 277,469 299,662
- ------------------------------------------------------------------------------------------------ --------------------- -------------
Long-term debt and mandatorily redeemable securities 23,237 17,964
Subordinated notes 59,022 59,022
Accrued expenses and other liabilities 60,386 53,464
- ------------------------------------------------------------------------------------------------ --------------------- -------------
Total liabilities 3,165,701 3,237,115
====================================================================================================================================
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 21,617,073 shares in 2005 and 21,617,057 shares in 2004,
less unearned shares (236,589 -- 2005 and 236,573 -- 2004) 7,578 7,578
Capital surplus 214,001 214,001
Retained earnings 139,601 115,830
Cost of common stock in treasury (711,299 shares -- 2005 and 651,257 shares -- 2004) (12,364) (10,512)
Accumulated other comprehensive loss (3,240) (297)
====================================================================================================================================
Total shareholders' equity 345,576 326,600
====================================================================================================================================
Total liabilities and shareholders' equity $ 3,511,277 $ 3,563,715
====================================================================================================================================
The accompanying notes are a part of the consolidated financial statements.
27
CONSOLIDATED STATEMENTS OF INCOME
- ---------------------------------
Year Ended December 31 (Dollars in thousands, except per share data) 2005 2004 2003
- --------------------------------------------------------------------- -------------------------------- ----------------- -----------
Interest income:
Loans and leases $ 147,814 $ 129,059 $ 137,382
Investment securities, taxable 14,777 16,361 18,410
Investment securities, tax-exempt 5,275 5,065 5,614
Other 666 952 916
- --------------------------------------------------------------------- -------------------------------- ----------------- -----------
Total interest income 168,532 151,437 162,322
- --------------------------------------------------------------------- -------------------------------- ----------------- -----------
Interest expense:
Deposits 56,341 41,698 49,153
Short-term borrowings 8,628 6,079 5,121
Subordinated notes 4,008 3,863 3,804
Long-term debt and mandatorily redeemable securities 1,127 1,109 992
- --------------------------------------------------------------------- -------------------------------- ----------------- -----------
Total interest expense 70,104 52,749 59,070
- --------------------------------------------------------------------- -------------------------------- ----------------- -----------
Net interest income 98,428 98,688 103,252
(Recovery of) provision for loan and lease losses (5,855) 229 17,361
- ------------------------------------------------------------------------------- ------------------------ ---------------- ----------
Net interest income after (recovery of) provision for loan and lease losses 104,283 98,459 85,891
- ------------------------------------------------------------------------------- ------------------------ ---------------- ----------
Noninterest income:
Trust fees 12,877 12,361 10,664
Service charges on deposit accounts 17,775 16,228 15,532
Mortgage banking income 10,868 9,553 19,635
Insurance commissions 4,133 3,695 3,047
Equipment rental income 16,067 18,856 25,448
Other income 6,463 6,759 9,806
Investment securities and other investment gains (losses) 350 (4,719) (3,936)
- ------------------------------------------------------------------------------- ------------------------ ---------------- ----------
Total noninterest income 68,533 62,733 80,196
- -------------------------------------------------------------------- ---------------------------------- ---------------- -----------
Noninterest expense:
Salaries and employee benefits 69,767 63,083 69,457
Net occupancy expense 7,749 7,196 6,881
Furniture and equipment expense 11,418 10,290 10,363
Depreciation -- leased equipment 12,895 15,315 19,773
Professional fees 3,362 6,563 2,925
Supplies and communications 5,462 5,708 6,163
Business development and marketing expense 3,630 3,613 3,481
Loan and lease collection and repossession expense (1,094) 4,946 8,112
Other expense 10,250 10,377 11,749
- -------------------------------------------------------------------- ---------------------------------- ---------------- -----------
Total noninterest expense 123,439 127,091 138,904
- -------------------------------------------------------------------- ---------------------------------- ---------------- -----------
Income before income taxes 49,377 34,101 27,183
Income taxes 15,626 9,136 8,029
- -------------------------------------------------------------------- ---------------------------------- ---------------- -----------
Net income $ 33,751 $ 24,965 $ 19,154
- -------------------------------------------------------------------- ---------------------------------- ---------------- -----------
Basic net income per common share $ 1.63 $ 1.21 $ 0.92
- -------------------------------------------------------------------- ---------------------------------- ---------------- -----------
Diluted net income per common share $ 1.61 $ 1.19 $ 0.91
====================================================================================================================================
The accompanying notes are a part of the consolidated financial statements.
28
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
- -----------------------------------------------
Accumulated
Cost of Other
Common Comprehensive
Common Capital Retained Stock Income (Loss),
(Dollars in thousands, except per share data) Total Stock Surplus Earnings in Treasury Net
- ---------------------------------------- ---------------- -------------- ------------- -------------- ------------- ----------------
Balance at January 1, 2003 $ 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, net of tax (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
Comprehensive income, net of tax:
Net income 24,965 - - 24,965 - -
Change in unrealized gains of
available-for-sale securities, net of tax (2,652) - - - - (2,652)
---------
Total comprehensive income 22,313 - - - - -
Issuance of 227,231 common shares under
stock based compensation plans, including
related tax effects 3,253 - - (970) 4,223 -
Cost of 214,295 shares of common
stock acquired for treasury (4,958) - - - (4,958) -
Cash dividends ($.420 per share) (8,699) (8,699) - -
- ----------------------------------------------- ---------------- ------------- ----------------- ---------------- --- -----------
Balance at December 31, 2004 $ 326,600 $ 7,578 $ 214,001 $ 115,830 $ (10,512) $ (297)
Comprehensive income, net of tax:
Net income 33,751 - - 33,751 - -
Change in unrealized gains of
available-for-sale securities, net of tax (2,943) - - - - (2,943)
---------
Total comprehensive income 30,808 - - - - -
Issuance of 51,433 common shares under
stock based compensation plans, including
related tax effects 528 - - 159 369 -
Cost of 111,475 shares of common
stock acquired for treasury (2,221) - - - (2,221) -
Cash dividends ($.490 per share) (10,139) - - (10,139) - -
- -------------------------------------------- -------------- ------------ --------------- --------------- ------------- ----------
Balance at December 31, 2005 $ 345,576 $ 7,578 $ 214,001 $ 139,601 $ (12,364) $(3,240)
====================================================================================================================================
The accompanying notes are a part of the consolidated financial statements.
29
CONSOLIDATED STATEMENTS OF CASH FLOW
- ------------------------------------
Year Ended December 31 (Dollars in thousands) 2005 2004 2003
- ------------------------------------------------------------------------------ ---------- ----------- ---- ---------------------
Operating activities:
Net income $ 33,751 $ 24,965 $ 19,154
Adjustments to reconcile net income to net cash provided by operating activities:
(Recovery of) provision for loan losses (5,855) 229 17,361
Depreciation of premises and equipment 5,002 4,813 5,090
Depreciation of equipment owned and leased to others 12,895 15,315 19,773
Amortization of investment security premiums and accretion of discounts, net 4,471 6,553 5,871
Amortization of mortgage servicing rights 6,782 7,384 8,007
Mortgage servicing asset impairment (recoveries) charges (2,271) (275) 581
Deferred income taxes (2,908) 5,346 (2,171)
Realized investment securities (gains) losses (350) 4,719 3,936
Change in mortgages held for sale (11,513) 4,504 86,425
Change in trading account securities - - 13,347
Change in interest receivable (1,876) 1,036 1,245
Change in interest payable 3,265 490 (3,810)
Change in other assets (1,347) (1,431) 6,727
Change in other liabilities 8,391 (8,871) 12,642
Other 827 233 1,839
- ------------------------------------------------------------------------------ ---------- ----------- ---- ---------------------
Net cash from operating activities 49,264 65,010 196,017
- ------------------------------------------------------------------------------ ---------- ----------- ---- ---------------------
Investing activities:
Proceeds from sales and maturities of investment securities 344,466 233,245 351,747
Purchases of investment securities (196,061) (274,976) (481,565)
Net change in short-term investments 151,552 (218,776) 80,526
Loans sold or participated to others 286 (557) 52,158
Net change in loans and leases (182,668) (35,908) (110,241)
Net change in equipment owned under operating leases (23,887) 7,732 3,815
Purchases of premises and equipment (5,858) (3,736) (2,072)
- ---------------------------------------------------------------------- ------------------------------ ------------- ------------
Net cash from (used in) investing activities 87,830 (292,976) (105,632)
- ---------------------------------------------------------------------- ------------------------------ ------------- ------------
Financing activities:
Net change in demand deposits, NOW accounts and savings accounts (132,699) 309,534 (39,210)
Net change in certificates of deposits 71,284 10,254 (186,480)
Net change in short-term borrowings (22,193) (110,497) 130,175
Proceeds from issuance of long-term debt 5,368 1,357 2,344
Proceeds from issuance of subordinated notes - 30,929 -
Payments on subordinated notes - (28,351) -
Payments on long-term debt (274) (6,224) (2,484)
Net proceeds from issuance of treasury stock 528 3,253 2,598
Acquisition of treasury stock (2,221) (4,958) (646)
Cash dividends (10,325) (8,863) (7,789)
- -------------------------------------------------------------------------- -------------------------- ------------- ------------
Net cash (used in) from financing activities (90,532) 196,434 (101,492)
- -------------------------------------------------------------------------- -------------------------- ------------- ------------
Net change in cash and cash equivalents 46,562 (31,532) (11,107)
- -------------------------------------------------------------------------- -------------------------- ------------- ------------
Cash and cash equivalents, beginning of year 78,255 109,787 120,894
- --------------------------------------------------------------- ------------------------------------- ------------- ------------
Cash and cash equivalents, end of year $ 124,817 $ 78,255 $ 109,787
- --------------------------------------------------------------- ------------------------------------- ------------- ------------
Supplemental Information:
Cash paid for:
Interest $ 66,839 $ 52,259 $ 62,880
Income taxes 12,002 6,216 2,655
================================================================================================================================
The accompanying notes are a part of the consolidated financial statements.
30
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 S, investments in
subsidiaries are carried at 1st Source's equity in the underlying net assets.
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS -- Financial
statements prepared in accordance with U. S. generally accepted accounting
principles require 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 currently 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 are 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 (loss) in
shareholders' equity.
The fair value is determined based on quoted market prices. If quoted market
prices are not available, fair value is determined based on quoted prices of
similar instruments. Available-for-sale and held-to-maturity securities are
reviewed quarterly for possible other-than-temporary impairment. The review
includes an analysis of the facts and circumstances of each individual
investment such as length of time the fair value has been below cost, the
expectation for that security's performance, the credit worthiness of the
issuer, and 1st Source's intent and ability to hold the security for a time
necessary to recover the amortized cost. A decline in value that is determined
to be other-than-temporary is recorded as a loss in the Consolidated Statements
of Income.
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 AND LEASES -- Loans are stated at the principal amount outstanding, net of
unamortized deferred loan origination fees and costs and net of unearned income.
Interest income is accrued as earned based on unpaid principal balances.
Origination fees and direct loan and lease origination costs are deferred and
the net amount amortized to interest income over the estimated life of the
related loan or lease. Loan commitment fees are deferred and amortized into
other income over the commitment period. At December 31, 2005 and 2004, net
deferred loan and lease costs were $5.66 million and $4.61 million,
respectively.
Direct financing leases are carried at the aggregate of lease payments plus
estimated residual value of the leased property, less unearned income. Interest
income of direct financing leases is recognized over the term of the lease to
achieve a constant periodic rate of return on the outstanding investment.
The accrual of interest on loans and leases is discontinued when a loan or lease
becomes contractually delinquent for 90 days, except for residential mortgage
loans and consumer loans that are well secured and in the process of collection.
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 and lease losses. However, in some
cases, 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. When a loan or lease is classified as nonaccrual and the future
collectibility of the recorded loan or lease balance is doubtful, collections on
interest and principal are applied as a reduction to principal outstanding.
A loan or lease 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 or lease agreement. Interest on impaired loans and leases, which are
not classified as nonaccrual, is recognized on the accrual basis.
1st Source, through its subsidiary Trustcorp, sells mortgage loans to the
Government National Mortgage Association (GNMA) in the normal course of business
and retains the servicing rights. The GNMA programs under which the loans are
sold allow 1st Source to repurchase individual delinquent loans that meet
certain criteria from the securitized loan pool. At 1st Source's option, and
without GNMA's prior authorization, 1st Source may repurchase a delinquent loan
for an amount equal to 100% of the remaining principal balance on the loan.
Under Statements of Financial Accounting Standards (SFAS) No. 140, once 1st
Source has the unconditional ability to repurchase a delinquent loan, 1st Source
is deemed to have regained effective control over the loan and is required to
recognize the loan on its balance sheet and record an offsetting liability,
regardless of 1st Source's intent to repurchase the loan. At December 31, 2005
and 2004, residential real estate portfolio loans included $18.09 million and
$19.31 million, respectively, of loans available for repurchase under the GNMA
optional repurchase programs with the offsetting liability recorded within other
borrowed funds.
31
MORTGAGE BANKING ACTIVITIES -- Loans held 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 considering 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.
As part of mortgage banking operations, 1st Source enters into commitments to
purchase or originate loans whereby the interest rate on these loans is
determined prior to funding ("rate lock commitments"). Similar to loans held for
sale, the fair value of rate lock commitments is subject to change primarily due
to changes in interest rates. Under 1st Source's risk management policy, these
fair values are hedged primarily by selling forward contracts on agency
securities. The rate lock commitments on mortgage loans intended to be sold and
the related hedging instruments are recorded at fair value with changes in fair
value recorded in current earnings. The fair value of rate lock commitments is
determined using current secondary market prices for underlying loans with
similar coupons, maturity and credit quality, subject to the anticipated loan
funding probability, or fallout factor. The benefit of servicing rights inherent
in the loans underlying the rate lock commitments is not recognized until these
loans are funded and sold.
RESERVE FOR LOAN AND LEASE LOSSES -- The reserve for loan and lease losses is
maintained at a level believed to be adequate by management to absorb probable
losses inherent in the loan and lease portfolio. The determination of the
reserve requires significant judgment reflecting management's best estimate of
probable loan and lease losses related to specifically identified loans and
leases as well as probable losses in the remainder of the various loan and lease
portfolios. The methodology for assessing the appropriateness of the reserve
consists of several key elements, which include: specific reserves for
identified special attention loans and leases (classified loans and leases and
internal watch list credits), percentage allocations for special attention loans
and leases without specific reserves, formula reserves for each business lending
division portfolio including a higher percentage reserve allocation for special
attention loans and leases without a specific reserve and reserves for pooled
homogenous loans and leases. 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 and leases. 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 leases
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 and lease origination,
servicing and risk management processes. Special attention loans and leases
without specific reserves receive a higher percentage allocation ratio than
credits not considered special attention.
Pooled loans and leases are smaller credits and are homogenous in nature, such
as consumer credits and residential mortgages. Pooled loan and lease 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 1st Source serves.
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 and lease
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.
32
Loans and leases, which are deemed uncollectible, are charged off and deducted
from the reserve, while recoveries of amounts previously charged off are
credited to the reserve. A provision for loan and lease losses is charged to
operations based on management's periodic evaluation of the factors previously
mentioned, as well as other pertinent factors.
EQUIPMENT OWNED UNDER OPERATING LEASES -- 1st Source finances various types of
construction equipment, medium and heavy duty trucks, and automobiles under
leases 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 residual values are reviewed periodically to ensure the recorded
amount does not exceed the fair market value at the lease termination.
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, 2005
and 2004, other real estate had carrying values of $0.96 million and $1.88
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. Valuation resources 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 or lease is written down, if
necessary, to the fair value of the equipment or vehicle by a charge to the
reserve for loan and lease losses. Subsequent write-downs are included in
noninterest expense. Gains or losses not previously recognized resulting from
the sale of repossessed assets are recognized on the date of sale. Repossessed
assets totaled $4.28 million and $4.38 million, as of December 31, 2005 and
2004, 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 31.5 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 in the amount of 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 in 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. Goodwill is reviewed
at least annually for impairment. Intangible assets that 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. 1st Source performed the required annual
impairment test of goodwill during the first quarter of 2005 and determined that
no impairment exists.
VENTURE CAPITAL INVESTMENT -- Venture capital investments in partnerships 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 in these partnerships are determined using quoted
market prices. For other investments in these partnerships, 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, 2005 and 2004 were $4.75 million and $2.74 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, Federal Home Loan Bank notes, and borrowings
from non-affiliated banks. Federal funds purchased, securities sold under
agreements to repurchase, and other short-term borrowings mature within one to
365 days of the transaction date. Commercial paper matures within seven to 270
days. Other short-term borrowings on the balance sheet includes 1st Source's
liability related to mortgage loans available for repurchase under GNMA optional
repurchase programs.
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. 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.
33
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
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 by the weighted-average number of shares of
common stock outstanding, which were as follows (in thousands): 2005, 20,686;
2004, 20,709; and 2003, 20,859. Diluted earnings per share is computed by
dividing net income 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): 2005, 20,957; 2004, 20,985; and 2003, 21,150.
At December 31, 2005, the company had six stock-based employee compensation
plans, which are described more fully in Note K. 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
K. 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) 2005 2004 2003
- -------------------------------------------------------------------------------- -------------------- ----------------- ------------
Net income, as reported $ 33,751 $ 24,965 $ 19,154
Add:
Stock-based employee compensation expense included in reported net income,
net of related tax effects 2,875 1,392 1,360
Deduct:
Stock-based employee compensation expense determined under fair value based
method for all awards, net of related tax effects (2,998) (1,586) (1,593)
- -------------------------------------------------------------------------------- -------------------- ----------------- ------------
Pro forma net income $ 33,628 $ 24,771 $ 18,921
- -------------------------------------------------------------------------------- -------------------- ----------------- ------------
Earnings per share:
Basic -- as reported $ 1.63 $ 1.21 $ 0.92
Basic -- pro forma $ 1.63 $ 1.20 $ 0.91
- -------------------------------------------------------------------------------- -------------------- ----------------- ------------
Diluted -- as reported $ 1.61 $ 1.19 $ 0.91
Diluted -- pro forma $ 1.61 $ 1.18 $ 0.90
====================================================================================================================================
SEGMENT INFORMATION -- It is management's opinion that 1st Source has two
principal business segments, namely: commercial banking (conducted through its
wholly-owned subsidiary, 1st Source Bank) and mortgage banking (conducted
through its wholly-owned subsidiary, Trustcorp). While 1st Source's chief
decision makers monitor the revenue streams of various products and services,
the identifiable segments' operations are managed and financial performance is
evaluated on a company-wide basis. Accordingly, all of 1st Source's financial
service operations are considered by management to be aggregated in one
reportable operating segment.
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 an earnings impact only to the extent that the hedge is
ineffective in achieving offsetting changes in fair value. If it is determined
that the derivative instrument is not highly effective as a hedge, hedge
accounting is discontinued and the adjustment to fair value of the derivative
instrument is recorded in earnings. 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 recognized in
noninterest income/expense. Deferred gains and losses from derivatives that are
terminated are amortized over the shorter of the original remaining term of the
derivative or the remaining life of the underlying asset or liability.
34
Note B -- Recent Accounting Pronouncements
MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT: In November 2005, the Financial
Accounting Standards Board (FASB) issued Staff Position (FSP) SFAS No. 115-1 and
124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments." The FSP addresses the determination of when an investment
is considered impaired, whether that impairment is other-than-temporary, and the
measurement of an impairment loss. The FSP also includes accounting
considerations subsequent to the recognition of an other-than-temporary
impairment and requires certain disclosures about unrealized losses that have
not been recognized as other-than-temporary impairments. The FSP amends SFAS No.
115, "Accounting for Certain Investments in Debt and Equity Securities," and
SFAS No. 124, "Accounting for Certain Investments Held by Not-for-Profit
Organizations," and APB Opinion No. 18, "The Equity Method of Accounting for
Investments in Common Stock." The FSP nullifies certain requirements of EITF
Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and its
Application to Certain Investments," and supercedes Emerging Issues Task Force
(EITF) Abstracts, Topic D-44, "Recognition of Other-Than-Temporary Impairment
upon the Planned Sale of a Security Whose Cost Exceeds Fair Value." The FSP is
required to be applied to reporting periods beginning after December 15, 2005.
The issuance of this FSP is not expected to have a material impact on the
financial condition, the results of operations, or liquidity of 1st Source.
ACCOUNTING CHANGES AND ERROR CORRECTIONS: In May 2005, the FASB issued SFAS No.
154, "Accounting for Changes and Error Corrections," which changes the
accounting for and reporting of a change in accounting principle. This statement
also applies to all voluntary changes in accounting principle and changes
required by an accounting pronouncement in the unusual instance that the
pronouncement does not include specific transition provisions. This statement
requires retrospective application to prior period financial statements of
changes in accounting principle, unless it is impractical to determine either
the period - specific or cumulative effects of the change. SFAS No. 154 is
effective for accounting changes made in fiscal years beginning after December
15, 2005. The adoption of this standard is not expected to have a material
effect on the financial condition, the results of operations or liquidity of 1st
Source.
EXCHANGES OF NONMONETARY ASSETS: In December 2004, the FASB issued SFAS No. 153,
"Exchanges of Nonmonetary Assets," an amendment to APB Opinion No. 29,
"Accounting for Nonmonetary Transactions." This statement amends the principle
that exchanges of nonmonetary assets should be measured based on the fair value
of the assets exchanged and more broadly provides for exceptions regarding
exchanges of nonmonetary assets that do not have commercial substance. This
Statement is effective for nonmonetary asset exchanges occurring in fiscal
periods beginning after June 15, 2005. The adoption of this standard is not
expected to have a material effect on the financial condition, the results of
operations or liquidity of 1st Source.
ACCOUNTING FOR STOCK-BASED COMPENSATION: On December 16, 2004, the FASB issued
SFAS No. 123(R), "Share-Based Payment," which is a revision of SFAS No. 123
"Accounting for Stock-Based Compensation." SFAS No. 123(R) supersedes Accounting
Principles Board (APB) Opinion No. 25 "Accounting for Stock Issued to
Employees," and amends SFAS No. 95, "Statement of Cash Flows." Generally, the
approach in SFAS No. 123(R) is similar to the approach described in SFAS No.
123. However, SFAS No. 123(R) requires all share-based payments to employees,
including grants of employee stock options, to be recognized in the income
statement based on their fair values. Pro forma disclosure is no longer an
alternative. SFAS No. 123(R) must be adopted no later than January 1, 2006.
Early adoption is permitted in periods in which financial statements have not
yet been issued. 1st Source will adopt SFAS No. 123(R) on January 1, 2006.
SFAS No. 123(R) permits public companies to adopt its requirements using
one of two methods:
1. A "modified prospective" method in which compensation cost is recognized
beginning with the effective date (a) based on the requirements of SFAS No.
123(R) for all share-based payments granted after the effective date, and
(b) based on the requirements of SFAS No. 123 for all awards granted to
employees prior to the effective date of SFAS No. 123(R) that remain
unvested on the effective date.
2. A "modified retrospective" method which includes the requirements of the
modified prospective method described above, but also permits entities to
restate based on the amounts previously recognized under SFAS No. 123 for
purposes of pro forma disclosures either (a) all prior periods presented,
or (b) prior interim periods of the year of adoption.
1st Source will utilize the modified prospective method upon adoption of
SFAS No. 123(R).
As permitted by SFAS No. 123, 1st Source currently accounts for share-based
payments to employees using APB Opinion No. 25's intrinsic value method. Under
the terms of the Executive Incentive Plan and Restricted Stock Award Plan, 1st
Source recognizes the entire share-based compensation cost in net income at the
grant date. 1st Source recognizes no compensation cost for employee stock
options. Accordingly, the adoption of SFAS No. 123(R)'s fair value method could
have a significant impact on 1st Source's results of operations, although 1st
Source expects the adoption will have minimal impact on 1st Source's overall
financial position. 1st Source is still calculating the impact of adoption of
SFAS No. 123(R), including the result of recognizing share-based compensation
cost for the awards granted under the Executive Incentive Plan and Restricted
Stock Award Plan over the "requisite service period" as defined in SFAS No.
123(R) and estimating forfeitures. SFAS No. 123(R) also requires the benefits of
tax deductions in excess of recognized compensation cost to be reported as a
financing cash flow, rather than as an operating cash flow as required under
current literature. This requirement will reduce net operating cash flows and
increase net financing cash flows in periods after adoption. While 1st Source
cannot estimate what those amounts will be in the future (because they depend
on, among other things, when employees exercise stock options), the amount of
operating cash flows recognized in prior periods for such excess tax deductions
were $0, $1.09 million, and $0 in 2005, 2004, and 2003, respectively.
35
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.
1st Source has not acquired any loans subsequent to the effective date of SOP
03-3; therefore, implementation of this statement did not have a material 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 C -- Investment Securities
Investment securities available-for-sale were as follows:
Amortized Gross Gross
(Dollars in thousands) Cost Unrealized Gains Unrealized Losses Fair Value
- --------------------------------------------------------- -------------------------- ----- ---------- ----------------- ------------
December 31, 2005
U.S. Treasury and government agencies securities $ 357,754 $ - $ (5,543) $ 352,211
States and political subdivisions 179,797 80 (2,144) 177,733
Mortgage-backed securities 58,039 162 (849) 57,352
Other securities 42,288 3,307 (266) 45,329
- ---------------------------------------------------------- -------------------------- ---------------- ----------------- -----------
Total investment securities $ 637,878 $ 3,549 $ (8,802) $ 632,625
- ---------------------------------------------------------- -------------------------- ---------------- ----------------- -----------
December 31, 2004
U.S. Treasury and government agencies securities $ 498,507 $ 70 $ (4,424) $ 494,153
States and political subdivisions 171,338 1,496 (318) 172,516
Mortgage-backed securities 54,442 412 (353) 54,501
Other securities 66,117 2,821 (185) 68,753
- ---------------------------------------------------------- -------------------------- ---------------- ----------------- -----------
Total investment securities $ 790,404 $ 4,799 $ (5,280) $ 789,923
====================================================================================================================================
The contractual maturities of investments in securities available-for-sale at
December 31, 2005, 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 $ 251,770 $ 250,282
Due after one year through five years 260,095 254,009
Due after five years through ten years 26,336 26,121
Due after ten years 3,500 3,500
Mortgage-backed securities 58,039 57,352
Equity securities 38,138 41,361
- -------------------------------------------------------- ------------
Total securities $ 637,878 $ 632,625
=====================================================================
36
At December 31, 2005, the mortgage-backed securities held by 1st Source
consisted primarily of FNMA and FHLMC pass-through certificates which are
guaranteed by those respective agencies of the United States government. At
December 31, 2005, other securities held by 1st Source consisted primarily of
FNMA and FHLMC preferred securities and FHLB securities.
Gross losses of $0.64 million, $4.62 million, and $3.03 million and gross
gains of $0.17 million, $0.15 million and $0.01 million were recognized on
investment securities available-for-sale, in 2005, 2004, and 2003, respectively.
The gross losses in 2005 and 2004 include $0.61 million and $4.58 million,
respectively, in other-than-temporary impairment on preferred stock issued by
the FNMA and the FHLMC. The gross loss in 2003 includes $2.99 million of
impairment charges on the securitization retained interest. Realized and
unrealized gains and (losses) on trading securities were $0, ($0.04) million,
and $0.60 million in 2005, 2004 and 2003, respectively. There were no trading
securities outstanding at December 31, 2005 or 2004.
The following tables summarize 1st Source's gross unrealized losses and fair
value by investment category and age:
Less than 12 Months 12 months or Longer Total
------------------- ------------------- -----
Fair Unrealized Fair Unrealized Fair Unrealized
(Dollars in thousands) Value Losses Value Losses Value Losses
- ----------------------------------------------- ------------ -------------- --------------- -------------- -------------- ----------
December 31, 2005
U.S. Treasury and government agencies securities $ 76,363 $ (153) $ 255,799 $ (5,390) $ 332,162 $ (5,543)
States and political subdivisions 99,320 (1,105) 48,301 (1,039) 147,621 (2,144)
Mortgage-backed securities 22,175 (344) 15,766 (505) 37,941 (849)
Other securities 3,409 (84) 3,369 (182) 6,778 (266)
- ----------------------------------------------- ------------ -------------- --------------- -------------- -------------- ----------
Total temporarily impaired securities $ 201,267 $ (1,686) $ 323,235 $ (7,116) $ 524,502 $ (8,802)
- ------------------------------------------------ ------------ -------------- --------------- -------------- -------------- ---------
December 31, 2004
U.S. Treasury and government agencies securities $ 443,597 $ (3,419) $ 40,487 $ (1,005) $ 484,084 $ (4,424)
States and political subdivisions 51,784 (301) 1,136 (17) 52,920 (318)
Mortgage-backed securities 10,937 (68) 19,798 (285) 30,735 (353)
Other securities 5,827 (44) 3,409 (141) 9,236 (185)
- ------------------------------------------------ ------------ -------------- --------------- -------------- -------------- ---------
Total temporarily impaired securities $ 512,145 $ (3,832) $ 64,830 $ (1,448) $ 576,975 $ (5,280)
====================================================================================================================================
At December 31, 2005, 1st Source did not believe any individual unrealized loss
represented other-than-temporary impairment. The unrealized losses were
primarily attributable to changes in interest rates. 1st Source had both the
intent and the ability to hold these securities for a time necessary to recover
the amortized cost.
At December 31, 2005 and 2004, investment securities with carrying values of
$318.51 million and $285.06 million, respectively, were pledged as collateral to
secure government deposits, security repurchase agreements, and for other
purposes.
Note D -- Loans and Lease Financings
Total loans and leases outstanding were recorded net of unearned income and
deferred loan fees and costs at December 31, 2005 and 2004, and totaled $2.46
billion and $2.28 billion, respectively.
The loan and lease portfolio includes direct financing leases, which are
included in auto, light truck and environmental equipment, medium and heavy duty
truck, aircraft financing, and construction equipment financing on the
consolidated balance sheet.
A summary of the gross investment in lease financing and the components of the
investment in lease financing at December 31, 2005 and 2004, follows:
(Dollars in thousands) 2005 2004
- -------------------------------------------------------------- --------------
Direct finance leases $ 155,737 $ 188,244
- --------------------------------------------------------------- -------------
Rentals receivable 99,276 130,930
Estimated residual value of leased assets 56,461 57,314
- --------------------------------------------------------------- -------------
Gross investment in lease financing 155,737 188,244
Unearned income (12,826) (17,219)
- --------------------------------------------------------------- -------------
Net investment in lease financing $ 142,911 $ 171,025
=============================================================================
37
At December 31, 2005, the minimum future lease payments receivable for each of
the years 2006 through 2010 were $36.77 million, $26.49 million, $17.86 million,
$10.91 million, and $5.42 million, respectively.
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
amounts of these loans were $17.48 million and $23.44 million at December 31,
2005 and 2004, respectively. During 2005, $17.31 million of new loans were made
and repayments and other reductions totaled $23.27 million.
Note E -- Reserve for Loan and Lease Losses
Changes in the reserve for loan and lease losses for each of the three years
ended December 31 are shown below.
(Dollars in thousands) 2005 2004 2003
- --------------------------------------------------------------- -------------- ------------
Balance, beginning of year $ 63,672 $ 70,045 $ 59,218
(Recovery of) provision for loan and lease losses (5,855) 229 17,361
Charge-offs (5,572) (14,681) (17,538)
Recoveries 6,452 8,079 4,181
Reserves acquired in acquisitions - - 6,823
- --------------------------------------------------------------- -------------- ------------
Balance, end of year $ 58,697 $ 63,672 $ 70,045
===========================================================================================
At December 31, 2005 and 2004, nonaccrual and restructured loans and leases,
substantially all of which are collateralized, were $16.55 million and $25.25
million, respectively. Interest income for the years ended December 31, 2005,
2004, and 2003, would have increased by approximately $1.38 million, $2.27
million, and $2.64 million, respectively, if these loans and leases had earned
interest at their full contract rate.
As of December 31, 2005 and 2004, impaired loans and leases totaled $18.53
million and $47.22 million, respectively, of which $3.10 million and $22.30
million had corresponding specific reserves for loan and lease losses totaling
$3.03 million and $10.43 million, respectively. The remaining balances of
impaired loans and leases had no specific reserves for loan and lease losses
associated with them. As of December 31, 2005, a total of $12.62 million of the
impaired loans and leases were nonaccrual loans and leases. For 2005, 2004, and
2003 the average recorded investment in impaired loans and leases was $29.39
million, $53.21 million and $60.36 million, respectively, and interest income
recognized on impaired loans and leases totaled $1.04 million, $2.65 million,
and $2.63 million, respectively.
Note F -- Operating Leases
1st Source finances various types of construction equipment, medium and heavy
duty trucks, automobiles, and miscellaneous production equipment under leases
principally classified as operating leases. These operating leases are reported
at cost, net of accumulated depreciation. These operating lease arrangements
require the lessee to make a fixed monthly rental payment over a specified lease
term, typically from three to seven years. These operating lease assets are
recorded net of accumulated depreciation in the consolidated balance sheet.
Rental income is earned by 1st Source on the operating lease assets and reported
as noninterest income. These operating lease assets are depreciated over the
term of the lease to the estimated fair value of the asset at the end of the
lease. The depreciation of these operating lease assets is reported as a
component of noninterest expense. At the end of the lease, the operating lease
asset is either purchased by the lessee or returned to 1st Source.
Operating lease equipment at December 31, 2005 and 2004, was $58.25 million and
$47.26 million, respectively, net of accumulated depreciation of $29.79 million
and $35.37 million, respectively. Depreciable lives for operating lease
equipment generally range from three to seven years.
The minimum future lease rental payments due from clients on operating lease
equipment at December 31, 2005, totaled $44.23 million, of which $14.35 million
is due in 2006, $10.13 million in 2007, $8.11 million in 2008, $6.43 million in
2009, $3.66 million in 2010, $1.06 million in 2011, and $0.49 million in 2012.
Depreciation expense related to operating lease equipment for the year ended
December 31, 2005 was $12.90 million.
Note G -- Premises and Equipment
Premises and equipment as of December 31 consisted of the following:
(Dollars in thousands) 2005 2004
- -------------------------------------------------------- ------------
Land $ 6,884 $ 6,719
Buildings and improvements 42,616 40,905
Furniture and equipment 33,205 32,476
- -------------------------------------------------------- ------------
Total premises and equipment 82,705 80,100
Accumulated depreciation and amortization (44,995) (42,786)
- -------------------------------------------------------- ------------
Net premises and equipment $ 37,710 $ 37,314
=====================================================================
Depreciation and amortization of properties and equipment totaled $5.00 million
in 2005, $4.81 million in 2004, and $5.09 million in 2003.
38
Note H -- Mortgage Servicing Assets
The unpaid principal balance of residential mortgage loans serviced for
third parties was $1.54 billion at December 31, 2005, compared to $1.91 billion
at December 31, 2004, and $2.06 billion at December 31, 2003.
Changes in the carrying value of mortgage servicing assets and the
associated valuation allowance follow:
Year Ended December 31 (Dollars in thousands) 2005 2004
- ------------------------------------------------------------------------------------ --------------------------------- -------------
Mortgage servicing assets:
Balance at beginning of period $ 23,715 $ 27,601
Additions 10,012 9,985
Amortization (6,782) (7,384)
Application of valuation allowance to directly write-down servicing assets - (700)
Sales (7,552) (5,787)
- ------------------------------------------------------------------------------------- --------------------------------- ------------
Carrying value before valuation allowance at end of period 19,393 23,715
- ------------------------------------------------------------------------------------- --------------------------------- ------------
Valuation allowance:
Balance at beginning of period (2,301) (3,276)
Impairment recoveries 2,271 275
Application of valuation allowance to directly write-down servicing assets - 700
- ------------------------------------------------------------------------------------- --------------------------------- ------------
Balance at end of period $ (30) $ (2,301)
- ------------------------------------------------------------------------------------- --------------------------------- ------------
Net carrying value of mortgage servicing assets at end of period $ 19,363 $ 21,414
- ------------------------------------------------------------------------------------- --------------------------------- ------------
Fair value of mortgage servicing assets at end of period $ 23,967 $ 23,521
====================================================================================================================================
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 2005, management
determined that it was not necessary to permanently write-down any previously
established valuation allowance. At December 31, 2005, the fair value of
mortgage servicing assets exceeded the carrying value reported in the
consolidated balance sheet by $4.60 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.
The key economic assumptions used to estimate the value of mortgage
servicing rights follow:
Year Ended December 31 (Dollars in thousands) 2005 2004
- ----------------------------------------------------------------------
Expected weighted-average life (in years) 3.01 3.10
Weighted-average constant prepayment rate (CPR) 12.66 % 20.16 %
Weighted-average discount rate 8.71 % 8.68 %
======================================================================
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,
were approximately $21.04 million and $37.96 million at December 31, 2005 and
December 31, 2004, respectively.
Note I -- Intangible Assets and Goodwill
At December 31, 2005, intangible assets consisted of goodwill of $18.85 million
and other intangible assets of $2.53 million, net of accumulated amortization of
$10.43 million. At December 31, 2004, intangible assets consisted of goodwill of
$18.85 million and other intangible assets of $4.74 million, net of accumulated
amortization of $7.77 million. Intangible asset amortization was $2.66 million,
$2.63 million, and $2.75 million for 2005, 2004, and 2003, respectively.
Amortization on other intangible assets is expected to total $1.91 million,
$0.21 million, $0.11 million, and $0.11 million in 2006, 2007, 2008, and 2009,
respectively.
A summary of core deposit intangible and other intangible assets follows:
Year Ended December 31 (Dollars in thousands) 2005 2004
- -------------------------------------------------------- --------------
Core deposit intangibles:
Gross carrying amount $ 5,762 $ 5,307
Less: accumulated amortization (4,260) (3,244)
- -------------------------------------------------------- --------------
Net carrying amount $ 1,502 $ 2,063
- -------------------------------------------------------- --------------
Other intangibles:
Gross carrying amount $ 7,201 $ 7,201
Less: accumulated amortization (6,174) (4,527)
- -------------------------------------------------------- --------------
Net carrying amount $ 1,027 $ 2,674
=======================================================================
39
Note J -- Long-Term Debt and Mandatorily Redeemable Securities
Details of long-term debt and mandatorily redeemable securities as of
December 31, 2005 and 2004, are as follows:
(Dollars in thousands) 2005 2004
- --------------------------------------------------------------- ---------------- ------------
Term loan $ 10,000 $ 10,000
Federal Home Loan Bank borrowings (4.79%-6.98%) 5,989 1,008
Mandatorily redeemable securities 6,273 6,093
Other long-term debt 975 863
- --------------------------------------------------------------- ---------------- ------------
Total long-term debt and mandatorily redeemable securities $ 23,237 $ 17,964
=============================================================================================
Annual maturities of long-term debt outstanding at December 31, 2005, for
the next five years beginning in 2006, are as follows (in thousands): $265;
$10,304; $5,234; $226; and $110.
At December 31, 2005, the $10.00 million term loan bore a fixed interest rate of
4.76%. 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, 2005, the Federal Home Loan Bank borrowings represented a source
of funding for certain residential mortgage activities and consisted of five
fixed rate notes with maturities ranging from 2006 to 2022. These notes were
collateralized by $9.58 million of certain real estate loans and $5.00 million
of investment securities.
Mandatorily redeemable securities as of December 31, 2005, of $6.27 million
reflected the "book value" shares under the 1st Source Executive Incentive Plan.
See "Executive Incentive Plan" section of Note K 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 2005
and 2004 was $0.54 million and $0.38 million, respectively.
Note K -- Common Stock
1st Source has adopted SFAS No. 123 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 $4.66
million, $2.26 million, and $2.19 million for the years ended December 31, 2005,
2004, and 2003, respectively.
STOCK OPTION PLANS -- 1st Source's incentive stock option plans include the 1992
Stock Option Plan (the "1992 Plan") and the 2001 Stock Option Plan (the "2001
Plan"). As of December 31, 2005, an aggregate 2,445,291 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 and Human Resources 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 2003 (no options
were granted in 2004 or 2005): a risk-free interest rate of 3.39%; an expected
dividend yield of 2.32%; an expected volatility factor of 37.02%; and an
expected option life of 6.39 years. The weighted-average grant date fair value
of options granted in 2003 was $4.94.
40
The following table is a summary of the activity with respect to 1st
Source's stock option plans for the years ended December 31, 2003, 2004 and
2005:
Number of Weighted-Average
Shares Exercise Price
- ------------------------------------------------------------- ------------------
Options outstanding, January 1, 2003 828,082 $ 20.33
- ------------------------------------------------------------- ------------------
Options granted 20,000 13.24
Options exercised (71,528) 8.71
Options forfeited (4,235) 19.24
- ------------------------------------------------------------- ------------------
Options outstanding, December 31, 2003 772,319 21.23
- --------------------------------------------------------------- ----------------
Options granted - -
Options exercised (207,753) 8.39
Options forfeited (3,027) 24.00
- --------------------------------------------------------------- ----------------
Options outstanding, December 31, 2004 561,539 25.97
- --------------------------------------------------------------- ----------------
Options granted - -
Options exercised (27,019) 12.44
Options forfeited (6,481) 29.93
- --------------------------------------------------------------- ----------------
Options outstanding, December 31, 2005 528,039 26.61
- --------------------------------------------------------------- ----------------
Options exercisable, December 31, 2005 504,706 $ 27.07
================================================================================
The following table summarizes information about stock options outstanding at
December 31, 2005:
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
- ----------------------------- ----------------- ---------------------- ---------------------- ------------- ----------------
$ 12.44 to $ 19.99 109,938 3.09 $ 14.48 94,938 $ 14.68
$ 20.00 to $ 29.99 65,793 4.59 22.74 57,460 22.71
$ 30.00 to $ 31.99 352,308 2.55 31.12 352,308 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
2005, 2004, and 2003 offerings were $21.84 (2.02%), $22.38 (3.69%), and $16.47
(4.96%), 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 1, 2005 and runs through May 31, 2007, with $302,253
in stock value to be purchased at $21.84 per share. The fair value of the
employees' purchase rights for the 2005, 2004, and 2003 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 3.40% for 2005;
2.52% for 2004; and 1.38% for 2003; an expected dividend yield of 2.17% for
2005; 1.66% for 2004; and 2.72% for 2003; an expected volatility factor of
27.49% for 2005; 44.20% for 2004; and 49.56% for 2003; and an expected life of
2.00 years for 2005, 2004, and 2003. The fair value for shares offered in 2005,
2004, and 2003 was $3.44, $5.81, and $4.61, 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:
2005 2004 2003
- ------------------------------------------------------------------------ ---
Net income (dollars in thousands):
As reported $ 33,751 $ 24,965 $ 19,154
Proforma 33,628 24,771 18,921
- ------------------------------------------------------------------------ ---
Diluted net income per common share:
As reported $ 1.61 $ 1.19 $ 0.91
Proforma $ 1.61 $ 1.18 $ 0.90
============================================================================
41
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 2005, 2004,
and 2003 are summarized as follows:
2005 2004 2003
- ----------------------------------------------------------------------------
Number of shares 65,418 31,973 13,776
Weighted-average grant-date fair value $15.76 $15.19 $14.77
============================================================================
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.
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 2005, 2004, and 2003 are summarized below:
2005 2004 2003
- ----------------------------------------------------------------------------
Number of shares 10,918 2,000 15,158
Weighted-average grant-date fair value $22.24 $20.84 $19.37
============================================================================
Note L --Subordinated Notes
As of December 31, 2005, 1st Source sponsored three trusts, 1st Source Capital
Trust II, III and IV (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 Capital Trust II, III and IV
are payable quarterly 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.
The capital securities held by the Capital Trusts qualify as Tier 1 capital for
1st Source under Federal Reserve Board guidelines. On March 1, 2005, the Federal
Reserve issued rules that retain Tier 1 capital treatment for trust preferred
securities but with stricter limits. Under the final rules, after a five-year
transition period, the aggregate amount of trust preferred securities and
certain other capital elements will retain its current limit of 25% of Tier 1
capital elements, net of goodwill. The amount of trust preferred securities and
certain other elements in excess of the limit could be included in Tier 2
capital, subject to restrictions. These new rules have no impact on 1st Source's
Tier 1 capital.
The subordinated notes are summarized as follows, at December 31, 2005:
Amount of Interest Maturity
(Dollars in thousands) Subordinated Notes Rate Date
- --------------------------------------------------------------------------------
March 1997 issuance-floating rate $ 17,784 6.26% 03/31/27
November 2002 issuance-floating rate 10,310 6.95% 11/15/32
September 2004 issuance-fixed rate 30,928 7.66% 12/15/34
- --------------------------------------------------------------------------------
Total $ 59,022
================================================================================
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%.
42
Note M -- Employee Benefit Plans
1st Source maintains the 1st Source Profit Sharing Plan which includes a defined
contribution profit sharing and savings plan and a defined contribution money
purchase pension plan covering the majority of its employees.
The defined contribution profit sharing and savings 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, 2005, 2004,
and 2003, amounted to $2.21 million, $1.65 million, and $1.99 million,
respectively.
Contributions to the defined contribution money purchase pension plan are based
on 2% of participants' eligible compensation. For the years ended December 31,
2005, 2004, and 2003, total pension expense for this plan amounted to $0.86
million, $0.72 million, and $0.87 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, 2005, 2004, and 2003, amounted to
$0.14 million, $0.13 million, and $0.16 million, respectively.
In addition to the 1st Source Profit Sharing Plan, 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 life insurance is $3,000.
1st Source's net periodic postretirement benefit cost recognized in the
consolidated financial statements for the years ended December 31, 2005, 2004,
and 2003 amounted to $0.33 million, $0.10 million, and ($0.34) million,
respectively. 1st Source's accrued postretirement benefit cost was not material
at December 31, 2005, 2004 and 2003.
Note N -- Income Taxes
Income tax expense was comprised of the following:
Year Ended December 31 (Dollars in thousands) 2005 2004 2003
- --------------------------------------------------------------------------------
Current:
Federal $ 16,625 $ 2,920 $ 9,226
State 1,909 870 2,315
- --------------------------------------------------------------------------------
Total current 18,534 3,790 11,541
- --------------------------------------------------------------------------------
Deferred:
Federal (2,644) 4,610 (2,697)
State (264) 736 (815)
- --------------------------------------------------------------------------------
Total deferred (2,908) 5,346 (3,512)
- --------------------------------------------------------------------------------
Total provision $ 15,626 $ 9,136 $ 8,029
================================================================================
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:
2005 2004 2003
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 $ 17,282 35.0% $ 11,935 35.0% $ 9,514 35.0%
(Decrease) increase in income taxes resulting from:
Tax-exempt interest income (1,749) (3.5) (1,782) (5.2) (1,969) (7.3)
State taxes, net of federal income tax benefit 1,069 2.2 1,044 3.1 975 3.6
Dividends received deduction (188) (0.4) (1,607) (4.7) (48) (0.2)
Other (788) (1.6) (454) (1.4) (443) (1.6)
- ---------------------------------------------------- ------------------ ------ ----- ------------- ------------------------ --------
Total $ 15,626 31.7% $ 9,136 26.8% $ 8,029 29.5%
====================================================================================================================================
The tax expense (benefit) applicable to securities gains and losses for the
years 2005, 2004 and 2003 was $134,000, $(1,808,000) and $(1,508,000),
respectively.
43
Deferred tax assets and liabilities as of December 31, 2005 and 2004
consisted of the following:
Year Ended December 31 (Dollars in thousands) 2005 2004
- ----------------------------------------------------------------------------------------- -----------
Deferred tax assets:
Reserve for loan and lease losses $ 23,060 $ 26,396
Accruals for employee benefits 5,120 3,680
Net unrealized losses on securities available-for-sale 2,013 184
Securities valuation reserve 1,150 (134)
Alternative minimum tax - 2,567
Other 1,010 1,637
- ----------------------------------------------------------------------------------------- -----------
Total deferred tax assets 32,353 34,330
- ----------------------------------------------------------------------------------------- -----------
Deferred tax liabilities:
Differing depreciable bases in premises and leased equipment 34,433 40,141
Mortgage servicing 7,534 8,278
Differing bases in assets related to acquisitions 959 1,734
Other 2,732 2,219
- ----------------------------------------------------------------------------------------- -----------
Total deferred tax liabilities 45,658 52,372
- ----------------------------------------------------------------------------------------- -----------
Net deferred tax liability $ 13,305 $ 18,042
=====================================================================================================
Note 0 -- Contingent Liabilities, Commitments, and Financial Instruments with
Off-Balance-Sheet Risk
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.
COMMITMENTS -- 1st Source and its subsidiaries are obligated under operating
leases for certain office premises and equipment. In 1982, 1st Source sold the
headquarters building and entered into a leaseback agreement with the purchaser.
At December 31, 2005, the remaining term of the lease was six 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, $2.87 million in 2006, $2.25 million in 2007, $1.89 million in
2008, $1.63 million in 2009, $1.28 million in 2010, and $2.09 million,
thereafter. As of December 31, 2005, 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) 2005 2004 2003
- ---------------------------------------------------------------------------
Gross rental expense $ 3,574 $ 3,075 $ 3,216
Sublease rental income (1,809) (1,558) (1,502)
- ---------------------------------------------------------------------------
Net rental expense $ 1,765 $ 1,517 $ 1,714
===========================================================================
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 are essentially the same as
those involved in extending loan commitments to customers.
44
As of December 31, 2005 and 2004, 1st Source and its subsidiaries had
commitments outstanding to originate and purchase mortgage loans aggregating
$130.73 million and $106.61 million, respectively. Outstanding commitments to
sell loans aggregated $98.39 million at December 31, 2005, and $83.82 million at
December 31, 2004. Standby letters of credit totaled $76.43 million and $90.67
million at December 31, 2005 and 2004, respectively. Standby letters of credit
have terms ranging from six months to one year.
Note P -- Derivative Financial Instruments
1st Source has certain interest rate derivative positions that are not
designated as hedging instruments. These derivative positions relate to
transactions in which 1st Source enters into an interest rate swap with a client
while at the same time entering into an offsetting interest rate swap with
another financial institution. In connection with each transaction, 1st Source
agrees to pay interest to the client on a notional amount at a variable interest
rate and receive interest from the client on a same notional amount at a fixed
interest rate. At the same time, 1st Source agrees to pay another financial
institution the same fixed interest rate on the same notional amount and receive
the same variable interest rate on the same notional amount. The transaction
allows 1st Source's client to effectively convert a variable rate loan to a
fixed rate. Because 1st Source acts as an intermediary for its client, changes
in the fair value of the underlying derivative contracts offset each other and
do not impact 1st Source's results of operations. At December 31, 2005, the
notional amount of non-hedging interest rate swaps was $5.61 million.
Note Q -- 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 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 that 1st Source meets all capital adequacy requirements to
which it is subject.
As of December 31, 2005, 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 L, the capital securities held by the Capital Trusts
qualify as Tier 1 capital for 1st Source under Federal Reserve Board guidelines.
The actual capital amounts and ratios of 1st Source and its largest subsidiary,
the Bank, as of December 31, 2005, 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 $ 421,771 14.90% $ 226,521 8.00% $ 283,151 10.00%
1st Source Bank 397,061 14.29% 222,211 8.00% 277,763 10.00%
Tier I Capital (to Risk-Weighted Assets):
Consolidated 384,685 13.59% 113,261 4.00% 169,891 6.00%
1st Source Bank 361,760 13.02% 111,105 4.00% 166,658 6.00%
Tier I Capital (to Average Assets):
Consolidated 384,685 11.42% 134,725 4.00% 168,406 5.00%
1st Source Bank 361,760 11.02% 131,327 4.00% 164,159 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, 2005 and 2004, were approximately $8.45 million and $4.81 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 2006 of $56.97 million, plus an additional amount equal to
its net profits for 2006, as defined by statute, up to the date of any such
dividend declaration.
1st Source's mortgage subsidiary, Trustcorp, is required to maintain minimum net
worth capital requirements established by various governmental agencies.
Trustcorp's net worth requirements are governed by the Department of Housing and
Urban Development and GNMA. As of December 31, 2005, Trustcorp met its minimum
net worth capital requirements.
45
Note R -- Fair Values of Financial Instruments
The fair values of 1st Source's financial instruments as of December 31, 2005
and 2004 are summarized in the table below.
2005 2004
Carrying or Carrying or
(Dollars in thousands) Contract Value Fair Value Contract Value Fair Value
- ------------------------------------------------------------- ------------------------ -------------------------------- ------------
Assets:
Cash and due from banks $ 124,817 $ 124,817 $ 78,255 $ 78,255
Federal funds sold and interest bearing deposits with other banks 68,578 68,578 220,131 220,131
Investment securities, available-for-sale 632,625 632,625 789,923 789,923
Mortgages held for sale 67,224 67,448 55,711 55,821
Loans and leases, net of reserve for loan and lease losses 2,404,734 2,380,891 2,216,496 2,221,357
Interest rate swaps 65 65 - -
- ------------------------------------------------------------- ------------------------ -------------------------------- ------------
Liabilities:
Deposits $ 2,745,587 $ 2,750,212 $ 2,807,003 $ 2,816,693
Short-term borrowings 277,469 277,469 299,662 299,662
Long-term debt and mandatorily redeemable securities 23,237 23,065 17,964 18,033
Subordinated notes 59,022 58,619 59,022 59,767
Interest rate swaps 65 65 652 652
Off-balance-sheet instruments * - (431) - (593)
====================================================================================================================================
* 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.
LOANS AND LEASES -- For variable rate loans and leases that reprice frequently
and with no significant change in credit risk, fair values are based on carrying
values. The fair values 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 and
leases are estimated using discounted cash flow analyses which use interest
rates currently being offered for loans and leases with similar terms to
borrowers of similar credit quality.
DEPOSITS -- The fair values for all deposits other than time deposits are equal
to the amounts payable on demand (the carrying value). Fair values of variable
rate time deposits are equal to their carrying values. Fair values for fixed
rate time deposits are estimated using discounted cash flow analyses using
interest rates currently being offered for deposits with similar remaining
maturities.
SHORT-TERM BORROWINGS -- The carrying values of Federal funds purchased,
securities sold under repurchase agreements, and other short-term borrowings,
including 1st Source's liability related to mortgage loans available for
repurchase under GNMA optional repurchase programs, approximate their fair
values.
LONG-TERM DEBT AND MANDATORILY REDEEMABLE SECURITIES -- The fair values of 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 calculated 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.
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 specific 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 do not reflect any premium or discount that could result from
offering for sale at one time 1st Source's entire holdings of a particular
financial instrument. These estimates are subjective in nature and require
considerable judgment to interpret market data. Accordingly, the estimates
presented herein are not necessarily indicative of the amounts 1st Source could
46
realize in a current market exchange, nor are they intended to represent the
fair value of 1st Source as a whole. The use of different market assumptions
and/or estimation methodologies may have a material effect on the estimated fair
value amounts. The fair value estimates presented herein are based on pertinent
information available to management as of the respective balance sheet date.
Although management is not aware of any factors that would significantly affect
the estimated fair value amounts, such amounts have not been comprehensively
revalued since the presentation dates, and therefore, estimates of fair value
after the balance sheet date may differ significantly from the amounts presented
herein.
Other significant assets, such as mortgage banking operation, premises and
equipment, other assets, and liabilities not defined as financial instruments,
are not included in the above disclosures. 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 S -- 1st Source Corporation (Parent Company Only) Financial Information
STATEMENTS OF FINANCIAL CONDITION
December 31 (Dollars in thousands) 2005 2004
- ----------------------------------------------------------------------------- ------------------------------------------------------
ASSETS
- ------
Cash $ 1 $ 2
Short-term investments with bank subsidiary 11,562 5,233
Investment securities, available-for-sale
(amortized cost of $12,893 and $17,740 at December 31, 2005 and 2004, respectively) 15,282 20,037
Investments in:
Bank subsidiaries 376,538 355,421
Non-bank subsidiaries 9,544 8,134
Loan receivables:
Non-bank subsidiaries 6,000 7,000
Premises and equipment, net 2,143 2,330
Other assets 8,074 5,952
- ----------------------------------------------------------------------------- ------------------------------------------ -----------
Total assets $ 429,144 $ 404,109
====================================================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
- ------------------------------------
Commercial paper borrowings $ 4,800 $ 836
Other liabilities 3,033 1,385
Long-term debt and mandatorily redeemable securities 75,735 75,288
- ----------------------------------------------------------------------------- ------------------------------------------ -----------
Total liabilities 83,568 77,509
Shareholders' equity 345,576 326,600
- ------------------------------------------------------------------------ ----------------------------------------------- -----------
Total liabilities and shareholders' equity $ 429,144 $ 404,109
====================================================================================================================================
47
STATEMENTS OF INCOME
Year Ended December 31 (Dollars in thousands) 2005 2004 2003
- ------------------------ ---------------------------------------------------------- ------------------- ----------- -----------
Income:
Dividends from bank and non-bank subsidiaries $ 11,552 $ 9,749 $ 8,715
Rental income from subsidiaries 2,472 829 2,668
Other 3,286 2,721 1,306
- ----------------------------------------------------------------------------------- ------------------- ----------- -----------
Total income 17,310 13,299 12,689
- ----------------------------------------------------------------------------------- ------------------- ----------- -----------
Expenses:
Interest on long-term debt and mandatorily redeemable securities 5,040 4,869 4,725
Interest on commercial paper and other short-term borrowings 73 10 26
Rent expense 1,059 1,059 1,059
Other 2,352 2,705 1,998
- ----------------------------------------------------------------------------------- ------------------- ----------- -----------
Total expenses 8,524 8,643 7,808
- ----------------------------------------------------------------------------------- ------------------- ----------- -----------
Income before income tax benefit and equity in undistributed income of subsidiaries 8,786 4,656 4,881
Income tax benefit 897 2,269 1,386
- ----------------------------------------------------------------------------------- ------------------- ----------- -----------
Income before equity in undistributed income of subsidiaries 9,683 6,925 6,267
Equity in undistributed income of subsidiaries:
Bank subsidiaries 24,057 19,832 13,285
Non-bank subsidiaries 11 (1,792) (398)
- ----------------------------------------------------------------------------------- ------------------- ----------- -----------
Net income $ 33,751 $ 24,965 $ 19,154
===============================================================================================================================
STATEMENTS OF CASH FLOWS
Year Ended December 31 (Dollars in thousands) 2005 2004 2003
- ------------------------ ---------------------------------------------------------- ------------------- ----------- -----------
Operating activities:
Net income $ 33,751 $ 24,965 $ 19,154
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in undistributed income of subsidiaries (24,068) (18,040) (12,887)
Depreciation of premises and equipment 305 283 338
Realized and unrealized investment securities (gains)losses (72) 851 1,092
Other (218) 523 (820)
- ------------------------------------------------ ---------------------------------- ------------------- ----------- -----------
Net cash from operating activities 9,698 8,582 6,877
- ------------------------------------------------ ---------------------------------- ------------------- ----------- -----------
Investing activities:
Proceeds from sales and maturities of investment securities 15,356 6,645 1,895
Purchases of investment securities (10,361) - (313)
Net change in premises and equipment (118) (264) (262)
(Increase) decrease in short-term investments with bank subsidiary (6,329) (2,080) 1,926
Decrease (increase) in loans made to subsidiaries, net 1,000 (285) (1,715)
Capital contributions to subsidiaries (1,460) - -
Return of capital from subsidiaries - 500 -
- ----------------------------------------------------------------------------------- ------------------- ----------- -----------
Net cash (used in) from investing activities (1,912) 4,516 1,531
- ----------------------------------------------------------------------------------- ------------------- ----------- -----------
Financing activities:
Net increase (decrease) in commercial paper and other short-term borrowings 3,964 (146) (2,456)
Proceeds from issuance of subordinated notes - 30,929 -
Payments on subordinated notes - (28,351) -
Proceeds from issuance of long-term debt 311 18 47
Payments on long-term debt (44) (5,048) (94)
Net proceeds from issuance of treasury stock 528 3,253 2,598
Acquisition of treasury stock (2,221) (4,958) (646)
Cash dividends (10,325) (8,863) (7,789)
- ----------------------------------------------------------------------------------- ------------------- ----------- -----------
Net cash used in financing activities (7,787) (13,166) (8,340)
- ----------------------------------------------------------------------------------- ------------------- ----------- -----------
Net change in cash and cash equivalents (1) (68) 68
Cash and cash equivalents, beginning of year 2 70 2
Cash and cash equivalents, end of year $ 1 $ 2 $ 70
===============================================================================================================================
48
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE.
None
ITEM 9A. CONTROLS AND PROCEDURES.
MANAGEMENT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
- --------------------------------------------------------------
Management of 1st Source Corporation ("1st Source") is responsible for
establishing and maintaining adequate internal control over financial reporting.
1st Source's internal control over financial reporting includes policies and
procedures pertaining to 1st Source's ability to record, process, and report
reliable information. Actions are taken to correct any deficiencies as they are
identified through internal and external audits, regular examinations by bank
regulatory agencies, 1st Source's formal risk management process, and other
means. 1st Source's internal control system is designed to provide reasonable
assurance to 1st Source's management and Board of Directors regarding the
preparation and fair presentation of 1st Source's published financial
statements.
All internal control systems, no matter how well designed, have inherent
limitations. Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial statement
preparation and presentation. Further, because of changes in conditions, the
effectiveness of internal control may vary over time.
1st Source's management assessed the effectiveness of internal control over
financial reporting as of December 31, 2005. In making this assessment, it used
the criteria set forth by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) in Internal Control -- Integrated Framework. Based on
management's assessment, we believe that, as of December 31, 2005, 1st Source's
internal control over financial reporting is effective based on those criteria.
Ernst & Young LLP, independent registered public accounting firm, has issued an
attestation report on management's assessment of 1st Source's internal control
over financial reporting. This report appears on page 25.
/s/ CHRISTOPHER J. MURPHY III /s/ LARRY E. LENTYCH
- ----------------------------- --------------------
Christopher J. Murphy III, Larry E. Lentych,
Chief Executive Officer Chief Financial Officer
South Bend, Indiana
ITEM 9B. OTHER INFORMATION.
None
49
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information under the caption "Proposal Number 1: Election of Directors,"
"Board Committees and other Corporate Governance Matters," and "Section 16(a)
Beneficial Ownership Reporting Compliance" of the 2006 Proxy Statement is
incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION.
The information under the caption "Remuneration of Executive Officers" of the
2006 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 2006 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 445,291 $ 27.97 -
2001 stock option plan 82,748 19.32 1,917,252
1997 employee stock purchase plan 22,863 22.08 165,847
1982 executive incentive plan - - 100,000 (1)(2)
1982 restricted stock award plan - - 172,362 (1)
- --------------------------------------------- ----------------------------- ---------------------------- ------------------- -----
Total plans approved by shareholders 550,902 $ 26.43 2,355,461
- --------------------------------------------- ----------------------------- ---------------------------- ------------------- -----
Equity compensation plans
not approved by shareholders - - -
- --------------------------------------------- -------------------------------- ----------------------------- --------------------
Total equity compensation plans 550,902 $ 26.43 2,355,461
==================================================================================================================================
(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.
The information under the caption "Proposal Number 1: Election of Directors" of
the 2006 Proxy Statement is incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
The information under the caption "Relationship with Independent Registered
Public Accounting Firm" of the 2006 Proxy Statement is incorporated herein by
reference.
50
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
(a) Financial Statements and Schedules:
The following Financial Statements and Supplementary Data are filed as part
of this annual report:
Reports of Independent Registered Public Accounting Firm
Consolidated statements of financial condition -- December 31, 2005 and
2004
Consolidated statements of income -- Years ended December 31, 2005, 2004,
and 2003
Consolidated statements of shareholders' equity -- Years ended December 31,
2005, 2004, and 2003
Consolidated statements of cash flows -- Years ended December 31, 2005,
2004, and 2003
Notes to consolidated financial statements -- December 31, 2005, 2004, and
2003
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) 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 incorporated herein by
reference.
4(a) Form of Common Stock Certificates of Registrant filed as exhibit to
Registration Statement 2-40481 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)(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.
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 incorporated herein by reference.
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 incorporated herein by reference.
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(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.
51
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.
10(j) Contract with Fiserv Solutions, Inc., dated November 23, 2005, filed
as exhibit to Form 10-K, dated, December 31, 2005, and incorporated
Inc. dated 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 II Delaware
1st Source Capital Trust III Delaware
1st Source Capital Trust IV 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
*Wholly-owned subsidiaries of 1st Source Bank
23 Consent of Ernst & Young LLP, Independent Registered Public Accounting
Firm.
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.
(c) Financial Statement Schedules -- None.
52
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: March 3, 2006
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, March 3, 2006
Christopher J. Murphy III President and
Chief Executive Officer
/s/ WELLINGTON D. JONES III Executive Vice President March 3, 2006
- ------------------------------- and Director
Wellington D. Jones III
/s/ LARRY E. LENTYCH Treasurer, March 3, 2006
- ------------------------------- Chief Financial Officer
Larry E. Lentych and Principal Accounting Officer
/s/ JOHN B. GRIFFITH Secretary March 3, 2006
- ------------------------------- and General Counsel
John B. Griffith
/s/ DAVID C. BOWERS Director March 3, 2006
- -------------------------------
David C. Bowers
/s/ DANIEL B. FITZPATRICK Director March 3, 2006
- -------------------------------
Daniel B. Fitzpatrick
/s/ TERRY L. GERBER Director March 3, 2006
- -------------------------------
Terry L. Gerber
/s/ LAWRENCE E. HILER Director March 3, 2006
- -------------------------------
Lawrence E. Hiler
/s/ WILLIAM P. JOHNSON Director March 3, 2006
- -------------------------------
William P. Johnson
/s/ CRAIG A. KAPSON Director March 3, 2006
- -------------------------------
Craig A. Kapson
/s/ REX MARTIN Director March 3, 2006
- -------------------------------
Rex Martin
/s/ DANE A. MILLER Director March 3, 2006
- -------------------------------
Dane A. Miller
/s/ TIMOTHY K. OZARK Director March 3, 2006
- -------------------------------
Timothy K. Ozark
/s/ JOHN T. PHAIR Director March 3, 2006
- -------------------------------
John T. Phair
/s/ MARK D. SCHWABERO Director March 3, 2006
- -------------------------------
Mark D. Schwabero
/s/ TOBY S. WILT Director March 3, 2006
- -------------------------------
Toby S. Wilt