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, 2004
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 whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes [x] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [x] No [ ]
The aggregate market value of the voting common stock held by non-affiliates of
the registrant as of June 30, 2004 was $256,337,615.
The number of shares outstanding of each of the registrant's classes of stock as
of February 9, 2005: Common Stock, without par value -- 20,725,043 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the annual proxy statement for the 2005 annual meeting of
shareholders to be held April 28, 2005, are incorporated by reference into Part
III.
TABLE OF CONTENTS
Part I
Item 1. Business 3
Item 2. Properties 8
Item 3. Legal Proceedings 8
Item 4. Submission of Matters to a Vote of Security Holders 8
Part II
Item 5. Market for Registrant's Common Equity,
Related Stockholder Matters and Issuer Purchases of
Equity Securities 8
Item 6. Selected Financial Data 9
Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations 9
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 50
Item 13. Certain Relationships and Related Transactions 50
Item 14. Principal Accounting Fees and Services 50
Part IV
Item 15. Exhibits, Financial Statement Schedules 51
Signatures 53
PART I
ITEM 1. BUSINESS.
GENERAL
1st Source Corporation is an Indiana corporation and registered bank holding
company headquartered in South Bend, Indiana, which commenced operations as a
bank holding company in 1971. As used herein, unless the context otherwise
requires, the term "1st Source" refers to 1st Source Corporation and its
subsidiaries. At December 31, 2004, 1st Source had assets of $3.56 billion,
loans and leases of $2.28 billion, deposits of $2.81 billion, and total
shareholders' equity of $326.60 million.
1st Source, through its principal subsidiary 1st Source Bank (hereafter known as
"Bank"), delivers a comprehensive range of consumer and commercial banking
services to individual and business customers through 62 banking locations in
the northern Indiana and southwestern Michigan regional market area. The Bank
also competes for business nationwide by offering 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. The Bank, which was chartered as an
Indiana state bank in 1922, is a member of the Federal Reserve System and its
deposits are insured by the Federal Deposit Insurance Corporation (FDIC) to the
extent provided by law. The Bank is headquartered in South Bend, Indiana, which
is in northern Indiana, approximately 95 miles east of Chicago and 140 miles
north of Indianapolis. Its principal regional market area consists of 15
counties.
The principal executive office of 1st Source is located at 100 North Michigan
Street, South Bend, Indiana 46601 and its telephone number is 574 235-2000.
Access to 1st Source's annual report on Form 10-K, quarterly reports on Form
10-Q, current reports on Form 8-K, and all amendments to those reports is
available at www.1stsource.com soon after the material is electronically filed
with the Securities Exchange Commission (SEC).
BANKING AND FINANCIAL SERVICES
1st Source offers a broad range of consumer and commercial banking services
through its lending operations, retail branches, and fee based businesses.
COMMERCIAL, AGRICULTURAL, AND REAL ESTATE LOANS -- 1st Source's commercial and
agriculture loans (excluding Specialty Finance Group loans and leases) at
December 31, 2004, were $425.02 million and were 18.64% of total loans and
leases outstanding. The primary focus of this lending area is with
privately-held or closely-controlled firms in 1st Source's regional market area.
Loans secured by real estate amounted to $583.44 million, which was 25.59% of
total loans and leases outstanding, at December 31, 2004. The primary focus of
this lending area is commercial real estate ($388.06 million at December 31,
2004, the majority of which is owner occupied) and residential mortgage lending
($195.38 million at December 31, 2004) in the regional market area. Most of the
residential mortgages are sold into the secondary market and serviced by 1st
Source's mortgage subsidiary, Trustcorp Mortgage Company (Trustcorp). Mortgage
loans held for sale were $55.71 million at December 31, 2004.
1st Source offers both fixed-rate and adjustable-rate consumer mortgage loans
secured by the properties, substantially all of which are located in 1st
Source's primary market area. Adjustable-rate mortgage loans help reduce 1st
Source's exposure to changes in interest rates; 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.
Commercial and commercial real estate loans generally involve higher credit
risks than residential real estate and consumer loans. Because payments on loans
secured by commercial real estate or equipment are often dependent upon the
successful operation and management of the collateral, repayment of such loans
may be influenced to a great extent by conditions in the market or the economy.
1st Source seeks to minimize these risks through its underwriting standards,
which require such loans to be qualified on the basis of the collateral's income
and debt service ratio. 1st Source obtains extensive financial information and
performs detailed credit risk analysis on its customers. 1st Source's credit
policy sets different maximum exposure limits depending on its relationship and
previous experience with each customer. Credit criteria may include, but are not
limited to, assessments of net worth, asset ownership, bank and trade credit
reference, credit bureau report, and operational history.
CONSUMER LOANS -- 1st Source's consumer loans at December 31, 2004, amounted to
$99.25 million and 4.35% of total loans and leases outstanding. Consumer loans
are primarily all other non-real estate loans to individuals in 1st Source's
regional market area.
Consumer loans can entail risk, particularly in the case of loans that are
unsecured or secured by rapidly depreciating assets. In these cases, any
repossessed collateral may not provide an adequate source of repayment of the
outstanding loan balance. The remaining deficiency often does not warrant
further substantial collection efforts against the borrower beyond obtaining a
deficiency judgment. In addition, consumer loan collections are dependent on the
borrower's continuing financial stability, and thus are more likely to be
adversely affected by job loss, divorce, illness, or personal bankruptcy.
SPECIALTY FINANCE GROUP LOANS AND LEASES -- 1st Source's Specialty Finance Group
provides a broad range of comprehensive lease and equipment finance products
addressing the financing needs of diverse companies. This Group can be broken
down into four areas: auto, light truck, and environmental equipment financing;
medium and heavy duty truck financing; aircraft financing; and construction
equipment financing. The finance receivables generally provide for monthly
payments and may include prepayment penalty provisions.
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 financing at December 31, 2004, had outstandings of
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$263.64 million. 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 at December 31, 2004, had outstandings of
$267.83 million. 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 to aircraft dealers, charter
operators, air cargo carriers, and corporate aircraft users. Aircraft financing
at December 31, 2004, had outstandings of $444.48 million. 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 to
construction related companies. Construction equipment financing at December 31,
2004, had outstandings of $196.52 million. Construction equipment finance
receivables generally range from $100,000 to $7 million with fixed or variable
interest rates and terms of three to seven years.
1st Source also generates equipment rental income through the leasing of
construction equipment, various automobiles, and other equipment to customers
through operating leases. Total equipment rental income for 2004 totaled $18.86
million with depreciation on this equipment amounting to $15.32 million.
Specialty Finance Group loans and leases are subject to the same credit risk as
mentioned above in the discussion under Commercial, Agricultural, and Real
Estate Loans. In addition, 1st Source's leasing and equipment financing activity
is subject to the risk of cyclical downturns and other adverse economic
developments affecting these industries and markets. This area of lending, with
transportation in particular, is dependent upon general economic conditions and
the strength of the travel and transportation industries. For a further
discussion of business risk, see Part II, Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operations -- section titled
"Business Risks."
1st Source markets its specialty finance services with sales officers based in
23 locations nationwide. 1st Source markets its financing and leasing services
directly to the equipment end users for the acquisition or leasing of equipment,
and for capital loans.
1st Source's Specialty Finance Group marketing activities are relationship
driven and service oriented. 1st Source focuses on providing prompt, responsive,
and customized service to its customers and business prospects with a team of
dedicated marketing and management personnel who solicit business from the users
of the equipment, as well as from dealers and manufacturers. 1st Source's
relationship managers and executive personnel have, on average, over twenty
years of experience in the industries they serve. Management believes that the
knowledge base and relationships built by this team enables 1st Source to
compete effectively. The team's experience with the customer and prospect base,
equipment values, resale markets, and economic and industry conditions places
1st Source in a strong competitive position. 1st Source's initiatives include
making timely credit decisions, arranging financing structures which meet the
customers' needs as well as 1st Source's underwriting criteria, providing direct
contact between customers and 1st Source executives with decision-making
authority, and providing swift and knowledgeable responses to customers'
inquiries and issues.
1st Source's Specialty Finance Group obtains business in several ways. Officers
travel throughout their own geographic territories calling directly on
prospects. Officers receive referrals from present customers, as well as from
dealers, manufacturers, and some select, targeted advertising. Officers also
attend numerous trade shows.
1st Source's Specialty Finance Group has developed relationships with over 100
manufacturers, whereby on a non-exclusive basis, the manufacturers refer
customers to 1st Source for financing. However, 1st Source does not provide a
captive finance service, and thus has no expressed or written agreements or
obligations with any manufacturers. All prospects referred undergo the same
credit and documentation criteria as other customers.
DEPOSITS -- Through its network of 62 banking centers, 1st Source generates
deposits to fund its lending activities. Total deposits at December 31, 2004,
were $2.81 billion. To enhance customer service, in addition to its traditional
branches, 1st Source offers banking services through its network of 69 automated
teller machines, bank by phone services, and online personal and business
financial products. Service charges on deposit accounts totaled $16.23 million
in 2004.
FEE BASED BUSINESSES -- 1st Source maintains various fee based businesses to
complement net interest income.
Trust fees (which include investment management fees, estate administration
fees, mutual fund annuity fees, and fiduciary fees) are generated from employee
benefit services, personal and agency trusts, and estate administration. In
2004, trust fees were $12.36 million. The market value of trust assets under
management at December 31, 2004 was $2.41 billion. At December 31, 2004, these
trust assets were comprised of $815.85 million of employee benefit services,
$1.25 billion of personal and agency trusts, $164.27 million of estate
administration assets, and $180.24 million of custody assets.
Mortgage banking income for 2004 amounted to $9.55 million. Income from loan
sale and servicing is generated from the mortgage banking operations of
Trustcorp. Trustcorp serviced approximately $1.91 billion of mortgage loans at
December 31, 2004. During 2004, $0.28 million of impairment charges were
recovered on Trustcorp's mortgage servicing assets.
Insurance commissions from 1st Source's property and casualty insurance agency
totaled $3.70 million for 2004.
SERVICES OFFERED BY THE NON-BANKING SUBSIDIARIES
1st Source's other subsidiaries include 1st Source Leasing, Inc., a leasing
subsidiary; 1st Source Insurance, Inc., a general property and casualty
insurance agency; 1st Source Capital Corporation, a licensed small business
investment company; Michigan Transportation Finance Corporation, 1st Source
Specialty Finance, Inc., SFG Equipment Leasing, Inc., 1st Source Intermediate
Holding, LLC, 1st Source Commercial Aircraft Leasing Inc., SFG Equipment Leasing
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Corporation I, and Capstone 557 (Proprietary) Limited, companies that manage the
assets of the Specialty Finance Group; Trustcorp Mortgage Company, a mortgage
banking company with five offices in Indiana and Ohio, and 1st Source
Corporation Investment Advisors, Inc., a registered investment advisory
subsidiary, that provides investment management services to the 1st Source
Monogram Funds and the trust and investment clients of 1st Source Bank. 1st
Source's two inactive subsidiaries are FBT Capital Corporation and 1st Source
Funding, LLC. 1st Source's unconsolidated subsidiaries include, 1st Source
Capital Trust I, II, III, and IV (1st Source was in the process of dissolving
1st Source Capital Trust I at December 31, 2004). These subsidiaries were
created to issue trust preferred securities. During the third quarter of 2004,
1st Source issued $30.00 million of trust preferred securities through a newly
formed subsidiary, 1st Source Capital Trust IV. The net proceeds of the trust
preferred securities issued were used by 1st Source to redeem $27.50 million of
trust preferred securities which were issued by 1st Source Capital Trust I in
1997. At December 31, 2004, the balance of 1st Source's total issuance of trust
preferred securities was $57.25 million.
COMPETITION
The activities in which 1st Source and the Bank engage are highly competitive.
These activities and the geographic markets served primarily involve competition
with other banks, some of which are affiliated with large bank holding companies
headquartered outside of 1st Source's principal market. Larger financial
institutions competing within 1st Source's principal market, but headquartered
elsewhere, include Fifth Third Bank, Key Bank, National City Bank, Standard
Federal Bank, JPMorgan Chase (Bank One), and Wells Fargo Bank. Competition among
financial institutions is based upon interest rates offered on deposit accounts,
interest rates charged on loans and leases, 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 intermediaries, such as credit unions,
industrial loan associations, securities firms, insurance companies, small loan
companies, finance companies, mortgage companies, real estate investment trusts,
certain governmental agencies, credit organizations, and other enterprises.
Additional competition for depositors' funds comes from United States Government
securities, private issuers of debt obligations, and suppliers of other
investment alternatives for depositors. Many of 1st Source's non-bank
competitors are not subject to the same extensive federal regulations that
govern bank holding companies and banks. Such non-bank competitors may, as a
result, have certain advantages over 1st Source in providing some services.
1st Source competes against these financial institutions by offering 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
employees have with their customers, and the capacity for quick local
decision-making.
EMPLOYEES
1st Source employs approximately 1,200 persons on a full-time equivalent basis.
1st Source provides a wide range of employee benefits and considers employee
relations to be good.
REGULATION AND SUPERVISION
GENERAL -- 1st Source and the Bank are extensively regulated under federal and
state law. These laws and regulations are intended to protect depositors, not
shareholders. To the extent that the following information describes statutory
or regulatory provisions, it is qualified in its entirety by reference to the
particular statutory and regulatory provisions. Any change in applicable laws or
regulations may have a material effect on the business and prospects of 1st
Source. The operations of 1st Source may be affected by legislative changes and
by the policies of various regulatory authorities. 1st Source is unable to
predict the nature or the extent of the effects on its business and earnings
that fiscal or monetary policies, economic controls, or new federal or state
legislation may have in the future.
1st Source is a registered bank holding company under the Bank Holding Company
Act of 1956 (BHCA) and, as such, is subject to regulation, supervision, and
examination by the Board of Governors of the Federal Reserve System (Federal
Reserve). 1st Source is required to file annual reports with the Federal Reserve
and to provide the Federal Reserve such additional information as it may
require.
The Bank, as an Indiana state bank and member of the Federal Reserve System, is
supervised by the Indiana Department of Financial Institutions (DFI) and the
Federal Reserve. As such, the Bank is regularly examined by and subject to
regulations promulgated by the DFI and the Federal Reserve. Because the FDIC
provides deposit insurance to the Bank, the Bank is also subject to supervision
and regulation by the FDIC (even though the FDIC is not its primary federal
regulator).
BANK 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.
5
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, 2004,
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.
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 (the Act)
is intended to modernize the banking industry by removing barriers to
affiliation among banks, insurance companies, the securities industry, and other
financial service providers. It provides financial organizations with the
flexibility of structuring such affiliations through a holding company structure
or through a financial subsidiary of a bank, subject to certain limitations. The
Act establishes a new type of bank holding company, known as a financial holding
company, that may engage in an expanded list of activities that are "financial
in nature," which include securities and insurance brokerage, securities
underwriting, insurance underwriting, and merchant banking. The Act also sets
forth a system of functional regulation that makes the Federal Reserve the
"umbrella supervisor" for holding companies, while providing for the supervision
of the holding company's subsidiaries by other federal and state agencies. A
bank holding company may not become a financial holding company if any of its
subsidiary financial institutions are not well-capitalized or well-managed.
Further, each bank subsidiary of the holding company must have received at least
a satisfactory Community Reinvestment Act (CRA) rating. The Act also expands the
types of financial activities a national bank may conduct through a financial
subsidiary, addresses state regulation of insurance, generally prohibits unitary
thrift holding companies organized after May 4, 1999, from participating in new
financial activities, provides privacy protection for nonpublic customer
information of financial institutions, modernizes the Federal Home Loan Bank
system, and makes miscellaneous regulatory improvements. The Federal Reserve and
the Secretary of the Treasury must coordinate their supervision regarding
approval of new financial activities to be conducted through a financial holding
company or through a financial subsidiary of a bank. While the provisions of the
Act regarding activities that may be conducted through a financial subsidiary
directly apply only to national banks, those provisions indirectly apply to
state-chartered banks. In addition, the Bank is subject to other provisions of
the Act, including those relating to CRA and privacy, regardless of whether 1st
Source elects to become a financial holding company or to conduct activities
through a financial subsidiary of the Bank. 1st Source does not, however,
currently intend to file notice with the Board to become a financial holding
company or to engage in expanded financial activities through a financial
subsidiary of the Bank.
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 P 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 and certain
regulations of the Federal Reserve generally prohibit a bank from extending
credit, engaging in a lease or sale of property, or furnishing services to a
6
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 $6.60 million and less than $45.4 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 $45.4 million.
DIVIDENDS -- The ability of the Bank to pay dividends and management fees is
limited by various state and federal laws, by the regulations promulgated by its
primary regulators, and by the principles of prudent bank management.
MONETARY POLICY AND ECONOMIC CONTROL -- The commercial banking business in which
1st Source engages is affected not only by general economic conditions, but also
by the monetary policies of the Federal Reserve. Changes in the discount rate on
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, President Bush signed into law
the Sarbanes-Oxley Act of 2002 (SOA). 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.)
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.
Although 1st Source will incur additional expenses in complying with the
provisions of the SOA and the resulting regulations, management does not expect
that such compliance will have a material impact on 1st Source's results of
operations or financial condition.
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.
7
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% presently subleased to unrelated tenants.
1st Source also owns property and/or buildings on which 41 of the Bank
subsidiary's 62 banking centers are located, including the facilities in Allen,
Elkhart, Fulton, Huntington, Kosciusko, LaPorte, Marshall, Porter, St. Joseph,
Starke, and Wells Counties in the State of Indiana and Berrien County in the
State of Michigan, as well as 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, 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.
2004 Cash 2003 Cash
Common Stock Prices Sales Price Dividends Sales Price Dividends
(quarter ended) High Low Paid High Low Paid
- --------------------------------------------------------------------------------
March 31 $ 24.90 $ 20.96 $.100 $ 17.52 $ 12.80 $ .090
June 30 25.50 20.35 .100 19.50 12.57 .090
September 30 26.04 22.30 .110 21.80 17.00 .090
December 31 28.09 25.15 .110 22.64 18.85 .100
================================================================================
As of December 31, 2004, there were 1,085 holders of record of 1st Source common
stock.
The following table summarizes share repurchase activity of 1st Source during
the three months ended December 31, 2004.
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, 2004 - $ - - 649,070
November 01-30, 2004 411 26.27 411 648,659
December 01-31, 2004 - - - 648,659
====================================================================================================================================
*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 390,331 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 P of the Notes to Consolidated Financial Statements.
8
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) 2004 2003 2002 2001 2000
Interest income $ 151,437 $ 162,322 $ 199,503 $ 245,566 $ 238,222
Interest expense 52,749 59,070 80,817 126,957 134,288
- ----------------------------------------- --------- ------------ ---- ----------- ---- ----------- ----- ----------- ---- ----------
Net interest income 98,688 103,252 118,686 118,609 103,934
Provision for loan and lease losses 229 17,361 39,657 25,745 11,836
- ----------------------------------------- --------- ------------ ---- ----------- ---- ----------- ----- ----------- ---- ----------
Net interest income after provision for
loan and lease losses 98,459 85,891 79,029 92,864 92,098
Noninterest income 62,733 80,196 73,117 87,026 68,553
Noninterest expense 127,091 138,904 140,741 121,683 104,513
- ----------------------------------------- --------- ------------ ---- ----------- ---- ----------- ----- ----------- ---- ----------
Income before income taxes 34,101 27,183 11,405 58,207 56,138
Income taxes 9,136 8,029 1,366 19,709 18,565
- ----------------------------------------- --------- ------------ ---- ----------- ---- ----------- ----- ----------- ---- ----------
Net income $ 24,965 $ 19,154 $ 10,039 $ 38,498 $ 37,573
- ----------------------------------------- --------- ------------ ---- ----------- ---- ----------- ----- ----------- ---- ----------
Assets at year-end $ 3,563,715 $ 3,330,153 $ 3,407,468 $ 3,562,691 $ 3,182,181
Long-term debt and mandatorily redeemable
securities at year-end 17,964 22,802 16,878 11,939 12,060
Shareholders' equity at year-end 326,600 314,691 309,429 306,190 270,572
Basic net income per common share* 1.21 0.92 0.48 1.85 1.81
Diluted net income per common share* 1.19 0.91 0.47 1.82 1.79
Cash dividends per common share* .420 .370 .360 .351 .334
Dividend payout ratio 35.29% 40.66% 76.60% 19.29% 18.66%
Return on average assets 0.75% 0.59% 0.29% 1.14% 1.24%
Return on average common equity 7.81% 6.12% 3.23% 13.14% 14.88%
Average common equity to average assets 9.55% 9.60% 8.95% 8.69% 8.31%
====================================================================================================================================
*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" about
1st Source. Generally, the words "believe," "expect," "intend," "estimate,"
"anticipate," "project," "will," and similar expressions indicate
forward-looking statements. Those statements, including statements, projections,
estimates, or assumptions concerning future events or performance, and other
statements that are other than statements of historical fact, are subject to
material risks and uncertainties. 1st Source cautions readers not to place undue
reliance on any forward-looking statements, which speak only as of the date
made. 1st Source may make other written or oral forward-looking statements from
time to time. Readers are advised that various important factors could cause 1st
Source's actual results or circumstances for future periods to differ materially
from those anticipated or projected in such forward-looking statements. Such
factors include, but are not limited to, changes in laws, regulations, or U.S.
generally accepted accounting principles; 1st Source's competitive position
within its markets served; increasing consolidation within the banking industry;
unforeseen changes in interest rates; unforeseen changes in loan prepayment
assumptions; unforeseen downturns in the local, regional, or national economies
or in the industries in which 1st Source has credit concentrations; and the
matters described under Business Risks, below. 1st Source undertakes no
obligation to publicly update or revise any forward-looking statements.
BUSINESS RISKS
Like all other banking and financial service companies, 1st Source's
business and results of operations are subject to a number of risks, many of
which are outside of 1st Source's control. In addition to the other information
in this report, readers should carefully consider that the following important
factors, among others, could materially impact 1st Source's business and future
results of operations.
1ST SOURCE'S SUCCESS DEPENDS ON ITS ABILITY TO COMPETE EFFECTIVELY IN THE
COMPETITIVE FINANCIAL SERVICES INDUSTRY -- 1st Source and its operating
subsidiaries encounter strong competition for deposits, loans and leases, and
other financial services in all of its lines of business. 1st Source's principal
competitors include other commercial banks, savings banks, credit unions,
savings and loan associations, mutual funds, money market funds, finance
companies, trust companies, insurers, leasing companies, mortgage companies,
private issuers of debt obligations, venture capital firms, and suppliers of
other investment alternatives, such as securities firms and insurance companies.
9
Some of its non-bank competitors are not subject to the same degree of
regulation as 1st Source and its subsidiaries and have advantages over 1st
Source in providing certain services. Many of 1st Source's competitors are
significantly larger and have greater access to capital and other resources. In
recent years, there has been substantial consolidation among companies in the
financial services industry. Such consolidation may increase competition.
Further, 1st Source's ability to compete effectively is dependent on its ability
to adapt successfully to technological and other changes within the banking and
financial services industry.
1ST SOURCE'S BUSINESS MAY BE ADVERSELY AFFECTED BY THE HIGHLY REGULATED
ENVIRONMENT IN WHICH IT OPERATES -- 1st Source's failure to comply with the many
requirements of state and federal law could lead to termination or suspension of
its licenses, rights of rescission for borrowers, class action lawsuits, and
administrative enforcement actions. Recently enacted and future legislation and
regulations may have a significant impact on the financial services industry.
Regulatory or legislative changes could increase 1st Source's costs of doing
business, restrict its access to new products or markets, cause 1st Source to
change some of its products or the way it operates its different lines of
business, or otherwise adversely affect its operations or the manner in which it
conducts its business and, on the whole, adversely affect the profitability of
its businesses.
1ST SOURCE MAY BE ADVERSELY AFFECTED BY A GENERAL DETERIORATION IN ECONOMIC
CONDITIONS -- The risks associated with 1st Source's business are greater in
periods of a slowing economy or recession. Economic declines may be accompanied
by a decrease in demand for consumer and commercial credit and declining real
estate and other asset values. Declining real estate and other asset values,
particularly transportation related equipment, may reduce the ability of
borrowers to use such equity to support borrowings. Delinquencies, foreclosures,
and losses generally increase during economic slow downs or recessions.
Additionally, 1st Source's servicing costs, collection costs, and credit losses
may also increase in periods of economic slow down or recession.
1ST SOURCE IS SUBJECT TO CREDIT RISK INHERENT IN ITS LOAN AND LEASE PORTFOLIOS
- -- In the financial services industry, there is always a risk that certain
borrowers may not repay borrowings. 1st Source maintains a reserve for loan and
lease losses to absorb the level of losses that it estimates to be probable in
its portfolios. However, its 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 in its local business loan portfolio, and
changes in national economic conditions could adversely affect the quality of
its Specialty Finance Group's portfolio.
CERTAIN 1ST SOURCE LENDING PRODUCT LINES COULD CONTINUE TO EXPERIENCE SLOW DOWNS
- -- 1st Source has specialty national businesses in commercial loans and leases
secured by transportation and construction equipment, including the financing of
aircraft for dealers and air cargo operators, and the financing of vehicles for
the rental and leasing industries. 1st Source's aircraft and automobile rental
businesses were adversely affected by the slow down in the economy over the past
two years. Aircraft and used automobile values dropped precipitously. Customers
who rely on the use of aircraft or automobiles to produce income were negatively
affected, and 1st Source experienced substantial loan and lease losses in 2002
and 2003 primarily in its aircraft and auto rental financing units. Since some
of the relationships in these industries are large (up to $15 million), a
continued slow down could have a significant adverse impact on 1st Source's
performance.
1ST SOURCE COULD BE ADVERSELY IMPACTED BY THE NEGATIVE EFFECTS CAUSED BY
TERRORIST ATTACKS, POTENTIAL ATTACKS, AND OTHER DESTABILIZING EVENTS -- These
factors could contribute to the deterioration of the quality of our loan and
lease portfolio, as they could have a negative impact on the travel sensitive
businesses for which 1st Source provides financing.
1ST SOURCE'S FINANCIAL PERFORMANCE DEPENDS IN PART ON ITS ABILITY TO DEVELOP,
MARKET, AND DELIVER NEW AND INNOVATIVE PRODUCTS AND SERVICES THROUGH THE USE OF
TECHNOLOGY -- Developing and implementing such technology may require
significant financial investments and staff time, may be more difficult or
expensive to implement than anticipated, and there is no guarantee that the end
result will be attractive to 1st Source customers.
1ST SOURCE MAY BE ADVERSELY AFFECTED BY INTEREST RATE CHANGES -- Although 1st
Source actively manages its interest rate sensitivity, such management is not an
exact science. Rapid increases or decreases in interest rates could adversely
affect its net interest margin if changes in its cost of funds do not correspond
to changes in income yields. Such fluctuations could also continue to negatively
impact its mortgage banking operations, which are very interest rate sensitive,
by increasing the runoff rates in the servicing portfolio, reducing loan
origination activities, or increasing funding costs. An increase in interest
rates that adversely affects the ability of borrowers to pay the principal or
interest on loans and leases may lead to an increase in nonperforming assets and
a reduction of interest accrued into income, which could have a material adverse
effect on 1st Source's results of operations. 1st Source recorded non-cash
valuation adjustments in 2004, 2003, and 2002 for (recoveries)/impairment of the
carrying value of the mortgage servicing assets held by Trustcorp.
PROVISIONS IN 1ST SOURCE'S RESTATED ARTICLES OF INCORPORATION, BY-LAWS, AND
INDIANA LAW MAY DELAY OR PREVENT AN ACQUISITION OF 1ST SOURCE BY A THIRD PARTY
- -- 1st Source's restated articles of incorporation, by-laws, and Indiana law
contain provisions that may make it more difficult for a third party to acquire
1st Source without the consent of its Board of Directors. These provisions could
also discourage proxy contests and may make it more difficult for shareholders
to elect their own representatives as directors and take other corporate
actions.
Among other provisions, 1st Source's articles of incorporation authorize its
Board of Directors to issue shares of preferred stock and to determine its
terms, preferences, and other rights without shareholder approval. The issuance
of preferred stock could discourage a third party from acquiring control of the
company.
1st Source's by-laws do not permit cumulative voting of shareholders in the
election of directors, allowing the holders of a majority of its outstanding
shares to control the election of all its directors. 1st Source's by-laws also
provide that only its Board of Directors, and not its shareholders, may adopt,
alter, amend, and repeal its by-laws.
10
Indiana law provides several limitations that may discourage potential acquirers
from purchasing its common shares. In particular, Indiana law prohibits business
combinations with a person who acquires 10% or more of its common shares during
the five-year period after the acquisition of 10% by that person or entity,
unless the acquirer receives prior approval for the acquisition of the shares or
business combination from its Board of Directors.
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), which begins on page 31, 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,
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" on page 32.
MORTGAGE SERVICING RIGHTS VALUATION -- 1st Source recognizes as assets the
rights to service mortgage loans for others, known as mortgage servicing rights
whether the servicing rights are acquired through purchases or through
originated loans. Mortgage servicing rights do not trade in an active open
market with readily observable market prices. Although sales of mortgage
servicing rights do occur, the precise terms and conditions may not be readily
available. As such, the value of mortgage servicing assets are established and
valued using discounted cash flow modeling techniques which require management
to make estimates regarding estimated future net servicing cash flows, taking
into consideration actual and expected mortgage loan prepayment rates, discount
rates, servicing costs, and other economic factors. The expected and actual
rates of mortgage loan prepayments are the most significant factors driving the
value of mortgage servicing assets. Increases in mortgage loan prepayments
reduce estimated future net servicing cash flows because the life of the
underlying loan is reduced. In determining the fair value of the mortgage
servicing assets, mortgage interest rates, which are used to determine
prepayment rates, and discount rates are held constant over the estimated life
of the portfolio. Expected mortgage loan prepayment rates are derived from a
third-party model and adjusted to reflect 1st Source's actual prepayment
experience. Mortgage servicing assets are carried at the lower of the initial
capitalized amount, net of accumulated amortization or fair value. The values of
these assets are sensitive to changes in the assumptions used and readily
available market pricing does not exist. The valuation of mortgage servicing
assets is discussed further in Note A under the heading "Mortgage Banking
Activities" on page 32.
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" on page 31.
EARNINGS SUMMARY
Net income in 2004 was $24.97 million, up from $19.15 million in 2003 and up
from $10.04 million in 2002. Diluted net income per common share was $1.19 in
2004, $0.91 in 2003, and $0.47 in 2002. Return on average total assets was 0.75%
in 2004 compared to 0.59% in 2003, and 0.29% in 2002. Return on average common
equity was 7.81% in 2004 versus 6.12% in 2003 and 3.23% in 2002.
Net income in 2004 was favorably affected by a reduced provision for loan and
lease losses and reduced loan and lease collection and repossession expense as
credit quality improved. In addition, salaries and employee benefit expense
declined and trust and deposit fee income increased. Net income was unfavorably
affected by decreased net interest margins due to the interest rate environment
and a lower yielding earning asset base. The interest rate environment also
caused a decline in mortgage banking income. In addition, equipment rental
income decreased and professional fees increased. Net income for 2004 also
included $4.78 million of other-than-temporary impairment on investment
securities.
Dividends declared on common stock in 2004 amounted to $.420 per share, compared
to $.370 per share in 2003, and $.360 in 2002. 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.
11
SECURITIZED LOAN PORTFOLIO PURCHASE -- In December 2003, the Bank purchased its
securitized loan portfolio for $226 million. For several years, 1st Source
originated and serviced loans sold to and owned by the 1st Source Master Trust.
The loans were secured by business or personal use aircraft or by 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. At the time of purchase the Bank
established a loss reserve of $6.82 million against the portfolio, which was
consistent with loss reserves maintained for the Bank's on-balance sheet
portfolios. The transaction did not materially change 1st Source's overall loan
loss reserve as a percentage of loans outstanding, nor did it have a material
impact on the results of operations in 2003.
NET INTEREST INCOME -- Net interest income (the difference between income from
earning assets and the interest cost of funding those assets) is 1st Source's
primary source of earnings. Net interest income, on a fully taxable equivalent
basis, decreased 4.56% in 2004 following a 12.79% decrease in 2003.
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 3.25% in 2004 compared to 3.56% in 2003, and
3.87% in 2002. The net interest margin was negatively impacted in 2004, due to
the focus on higher quality credits which were priced at lower competitive
rates, the rewriting of fixed rate loans as customers took advantage of a lower
interest rate environment, and the increase of deposits of public funds late in
2004, which, given the temporary nature, could not be invested at a positive
spread. In addition, fees on loans and leases which are included in loan and
lease interest income decreased in 2004 from 2003 by $2.01 million due to the
recognition of these fees over the life of the loans and leases.
The average yield on earning assets in 2004 was 4.94%, compared to 5.54% in
2003, and 6.43% in 2002. Average earning assets in 2004 increased 4.71%
following a 5.33% decrease in 2003. The effective rate on interest bearing
liabilities was 2.04% in 2004 compared to 2.38% in 2003, and 2.95% for 2002.
12
The following table provides an analysis of net interest income and illustrates
the interest income earned and interest expense charged for each major component
of interest earning assets and interest bearing liabilities. The net interest
spread is the difference between the average yield earned on assets and the
average rate incurred on liabilities:
2004 2003 2002
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 $ 590,786 $ 16,361 2.77% $ 535,233 $ 18,410 3.44% $ 486,835 $ 21,359 4.39%
Tax-exempt(1) 171,600 7,502 4.37 167,740 8,306 4.95 152,343 8,865 5.82
Mortgages held for sale 69,964 3,868 5.53 112,157 6,496 5.79 118,546 7,881 6.65
Net loans and leases(2,3) 2,240,055 125,469 5.60 2,091,004 131,186 6.27 2,332,992 163,456 7.01
Other investments 49,585 952 1.92 75,488 916 1.21 58,916 1,078 1.83
- ----------------------------- -------------- ---------- -------- -------------- ---------- -------- ------------- ----------- ------
Total earning assets 3,121,990 154,152 4.94 2,981,622 165,314 5.54 3,149,632 202,639 6.43
Cash and due from banks 81,334 86,483 91,217
Reserve for loan and
lease losses (69,567) (63,123) (59,171)
Other assets 215,607 253,192 284,704
- ----------------------------- -------------- ---------- -------- -------------- ---------- -------- ------------- ----------- ------
Total assets $ 3,349,364 $ 3,258,174 $ 3,466,382
====================================================================================================================================
LIABILITIES AND
SHAREHOLDERS' EQUITY
Interest bearing deposits $ 2,105,013 $ 41,698 1.98% $ 2,145,467 $ 49,153 2.29% $ 2,408,801 $ 71,084 2.95%
Short-term borrowings 405,192 6,079 1.50 256,628 5,121 2.00 270,747 5,659 2.09
Subordinated notes 57,198 3,863 6.75 55,604 3,804 6.84 46,010 3,249 7.06
Long-term debt and
mandatorily redeemable
securities 22,921 1,109 4.84 20,132 992 4.93 13,066 825 6.31
- ---------------------------- -------------- ---------- -------- -------------- ---------- -------- ------------- ----------- -------
Total interest bearing
liabilities 2,590,324 52,749 2.04 2,477,831 59,070 2.38 2,738,624 80,817 2.95
Noninterest bearing deposits 384,157 413,794 362,509
Other liabilities 55,146 53,756 54,837
Shareholders' equity 319,737 312,793 310,412
- ---------------------------- -------------- ---------- -------- -------------- ---------- -------- ------------- ----------- -------
Total liabilities and
shareholders' equity $ 3,349,364 $ 3,258,174 $ 3,466,382
====================================================================================================================================
Net interest income $101,403 $106,244 $121,822
====================================================================================================================================
Net interest margin on a tax
equivalent basis 3.25% 3.56% 3.87%
====================================================================================================================================
(1) Interest income includes the effects of tax equivalent adjustments, using a
35% rate. Tax equivalent adjustments were $2,437 in 2004, $2,692 in 2003
and $2,828 in 2002.
(2) Loan and lease income includes fees on loans and leases of $1,336 in 2004,
$4,102 in 2003 and $5,042 in 2002. Loan and lease income also includes the
effects of tax equivalent adjustments, using a 35% rate. Tax equivalent
adjustments were $278 in 2004, $300 in 2003 and $308 in 2002.
(3) For purposes of this computation, nonaccruing loans and leases are included
in the average loan and lease balance outstanding.
13
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
- -------------------------------------------------------------------------------------- ----------
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)
=================================================================================================
2003 compared to 2002
Interest earned on:
Investment securities:
Taxable $ 2,531 $ (5,480) $ (2,949)
Tax-exempt 1,184 (1,743) (559)
Mortgages held for sale (405) (980) (1,385)
Net loans and leases (15,914) (16,356) (32,270)
Other investments 841 (1,003) (162)
- -------------------------------------------------------- ---------- ----------------- -----------
Total earning assets $(11,763) $ (25,562) $(37,325)
=================================================================================================
Interest paid on:
Interest bearing deposits $ (7,200) $ (14,731) $(21,931)
Short-term borrowings (300) (238) (538)
Subordinated notes 652 (97) 555
Long-term debt and mandatorily redeemable securities 280 (113) 167
- -------------------------------------------------------- ---------- ----------------- -----------
Total interest bearing liabilities $ (6,568) $ (15,179) $(21,747)
=================================================================================================
Net interest income $ (5,195) $ (10,383) $(15,578)
=================================================================================================
*The change in interest due to both rate and volume has been allocated to volume
and rate changes in proportion to the relationship of the absolute dollar
amounts of the change in each.
NONINTEREST INCOME -- Noninterest income for the most recent three years
ended December 31 was as follows:
(Dollars in thousands) 2004 2003 2002
- --------------------------------------------------------------------------------
Noninterest income:
Trust fees $ 12,361 $ 10,664 $ 10,252
Service charges on deposit accounts 16,228 15,532 14,947
Mortgage banking 9,553 19,635 7,766
Securitization income - 3,206 4,833
Insurance commissions 3,695 3,047 2,431
Equipment rental income 18,856 25,448 28,773
Other income 6,759 6,600 6,951
Investment securities and
other investment losses (4,719) (3,936) (2,836)
- --------------------------------------------------------------------------------
Total noninterest income $ 62,733 $ 80,196 $ 73,117
================================================================================
Noninterest income decreased 21.78% in 2004 from 2003 due to decreases in
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. Noninterest
income increased 9.68% in 2003 from 2002 primarily due to increased mortgage
banking income offset by decreased equipment rental income.
During 2004, the Bank and Trustcorp together produced $856.10 million in new
mortgages -- $140.75 million through the Bank; $236.73 million through
Trustcorp; and $478.62 million purchased from wholesale production sources.
Mortgage banking income decreased 51.35% in 2004 from 2003 compared to an
14
increase of 152.83% in 2003 from 2002. The 2004 decrease was the result of a
reduction in mortgage origination and sales due to a higher interest rate
environment in 2004 and the associated reduction in refinancing activity. In
2004, there was a recovery of impairment on mortgage servicing assets of $0.28
million versus impairment charges of $0.58 million and $7.33 million during 2003
and 2002, respectively. 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. Securitization income was down 33.66% in 2003
from 2002. In the first half of 2003, 1st Source allowed the Master Trust to
liquidate due to adequate capital and liquidity to hold the loans, otherwise
eligible for securitization, on the balance sheet, and the desire to eliminate
the expenses associated with the securitization. This resulted in lower gains on
loan sales and reduced servicing income for 2003. Servicing income was $3.50
million and $3.78 million in 2003 and 2002, respectively. Gains (losses) on loan
sales were $(0.30) million and $1.05 million in 2003 and 2002, respectively.
Trust fees increased by 15.91% in 2004 from 2003 compared to an increase of
4.02% in 2003 over 2002. These increases were reflective of strengthening sales
results as new clients brought assets to 1st Source for management and improved
asset management fees due to better market performance.
Service charges on deposit accounts increased 4.48% in 2004 from 2003 compared
to an increase of 3.91% in 2003 from 2002. The increase in 2004 was attributed
primarily to increased consumer overdraft fees. In 2003, overdraft, business
service, and debit card fees primarily accounted for the increase in service
charges on deposit accounts.
Premiums underwritten through 1st Source Insurance reached $30.64 million in
2004, a 15.63% increase over 2003. Insurance commissions continued to grow and
were up 21.27% in 2004 from 2003 compared to an increase of 25.34% in 2003 from
2002. The increases for 2004 and 2003 were attributed to growth in commercial
lines and higher premiums.
Equipment rental income generated from operating leases declined by 25.90%
during 2004 from 2003 compared to a decrease of 11.56% in 2003 from 2002.
Revenues from operating leases for construction equipment, automobiles, and
other equipment declined as customers in these industries opted to take
advantage of the tax benefits available for purchases of equipment versus
equipment rental.
Other income increased 2.41% in 2004 from 2003 compared to a decrease of 5.05%
in 2003 from 2002. The increase in 2004 from 2003 was primarily the result of
increased income on bank owned life insurance of $0.18 million. The decrease in
2003 from 2002 was primarily the result of the deferral of standby letters of
credit fees of $0.22 million.
In 2004, investment securities and other investment losses included $4.58
million of other-than-temporary impairment charges on investments in Federal
National Home Mortgage Association (FNMA) and the Federal Home Loan Mortgage
Corporation (FHLMC) preferred stock. 1st Source accounts for these securities in
accordance with Statements of Financial Accounting Standards (SFAS) No. 115,
"Accounting for Certain Investments in Debt and Equity Securities." Under SFAS
No. 115, if the decline in fair market value below cost is determined to be
other-than-temporary, the unrealized loss must be realized as expense in the
income statement. During 2004, based on a number of factors, including the
magnitude of the drop in market value below 1st Source's cost and the length of
time the market value had been below cost, 1st Source concluded that the decline
in value was other-than-temporary. Also, included in investment securities and
other investment losses in 2003 and 2002, were impairment charges on the
securitization retained asset of $2.99 million and $1.49 million, respectively.
The balance of the net investment securities and other investment losses in
2004, 2003, and 2002 were primarily the result of valuation adjustments on
venture capital and other investments.
NONINTEREST EXPENSE -- Noninterest expense for the recent three years ended
December 31 was as follows:
(Dollars in thousands) 2004 2003 2002
- --------------------------------------------------------------------------------------------------
Noninterest expense:
Salaries and employee benefits $ 63,083 $ 69,457 $ 67,398
Net occupancy expense 7,196 6,881 6,861
Furniture and equipment expense 10,290 10,363 10,719
Depreciation -- leased equipment 15,315 19,773 23,494
Professional fees 6,563 2,925 2,609
Supplies and communication 5,708 6,163 6,582
Business development and marketing expense 3,613 3,481 3,006
Intangible asset amortization 2,631 2,748 2,136
Loan and lease collection and repossession expense 4,946 8,112 9,851
Other expense 7,746 9,001 8,085
- --------------------------------------------------------------------------------------------------
Total noninterest expense $ 127,091 $ 138,904 $ 140,741
==================================================================================================
1st Source experienced a decrease in noninterest expense of 8.50% in 2004 from
2003 compared to a 1.31% decrease in 2003 from 2002. The leading factors
contributing to the decrease in noninterest expense in 2004 were reduced
salaries and benefits, decreased depreciation on leased equipment, and a decline
in loan and lease collection and repossession expenses offset by an increase in
professional fees.
Salaries and employee benefits decreased 9.18% in 2004 from 2003, following a
3.05% increase in 2003 from 2002. Salaries decreased 9.61% in 2004 and 2.55% in
2003. The largest component of the 2004 decrease was the impact of the
capitalization of an additional $3.21 million in salaries and benefits
15
in connection with the deferral of loan origination costs. In addition,
commission expense decreased $2.20 million as mortgage originations slowed in
2004 in comparison to the origination volume experienced in the prior year.
Employee benefits decreased 7.52% in 2004, following a 31.83% increase in 2003.
In 2004, employee benefits decreased due to a reduction in pension and profit
sharing expense and lower group insurance expense. In 2003, the change in
employee benefits was primarily the result of increased executive incentives
combined with an increase in group insurance expense. The number of full-time
equivalent employees was 1,201 at the end of 2004, compared to 1,220 and 1,233
at the end of 2003 and 2002, respectively.
Occupancy expense increased 4.57% in 2004 from 2003, compared to a 0.29%
increase in 2003 from 2002. During 2004, real estate property taxes increased as
the Indiana state wide property reassessment was finalized. During 2003, the
normal annual lease and operating cost increases exceeded the impact of three
branch closings.
Furniture and equipment expense, including depreciation, decreased in 2004 from
2003 by 0.71%, compared to a 3.32% decrease in 2003 from 2002. The decrease in
2004 was due to reduced equipment depreciation and repair expense offset by
increased software expense. The decrease in 2003 from 2002 was the result of
reduced equipment repair costs offset by increased computer processing charges.
Depreciation on operating leases decreased 22.55% in 2004 from 2003, following a
15.84% decrease in 2003 from 2002. Depreciation on operating leases declined in
conjunction with the decline in equipment owned under operating leases as
customers opted to take advantage of the tax benefits available for purchases of
equipment versus equipment rental.
Professional fees increased 124.38% in 2004 from 2003, compared to a 12.11%
increase in 2003 from 2002. 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. Professional fees also 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 7.38% in 2004 from 2003, compared
to a 6.37% decrease in 2003 from 2002. The decrease in 2004 and 2003 was due to
continued cost controls over printing and supplies and reduced communication
expense.
Business development and marketing expense increased 3.82% in 2004 from 2003,
compared to an increase of 15.77% in 2003 from 2002. During 2004, 1st Source
continued to engage in effective target advertising and marketing campaigns. The
increase in 2003 compared to 2002 was due to increased charitable contributions.
Intangible asset amortization decreased 4.28% in 2004 from 2003 compared to a
31.69% increase in 2003 from 2002. The reduction in 2004 was due to lower
amortization of intangibles related to insurance agency acquisitions. The
increase in 2003 from 2002 was attributed to the full year effect of
amortization on intangible assets due to branch acquisitions.
Loan and lease collection and repossession expenses decreased 39.03% or $3.17
million in 2004 from 2003, compared to a 17.65% or $1.74 million decrease in
2003 from 2002. In 2004, valuation adjustments on repossessed assets continued
to decrease along with a decrease in legal and collection expenses. These 2004
decreases were partially offset by valuation adjustments on equipment owned
under operating lease. The 2003 decrease was also the result of lower valuation
adjustments recorded on repossessed assets netted against increased legal and
collection efforts.
A decrease of 13.94% occurred in other expenses during 2004, compared to an
11.33% increase in 2003 from 2002. During 2004, 1st Source and Trustcorp
continued to experience favorable reductions in fraud and forgery losses
compared to 2003 and 2002. In addition, insurance costs, losses on the
disposition of fixed assets, and personal property taxes all declined compared
to 2003. These 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. The primary cause of the increase in 2003 from 2002 was
increased insurance costs and losses on the disposal of fixed assets.
INCOME TAXES -- 1st Source recognized income tax expense in 2004 of $9.14
million, compared to $8.03 million in 2003, and $1.37 million in 2002. The
effective tax rate in 2004 was 26.79% compared to 29.54% in 2003, and 11.98% in
2002. The effective tax rate declined in 2004 due to dividend received
deductions claimed for the period starting 2000 through 2004, reducing tax
expense by $1.61 million. 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) 2004 2003 2002 2001 2000
- -----------------------------------------------------------------------------------------------------------------------
Commercial and agricultural loans $ 425,018 $ 402,905 $ 428,367 $ 460,373 $ 496,303
Auto, light truck and environmental equipment 263,637 269,490 247,883 212,781 259,382
Medium and heavy duty truck 267,834 221,562 197,312 131,233 -
Aircraft financing 444,481 489,155 323,802 514,573 508,278
Construction equipment financing 196,516 219,562 303,126 328,004 272,250
Loans secured by real estate 583,437 533,749 567,950 586,580 593,287
Consumer loans 99,245 94,577 111,012 128,305 127,808
- ---------------------------------------------- ------------------------------------------------------------------------
Total loans and leases $ 2,280,168 $ 2,231,000 $ 2,179,452 $ 2,361,849 $ 2,257,308
=======================================================================================================================
At December 31, 2004, 14.5% 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 7.13% in 2004
following a 10.37% decrease in 2003. Loans and leases, net of unearned discount,
at December 31, 2004 were $2.28 billion and were 63.98% of total assets,
compared to $2.23 billion or 66.99% of total assets at December 31, 2003.
Commercial and agricultural lending outstandings, excluding those secured by
real estate, increased 5.49% during 2004. This increase was mainly due to
increased sales activity within the commercial loan and small business loan
areas coupled with improved market conditions.
Auto, light truck, and environmental equipment financing decreased 2.17% in 2004
from 2003. The decline in this portfolio was the result of a reduction in
automobile financing to the funeral industry.
Medium and heavy duty truck loans and leases experienced growth of $46.27
million, or an increase of 20.88%, in 2004. Much of this increase can be
attributed to rigorous sales efforts and the ability of the sales staff to
continue to produce in the available market for medium and heavy duty trucks.
Medium and heavy duty truck loans and leases were reclassified from auto, light
truck, and environmental equipment in 2001. This reclassification was made in
order to distinguish loans and leases secured by medium and heavy duty trucks
from auto, light truck, and environmental equipment for reporting purposes.
Aircraft financing at year-end 2004 decreased 9.13% from year-end 2003. This
decrease was mainly due to the intentional reduction of the portfolio in an
effort to reduce exposure in the commercial operator business segment.
Construction equipment financing decreased 10.50% in 2004 following a 27.57%
decrease in 2003. Much of this decrease can be attributed to the fact that this
division focused its efforts on attracting and servicing better credit quality
customers and management did not replace certain sales staff which left during
2004.
Loans secured by real estate increased 9.31% during 2004, of this increase 3.62%
was attributed to the inclusion of $19.31 million of Government National
Mortgage Association (GNMA) repurchase option loans in the loans secured by real
estate portfolio, in accordance with SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities." Improved
market conditions in this loan category also contributed to the increase.
Consumer loans increased 4.94% in 2004 compared to a decrease of 14.81% for
2003. Successful marketing to new and established customers 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, 2004. 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 $ 291,674 $ 131,506 $ 1,838 $ 425,018
Auto, light truck and environmental equipment 123,657 139,586 394 263,637
Medium and heavy duty truck 73,781 185,867 8,186 267,834
Aircraft financing 126,406 261,514 56,561 444,481
Construction equipment financing 74,083 120,785 1,648 196,516
- -------------------------------------------------------------- ------------- ----------------- -------------
Total $ 689,601 $ 839,258 $ 68,627 $ 1,597,486
============================================================================================================
Rate Sensitivity (Dollars in thousands) Fixed Rate Variable Rate Total
- -------------------------------------------------------------- ------------- ----------------- -------------
1 - 5 Years $ 561,707 $ 277,551 $ 839,258
Over 5 Years 11,252 57,375 68,627
- -------------------------------------------------------------- ------------- ----------------- -------------
Total $ 572,959 $ 334,926 $ 907,885
============================================================================================================
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 change. 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, 2004 totaled $63.67
million and was 2.79% of loans and leases, compared to $70.05 million or 3.14%
of loans and leases at December 31, 2003 and $59.22 million or 2.72% of loans
and leases at December 31, 2002. It is management's opinion that the reserve for
loan and leases losses is adequate to absorb losses inherent in the loan and
lease portfolio as of December 31, 2004.
The provision for loan and lease losses for 2004 was $0.23 million, compared to
$17.36 million in 2003 and $39.66 million in 2002. The decrease in the provision
is consistent with the lower charge-offs and the stabilization of the loan and
lease portfolio. Losses on loans to aircraft dealers and operators and loans and
leases secured by construction equipment decreased in 2004, and the aircraft
portfolio continued to show improving trends. Net (recoveries)/charge-offs to
aircraft dealers and operators were ($1.27) million, $5.25 million and $26.48
million in 2004, 2003, and 2002, 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) 2004 2003 2002 2001 2000
- ----------------------------------------------------------------------------------------------------------------------------
Amounts of loans and leases outstanding
at end of period $ 2,280,168 $ 2,231,000 $ 2,179,452 $ 2,361,849 $ 2,257,308
- ----------------------------------------------------------------------------------------------------------------------------
Average amount of net loans and leases
outstanding during period $ 2,240,055 $ 2,091,004 $ 2,332,992 $ 2,347,746 $ 2,156,489
- ----------------------------------------------------------------------------------------------------------------------------
Balance of reserve for loan and lease losses
at beginning of period $ 70,045 $ 59,218 $ 57,624 $ 44,644 $ 40,210
- ----------------------------------------------------------------------------------------------------------------------------
Charge-offs:
Commercial and agricultural loans 6,104 1,187 2,376 4,916 1,818
Auto, light truck and environmental equipment 2,408 2,789 6,380 753 109
Medium and heavy duty truck 352 69 771 - -
Aircraft financing 3,585 6,877 27,401 5,584 4,987
Construction equipment financing 686 4,712 2,326 762 393
Loans secured by real estate 456 344 340 215 30
Consumer loans 1,090 1,560 2,127 2,102 1,738
- ----------------------------------------------------------------------------------------------------------------------------
Total charge-offs 14,681 17,538 41,721 14,332 9,075
- ----------------------------------------------------------------------------------------------------------------------------
Recoveries:
Commercial and agricultural loans 1,312 519 1,311 328 298
Auto, light truck and environmental equipment 1,277 1,182 616 71 631
Medium and heavy duty truck 14 - - - -
Aircraft financing 4,460 1,698 759 92 230
Construction equipment financing 547 248 465 129 50
Loans secured by real estate 107 11 26 - 2
Consumer loans 362 523 481 351 462
- ----------------------------------------------------------------------------------------------------------------------------
Total recoveries 8,079 4,181 3,658 971 1,673
- ----------------------------------------------------------------------------------------------------------------------------
Net charge-offs 6,602 13,357 38,063 13,361 7,402
Provisions charged to operating expense 229 17,361 39,657 25,745 11,836
Reserves acquired in acquisitions - 6,823 - 596 -
- ----------------------------------------------------------------------------------------------------------------------------
Balance at end of period $ 63,672 $ 70,045 $ 59,218 $ 57,624 $ 44,644
============================================================================================================================
Ratio of net charge-offs to average net
loans and leases outstanding 0.29% 0.64% 1.63% 0.57% 0.34%
============================================================================================================================
Net charge-offs as a percentage of average loans and leases by
portfolio type follow:
2004 2003 2002 2001 2000
- -------------------------------------------------------------- --------------- -------------- -------------- ----------
Commercial and agricultural loans 1.14% 0.16% 0.23% 0.96% 0.31%
Auto, light truck and environmental equipment 0.43 0.62 2.27 0.29 (0.21)
Medium and heavy duty truck 0.14 0.03 0.47 - -
Aircraft financing (0.19) 1.73 6.40 1.03 1.04
Construction equipment financing 0.07 1.67 0.55 0.21 0.13
Loans secured by real estate 0.06 0.06 0.05 0.04 0.01
Consumer loans 0.77 1.04 1.39 1.37 1.02
- -------------------------------------------------------------- --------------- -------------- -------------- ----------
Total net charge-offs to average portfolio
loans and leases 0.29% 0.64% 1.63% 0.57% 0.34%
=======================================================================================================================
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):
2004 2003 2002 2001 2000
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
Loans Loans Loans Loans Loans
Reserve and Reserve and Reserve and Reserve and Reserve and
(Dollars in thousands) Amount Leases Amount Leases Amount Leases Amount Leases Amount Leases
- ----------------------------- -------- ---------- --------- ---------- --------- ---------- --------- ---------- --------- ---------
Commercial and agricultural loans $13,612 18.64% $ 9,589 18.06% $11,163 19.65% $14,247 19.49% $15,532 21.99%
Truck and automobile financing 12,633 23.31 13,966 22.01 11,006 20.43 9,924 14.57 5,764 11.49
Aircraft financing 26,475 19.49 31,733 21.93 21,603 14.86 19,987 21.79 12,884 22.52
Construction equipment financing 4,502 8.62 9,061 9.84 9,394 13.91 6,463 13.89 5,304 12.06
Loans secured by real estate 4,187 25.59 3,798 23.92 3,656 26.06 4,268 24.84 2,692 26.28
Consumer loans 2,263 4.35 1,898 4.24 2,396 5.09 2,735 5.42 2,468 5.66
- ----------------------------- -------- ---------- --------- ---------- --------- ---------- --------- ---------- --------- ---------
Total $63,672 100.00% $70,045 100.00% $59,218 100.00% $57,624 100.00% $44,644 100.00%
====================================================================================================================================
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. Nonperforming assets
amounted to $33.21 million at December 31, 2004 compared to $36.83 million at
December 31, 2003, and $64.12 million at December 31, 2002. Impaired loans and
leases totaled $47.22 million, $60.04 million, and $60.10 million at December
31, 2004, 2003, and 2002, respectively. During 2004, interest income that would
have been recorded on nonaccrual loans and leases under their original terms was
$3.21 million, compared to $3.66 million in 2003. Interest income that was
recorded on nonaccrual loans and leases was $0.94 million and $0.84 million in
2004 and 2003, respectively.
The overall decrease in nonperforming assets for 2004 was primarily related to a
decrease in aircraft and medium and heavy duty truck nonaccrual loans and leases
and the liquidation of repossessed aircraft, offset by an increase in commercial
nonaccrual loans.
Nonperforming assets at December 31 (Dollars in thousands) 2004 2003 2002 2001 2000
- -----------------------------------------------------------------------------------------------------------------------------------
Loans past due over 90 days $ 481 $ 212 $ 154 $ 453 $ 385
Nonaccrual loans and leases and restructured loans:
Commercial and agricultural loans 6,928 2,795 4,819 6,580 8,044
Auto, light truck and environmental equipment 2,336 2,419 4,730 3,746 1,769
Medium and heavy duty truck 179 1,823 1,384 - -
Aircraft financing 10,132 12,900 12,281 16,365 2,725
Construction equipment financing 4,097 4,663 9,844 5,126 3,026
Loans secured by real estate 1,141 1,786 2,191 3,349 2,755
Consumer loans 440 699 415 659 849
- -----------------------------------------------------------------------------------------------------------------------------------
Total nonaccrual loans and leases and restructured loans 25,253 27,085 35,664 35,825 19,168
- -----------------------------------------------------------------------------------------------------------------------------------
Total nonperforming loans and leases 25,734 27,297 35,818 36,278 19,553
- -----------------------------------------------------------------------------------------------------------------------------------
Other real estate 1,307 3,010 4,362 3,137 1,698
Repossessions:
Commercial and agricultural loans - 34 - - 157
Auto, light truck and environmental equipment 1,112 847 1,364 2,590 341
Medium and heavy duty truck - - - - -
Aircraft financing 3,037 4,551 19,242 770 1,700
Construction equipment financing 183 753 681 53 913
Consumer loans 50 78 56 96 100
- -----------------------------------------------------------------------------------------------------------------------------------
Total repossessions 4,382 6,263 21,343 3,509 3,211
- -----------------------------------------------------------------------------------------------------------------------------------
Operating leases 1,785 257 2,594 369 534
- -----------------------------------------------------------------------------------------------------------------------------------
Total nonperforming assets $ 33,208 $ 36,827 $ 64,117 $ 43,293 $ 24,996
====================================================================================================================================
Nonperforming loans and leases to loans and leases,
net of unearned discount 1.13% 1.22% 1.64% 1.54% 0.87%
====================================================================================================================================
Nonperforming assets to loans and leases and operating
leases, net of unearned discount 1.42% 1.59% 2.79% 1.74% 1.06%
====================================================================================================================================
19
POTENTIAL PROBLEM LOANS AND LEASES -- At December 31, 2004, the Bank had a
$3.69 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, 2004, 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 2004 increased 3.43% from 2003, following a 17.93%
increase from year-end 2002 to year-end 2003. Securities at December 31, 2004
were $789.92 million or 22.17% of total assets, compared to $763.76 million or
22.93% of total assets at December 31, 2003.
The carrying amounts of securities available-for-sale as of December 31 are
summarized as follows:
(Dollars in thousands) 2004 2003 2002
- --------------------------------------------------------------------------------
U.S. Treasury and government agencies,
including agency mortgage-backed securities $ 548,654 $ 504,722 $ 391,653
States and political subdivisions 172,516 171,515 156,010
Other securities 68,753 87,526 99,954
- --------------------------------------------------------------------------------
Total securities available-for-sale $ 789,923 $ 763,763 $ 647,617
================================================================================
The following table shows the maturities of securities available-for-sale at
December 31, 2004, at the carrying amounts and the weighted average yields of
such securities:
(Dollars in thousands) Amount Yield(1)
- -----------------------------------------------------------------------------
U.S. Treasuries and agencies,
including agency mortgage-backed securities
Under 1 year $ 195,146 2.27%
1 - 5 years 302,823 2.78
5 - 10 years 606 7.18
Over 10 years 50,079 3.82
- -----------------------------------------------------------------------------
Total U.S. Treasuries and agencies,
including agency mortgage-backed securities 548,654 2.70
- -----------------------------------------------------------------------------
State and political subdivisions
Under 1 year 22,997 5.17
1 - 5 years 137,014 4.08
5 - 10 years 12,505 4.53
Over 10 years - -
- -----------------------------------------------------------------------------
Total state and political subdivisions 172,516 4.26
- -----------------------------------------------------------------------------
Other securities
Under 1 year 65 7.45
1 - 5 years 3,834 3.03
5 - 10 years 75 6.55
Over 10 years 316 3.07
Marketable equity securities 64,463 4.90
- -----------------------------------------------------------------------------
Total other securities 68,753 4.78
- -----------------------------------------------------------------------------
Total securities available-for-sale $ 789,923 3.21%
=============================================================================
(1) Weighted average yields are based on amortized cost. Yields on tax-exempt
obligations are calculated on a fully tax equivalent basis assuming a 35% tax
rate. Marketable equity securities are excluded.
20
DEPOSITS
The average daily amounts of deposits and rates paid on such deposits are
summarized as follows:
2004 2003 2002
(Dollars in thousands) Amount Rate Amount Rate Amount Rate
- --------------------------------------------------- ---------- ------------ -------- -------------- ------
Noninterest bearing demand deposits $ 384,157 -% $ 413,794 -% $ 362,509 -%
Interest bearing demand deposits 707,168 0.88 645,131 0.79 686,763 1.40
Savings deposits 228,836 0.29 233,737 0.53 232,067 1.20
Other time deposits 1,169,009 2.98 1,266,599 3.38 1,489,971 3.94
- --------------------------------------------------- ---------- ------------ -------- -------------- ------
Total $ 2,489,170 $ 2,559,261 $ 2,771,310
==========================================================================================================
The amount of certificates of deposit of $100,000 or more and other time
deposits of $100,000 or more outstanding at December 31, 2004, by time remaining
until maturity is as follows:
(Dollars in thousands)
- ----------------------------------------------------------------------------
Under 3 months $ 118,825
4 - 6 months 35,987
7 - 12 months 42,216
Over 12 months 112,968
- ----------------------------------------------------------------------------
Total $ 309,996
============================================================================
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
- ------------------------------------------------------------------------------------------------------------------------
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 %
- -------------------------------------------------------------------------------------------------------------------------
2002
Balance at December 31, 2002 $ 212,040 $ 2,814 $ 45,824 $ 260,678
Maximum amount outstanding at any month-end 266,370 5,580 86,059 358,009
Average amount outstanding 218,009 4,023 48,715 270,747
Weighted average interest rate during the year 1.36 % 1.64 % 5.40 % 2.09 %
Weighted average interest rate for outstanding amounts at
December 31, 2002 0.65 % 1.06 % 1.76 % 0.85 %
=========================================================================================================================
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 2004, average core deposits equaled 66.97% of
average total assets, compared to 70.83% in 2003 and 66.56% in 2002. The
effective cost rate of core deposits in 2004 was 1.59%, compared to 1.81% in
2003 and 2.40% in 2002.
Average demand deposits (noninterest bearing core deposits) decreased 7.16% in
2004 compared to an increase of 14.15% in 2003. These represented 17.13% of
total core deposits in 2004, compared to 17.93% in 2003, and 15.71% in 2002.
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 2004, 1st Source's
reliance on purchased funds increased to 19.45% of average total assets from
15.60% in 2003.
SHAREHOLDERS' EQUITY -- Average shareholders' equity equated to 9.55% of average
total assets in 2004 compared to 9.60% in 2003. Shareholders' equity was 9.16%
of total assets at year-end 2004, compared to 9.45% at year-end 2003. In
accordance with 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 gain (loss) on available-for-sale securities, net of income taxes,
was ($0.30) million and $2.36 million at December 31, 2004 and 2003,
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. Under the current interest rate swaps
assumed from the Master Trust, 1st Source has agreements with another party to
exchange, at specific intervals, the difference between fixed-rate and
floating-rate interest amounts as calculated by reference to a notional amount
as a means to convert floating rate liabilities to a fixed rate. The notional
amounts totaled $90.00 million at December 31, 2004. At December 31, 2004, the
consolidated statement of financial condition was asset sensitive by $76.44
million more assets than liabilities scheduled to reprice within one year, or
approximately 1.04%.
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,
2004. The aggregate hypothetical increase in pre-tax earnings is estimated to be
$0.95 million on an annualized basis on all rate-sensitive financial
instruments, based on a hypothetical increase of a 100 basis point change in
interest rates. The aggregate hypothetical decrease in pre-tax earnings is
estimated to be $3.99 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.
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, 2004, except for
22
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.
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 - $ 1,648,376 $ - $ - $ - $ - $ 1,648,376
Certificates of deposit - 665,386 337,064 137,427 18,750 - 1,158,627
Long-term debt and mandatorily
redeemable securities J 233 10,439 326 873 6,093 17,964
Subordinated notes L - - - 59,022 - 59,022
Operating leases O 2,402 3,965 3,062 3,535 - 12,964
Purchase obligations - 11,594 2,519 524 - - 14,637
- ------------------------------- ------- --------------- ---- ---------- ---- ---------- ----- --------- ----- --------- ------------
Total contractual obligations $ 2,327,991 $ 353,987 $ 141,339 $ 82,180 $ 6,093 $ 2,911,590
====================================================================================================================================
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, 2004. 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, 2004 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 customers. 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
customers. These financial instruments include commitments to extend credit and
standby letters of credit. Further discussion of these commitments is included
in Part II, Item 8, Financial Statements and Supplementary Data -- Note 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
- ----------------------------------------------------------------------------------------------------------------------------
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
- ---------------------------------------------------------- ------------------------ ------------- -------------- ------------
2003
Interest income $ 42,729 $ 42,553 $ 38,991 $ 38,049
Interest expense 16,173 15,813 14,447 12,637
Net interest income 26,556 26,740 24,544 25,412
Provision for loan and lease losses 5,550 4,901 4,078 2,832
Investment securities and other investment losses (280) (275) (3,134) (247)
Income before income taxes 6,243 6,482 6,616 7,842
Net income 4,460 4,690 4,643 5,361
Diluted net income per common share 0.21 0.22 0.22 0.26
=============================================================================================================================
Net income was $7.86 million for the fourth quarter of 2004 compared to the
$5.36 million of net income reported for the fourth quarter of 2003. Diluted net
income per common share for the fourth quarter of 2004 amounted to $0.37,
compared to $0.26 per common share reported in the fourth quarter of 2003.
23
The recovery of provision for loan and lease losses was $0.59 million in the
fourth quarter compared to a provision for loan and lease losses of $2.83
million in the fourth quarter of 2003. 1st Source's reserve for loan and lease
losses as of December 31, 2004, was 2.79% of total loans, compared to 3.14% as
of December 31, 2003. Net charge-offs were $3.93 million for the fourth quarter
2004, compared to $2.83 million a year ago. Net charge-offs for the year were
$6.60 million compared to $13.36 million in 2003. The ratio of nonperforming
assets to net loans and leases was 1.42% on December 31, 2004, compared to 1.59%
on December 31, 2003.
Noninterest income for the fourth quarter of 2004 was $18.09 million, down 6.70%
from the fourth quarter of 2003. This decrease was due to a reduction in
equipment rental income offset by an increase in mortgage banking income. For
the year, noninterest income was $62.73 million, down 21.78% from 2003. The
predominant factor behind the decline in 2004 was mortgage banking income and
equipment rental income. Noninterest expense was $30.43 million for the fourth
quarter of 2004, down 10.82% from the fourth quarter of 2003. For the year,
noninterest expense was $127.09 million, down 8.50% from 2003. In general, 2004
noninterest expense reflects decreased salaries and employee benefits, leased
equipment depreciation, and loan and lease collection and repossession expense,
which were offset slightly by an increase in professional fees.
The 2004 earnings represent a return on average shareholders' equity of 7.81%,
compared to 6.12% for 2003. Return on total assets was 0.75% compared to 0.59%
for 2003.
As of December 31, 2004, the 1st Source common equity-to-assets ratio was 9.16%,
compared to 9.45% a year ago. Shareholders' equity was $326.60 million, up 3.78%
from $314.69 million a year ago. Total assets at the end of 2004 were $3.56
billion compared to $3.33 billion at the end of 2003. Total deposits were $2.81
billion, up 12.86% from the end of 2003, and total loans and leases were $2.28
billion, up 2.20% from 2003.
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 ON EFFECTIVENESS OF INTERNAL CONTROL OVER FINANCIAL REPORTING
To the Board of Directors and the Shareholders of 1st Source Corporation:
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting, that 1st
Source Corporation maintained effective internal control over financial
reporting as of December 31, 2004, 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, 2004, 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, 2004,
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 and subsidiaries as of December
31, 2004 and 2003, and the related consolidated statements of income, statements
of shareholders' equity, and cash flows for each of the three years in the
period ended December 31, 2004 of 1st Source Corporation and subsidiaries and
our report dated March 15, 2005, expressed an unqualified opinion thereon.
/s/ERNST & YOUNG LLP
- --------------------
Chicago, Illinois
March 15, 2005
25
REPORT ON CONSOLIDATED FINANCIAL STATEMENTS
To the Board of Directors and the 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, 2004 and
2003, and the related consolidated statements of income, statements of
shareholders' equity, and cash flows for each of the three years in the period
ended December 31, 2004. 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 financial statements referred to above present fairly,
in all material respects, the consolidated financial position of 1st Source
Corporation and subsidiaries at December 31, 2004 and 2003, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2004, 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, 2004,
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 15, 2005 expressed an unqualified opinion thereon.
/s/ERNST & YOUNG LLP
- --------------------
Chicago, Illinois
March 15, 2005
26
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
- -----------------------------------------------
December 31 (Dollars in thousands) 2004 2003
- -------------------------------------------------------------------------------------------------------------------------------
ASSETS
Cash and due from banks $ 78,255 $ 109,787
Federal funds sold and interest bearing deposits with other banks 220,131 1,355
Investment securities, available-for-sale
(amortized cost of $790,404 and $759,945 at December 31, 2004 and 2003, respectively) 789,923 763,763
Mortgages held for sale 55,711 60,215
Loans and leases, net of unearned discount:
Commercial and agricultural loans 425,018 402,905
Auto, light truck and environmental equipment 263,637 269,490
Medium and heavy duty truck 267,834 221,562
Aircraft financing 444,481 489,155
Construction equipment financing 196,516 219,562
Loans secured by real estate 583,437 533,749
Consumer loans 99,245 94,577
- ----------------------------------------------------------------------------------------------------------------- -------------
Total loans and leases 2,280,168 2,231,000
Reserve for loan and lease losses (63,672) (70,045)
- ----------------------------------------------------------------------------------------------------------------- -------------
Net loans and leases 2,216,496 2,160,955
Equipment owned under operating leases, net 47,257 70,305
Net premises and equipment 37,314 38,431
Accrued income and other assets 118,628 125,342
- ----------------------------------------------------------------------------------------------------------------- -------------
Total assets $ 3,563,715 $ 3,330,153
- ----------------------------------------------------------------------------------------------------------------- -------------
LIABILITIES
Deposits:
Noninterest bearing $ 378,867 $ 396,026
Interest bearing 2,428,136 2,091,189
- ----------------------------------------------------------------------------------------------------------------- -------------
Total deposits 2,807,003 2,487,215
- ----------------------------------------------------------------------------------------------------------------- -------------
Short-term borrowings:
Federal funds purchased and securities sold under agreements to repurchase 216,751 276,040
Other short-term borrowings 82,911 114,814
- ----------------------------------------------------------------------------------------------------------------- -------------
Total short-term borrowings 299,662 390,854
- ----------------------------------------------------------------------------------------------------------------- -------------
Long-term debt and mandatorily redeemable securities 17,964 22,802
Subordinated notes 59,022 56,444
Accrued expenses and other liabilities 53,464 58,147
- ----------------------------------------------------------------------------------------------------------------- -------------
Total liabilities 3,237,115 3,015,462
- ----------------------------------------------------------------------------------------------------------------- -------------
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 21,617,057 shares in 2004 and 21,626,584 shares in 2003,
less unearned shares (236,573 -- 2004 and 246,100 -- 2003) 7,578 7,578
Capital surplus 214,001 214,001
Retained earnings 115,830 100,534
Cost of common stock in treasury (651,257 shares -- 2004 and 664,193 shares -- 2003) (10,512) (9,777)
Accumulated other comprehensive (loss) income (297) 2,355
- ----------------------------------------------------------------------------------------------------------------- -------------
Total shareholders' equity 326,600 314,691
- ----------------------------------------------------------------------------------------------------------------- -------------
Total liabilities and shareholders' equity $ 3,563,715 $ 3,330,153
===============================================================================================================================
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) 2004 2003 2002
- --------------------------------------------------------------------- -------------- ---------------- ------------
Interest income:
Loans and leases $ 129,059 $ 137,382 $ 171,029
Investment securities, taxable 16,361 18,410 21,359
Investment securities, tax-exempt 5,065 5,614 6,037
Other 952 916 1,078
- --------------------------------------------------------------------- -------------- ---------------- ------------
Total interest income 151,437 162,322 199,503
- --------------------------------------------------------------------- -------------- ---------------- ------------
Interest expense:
Deposits 41,698 49,153 71,084
Short-term borrowings 6,079 5,121 5,659
Subordinated notes 3,863 3,804 3,249
Long-term debt and mandatorily redeemable securities 1,109 992 825
- --------------------------------------------------------------------- -------------- ---------------- ------------
Total interest expense 52,749 59,070 80,817
- --------------------------------------------------------------------- -------------- ---------------- ------------
Net interest income 98,688 103,252 118,686
Provision for loan and lease losses 229 17,361 39,657
- -------------------------------------------------------------------------------------- ---------------- -----------
Net interest income after provision for loan and lease losses 98,459 85,891 79,029
- -------------------------------------------------------------------------------------- ---------------- -----------
Noninterest income:
Trust fees 12,361 10,664 10,252
Service charges on deposit accounts 16,228 15,532 14,947
Mortgage banking income 9,553 19,635 7,766
Equipment rental income 18,856 25,448 28,773
Other income 10,454 12,853 14,215
Investment securities and other investment losses (4,719) (3,936) (2,836)
- -------------------------------------------------------------------------------------- ---------------- -----------
Total noninterest income 62,733 80,196 73,117
- --------------------------------------------------------------------- ---------------- ---------------- ----------
Noninterest expense:
Salaries and employee benefits 63,083 69,457 67,398
Net occupancy expense 7,196 6,881 6,861
Furniture and equipment expense 10,290 10,363 10,719
Depreciation -- leased equipment 15,315 19,773 23,494
Supplies and communications 5,708 6,163 6,582
Loan and lease collection and repossession expense 4,946 8,112 9,851
Other expense 20,553 18,155 15,836
- --------------------------------------------------------------------- ---------------- ---------------- ----------
Total noninterest expense 127,091 138,904 140,741
- -------------------------------------------------------------- --------------------- ---------------- ------------
Income before income taxes 34,101 27,183 11,405
Income taxes 9,136 8,029 1,366
- -------------------------------------------------------------- --------------------- ---------------- ------------
Net income $ 24,965 $ 19,154 $ 10,039
- -------------------------------------------------------------- --------------------- ---------------- ------------
Basic net income per common share $ 1.21 $ 0.92 $ 0.48
- -------------------------------------------------------------- --------------------- ---------------- ------------
Diluted net income per common share $ 1.19 $ 0.91 $ 0.47
==================================================================================================================
The accompanying notes are a part of the consolidated financial statements.
28
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
- -----------------------------------------------
Cost of Accumulated
Common Other
Common Capital Retained Stock Comprehensive
(Dollars in thousands, except per share data) Total Stock Surplus Earnings in Treasury Income (Loss), Net
- ----------------------------------------- ---------------- -------------- --------------------------- ------------- ----------------
Balance at January 1, 2002 $ 306,190 $ 7,579 $ 214,001 $ 91,591 $ (12,591) $ 5,610
- ------------------------------------------- --------------- ------------ -------------- ---- ---------- -------------- ----------
Comprehensive income, net of tax:
Net income 10,039 - - 10,039 - -
Change in unrealized gains of
available-for-sale securities (1,021) - - - - (1,021)
---------
Total comprehensive income 9,018 - - - - -
Issuance of 289,854 common shares under
stock based compensation plans, including
related tax effects 4,261 - - (3,196) 7,457 -
Cost of 128,276 shares of common
stock acquired for treasury (2,503) - - - (2,503) -
Cash dividends ($.360 per share) (7,537) - - (7,537) - -
- ------------------------------------------- --------------- ------------ ------------------ ---------- -------------- ----------
Balance at December 31, 2002 $ 309,429 $ 7,579 $ 214,001 $ 90,897 $ (7,637) $ 4,589
- ------------------------------------------- --------------- ------------------------------- ---------- --- ---------- ----------
Comprehensive income, net of tax:
Net income 19,154 - - 19,154 - -
Change in unrealized gains of
available-for-sale securities (2,234) - - - - (2,234)
---------
Total comprehensive income 16,920 - - - - -
Reclass of 399,241 mandatorily
redeemable shares to liabilities (5,897) - - (955) (4,942) -
Issuance of 205,973 common shares under
stock based compensation plans, including
related tax effects 2,598 (1) - (849) 3,448 -
Cost of 39,459 shares of common
stock acquired for treasury (646) - - - (646) -
Cash dividends ($.370 per share) (7,713) - - (7,713) - -
- ------------------------------------------- --------------- ------------- ------------- ---- ---------- --- ---------- ----------
Balance at December 31, 2003 $ 314,691 $ 7,578 $ 214,001 $ 100,534 $ (9,777) $ 2,355
- -------------------------------------------- -------------- ------------ -------------- --------------- -------------- ----------
COMPREHENSIVE INCOME, NET OF TAX:
NET INCOME 24,965 - - 24,965 - -
CHANGE IN UNREALIZED GAINS OF
AVAILABLE-FOR-SALE SECURITIES (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)
===================================================================================================================================
The accompanying notes are a part of the consolidated financial statements.
29
CONSOLIDATED STATEMENTS OF CASH FLOW
- ------------------------------------
Year Ended December 31 (Dollars in thousands) 2004 2003 2002
- ------------------------------------------------------------------------------- --------- ----------- ---------------- -------------
Operating activities:
Net income $ 24,965 $ 19,154 $ 10,039
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses 229 17,361 39,657
Depreciation of premises and equipment 4,813 5,090 5,122
Depreciation of equipment owned and leased to others 15,315 19,773 23,494
Amortization of investment security premiums and accretion of discounts, net 6,553 5,871 4,454
Amortization of mortgage servicing rights 7,384 8,007 6,306
Mortgage servicing asset impairment charges (275) 581 7,328
Deferred income taxes 5,346 (2,171) 14,803
Realized investment securities losses 4,719 3,936 2,836
Change in mortgages held for sale 4,504 86,425 26,875
Change in trading account securities - 13,347 (13,347)
Change in interest receivable 1,036 1,245 4,465
Change in interest payable 490 (3,810) (6,117)
Change in other assets (1,431) 6,727 (36,399)
Change in other liabilities (8,871) 12,642 (9,040)
Other 233 1,839 (6,117)
- ------------------------------------------------------------------------------ --------- ----------- ---------------- ---- ---------
Net cash from operating activities 65,010 196,017 74,359
- ------------------------------------------------------------------------------ --------- ----------- ---------------- ---- ---------
Investing activities:
Proceeds from sales and maturities of investment securities 233,245 351,747 329,324
Purchases of investment securities (274,976) (481,565) (319,226)
Net change in short-term investments (218,776) 80,526 (64,843)
Loans sold or participated to others (557) 52,158 295,732
Net change in loans (35,908) (110,241) (151,397)
Net change in equipment owned under operating leases 7,732 3,815 (1,587)
Purchases of premises and equipment (3,736) (2,072) (6,363)
- ---------------------------------------------------------------------- ------------------------------ ----------------- ------------
Net cash (used in) from investing activities (292,976) (105,632) 81,640
- ---------------------------------------------------------------------- ------------------------------ ----------------- ------------
Financing activities:
Net change in demand deposits, NOW accounts and savings accounts 309,534 (39,210) 81,220
Net change in certificates of deposits 10,254 (186,480) (251,121)
Net change in short-term borrowings (110,497) 130,175 (3,795)
Proceeds from issuance of long-term debt 1,357 2,344 16,042
Proceeds from issuance of subordinated notes 30,929 - 10,000
Payments on subordinated notes (28,351) - -
Payments on long-term debt (6,224) (2,484) (11,103)
Net proceeds from issuance of treasury stock 3,253 2,598 4,261
Acquisition of treasury stock (4,958) (646) (2,503)
Cash dividends (8,863) (7,789) (7,537)
- -------------------------------------------------------------------------- -------------------------- ---------------- -------------
Net cash from (used in) financing activities 196,434 (101,492) (164,536)
- -------------------------------------------------------------------------- -------------------------- ---------------- -------------
Net change in cash and cash equivalents (31,532) (11,107) (8,537)
- -------------------------------------------------------------------------- -------------------------- ---------------- -------------
Cash and cash equivalents, beginning of year 109,787 120,894 129,431
- -------------------------------------------------------------------------- -------------------------- ---------------- -------------
Cash and cash equivalents, end of year $ 78,255 $ 109,787 $ 120,894
====================================================================================================================================
Supplemental Information:
Cash paid (received) for:
Interest $ 53,239 $ 62,880 $ 86,934
Income taxes 6,216 2,655 (3,473)
====================================================================================================================================
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 R, 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 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, 2004, net deferred loan
and lease costs were $4.61 million.
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 that are well secured and in the process of collection. Such residential
mortgage loans are placed in nonaccrual at the time the loan is placed in
foreclosure. When interest accruals are discontinued, interest credited to
income in the current year is reversed and interest accrued in the prior year is
charged to the reserve for loan and lease losses. Management may elect to
continue the accrual of interest when the net realizable value of collateral is
sufficient to cover the principal and accrued interest. While a loan 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 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, 2004, residential real estate portfolio loans included
$19.31 million of loans available for repurchase under the GNMA optional
repurchase programs with the offsetting liability recorded within other borrowed
funds.
SECURITIZED ASSETS -- During December 2003, the Bank purchased the assets of
the 1st Source Master Trust, a qualified special purpose entity, from the
beneficial interest holders. The assets included $210.83 million in aircraft
loans, $15.19 million in auto rental loans and $4.39 million of loan related
assets. In addition, $24.53 million of the excess cash in the Master Trust was
31
returned to the Bank which resulted in the realization of the Bank's retained
interest in the securitization.
The Bank established a loss reserve of $6.82 million against the loans acquired
from the Master Trust, which was consistent with loss reserves maintained for
its on-balance sheet portfolios. The transaction did not have a significant
impact on earnings for 2003. At December 31, 2004 and 2003, the Bank had no
securitized assets.
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.
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 leases loss
reserves are based on historical net charge-offs, adjusted for delinquencies,
the effects of lending practices and programs and current economic conditions,
and projected trends in the geographic markets which we serve.
A comprehensive analysis of the reserve is performed by management on a
quarterly basis. Although management determines the amount of each element of
the reserve separately and relies on this process as an important credit
management tool, the entire reserve is available for the entire loan 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, 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 estimates are reviewed periodically to ensure realization.
OTHER REAL ESTATE -- Other real estate acquired through partial or total
satisfaction of nonperforming loans is included in other assets and recorded at
the estimated fair value less anticipated selling costs based upon the
property's appraised value at the date of transfer, with any difference between
the fair value of the property and the carrying value of the loan charged to the
reserve for loan losses. Subsequent changes in value are reported as adjustments
to the carrying amount and are recorded in noninterest expense on the income
statement. Gains or losses not previously recognized resulting from the sale of
other real estate are recognized on the date of sale. As of December 31, 2004
and 2003, other real estate had carrying values of $1.88 million and $4.62
million, respectively.
REPOSSESSED ASSETS -- Repossessed assets consist of specialty finance equipment,
including aircraft, construction equipment, and vehicles acquired through
foreclosure or in lieu of foreclosure. Repossessed assets are included in other
assets at the lower of cost or fair value of the equipment or vehicle. 1st
Source estimates fair value based on the best estimate of an orderly liquidation
value. Sources typically include vehicle and equipment dealers, valuation
guides, and other third parties, including appraisers. At the time of
foreclosure, the recorded amount of the loan 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 $4.38 million and $6.26 million, as of December 31, 2004 and
2003, 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. Effective January 1,
2002, in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets,"
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 2004 and
determined that no impairment exists.
VENTURE CAPITAL INVESTMENT -- Venture capital investments are carried at
estimated fair value with changes in fair value recognized in investment
securities and other investment (losses) gains. The fair values of publicly
traded investments are determined using quoted market prices. For other
investments, fair value is determined by the General Partner. All valuations are
approved by the Valuation Committee of the Advisory Board of the Partnership.
Venture capital investments in Partnerships are included in other assets on the
balance sheet. The balances as of December 31, 2004 and 2003 are $2.74 million
and $2.63 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 30
to 180 days of the transaction date. Commercial paper matures within 30 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.
Under an available line of credit agreement, 1st Source may borrow up to $1
million. At December 31, 2004 and 2003, there were no outstanding borrowings
under this line, which was assigned to support commercial paper borrowings.
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): 2004, 20,709;
2003, 20,859; and 2002, 20,935. 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): 2004, 20,985; 2003, 21,150; and 2002, 21,310.
At December 31, 2004, 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) 2004 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
Net income, as reported $ 24,965 $ 19,154 $ 10,039
Add:
Stock-based employee compensation expense included in reported net income,
net of related tax effects 1,392 1,360 -
Deduct:
Stock-based employee compensation expense determined under fair value based
method for all awards, net of related tax effects (1,582) (1,590) (333)
- --------------------------------------------------------------------------------- -------------------- ----------------- -----------
Pro forma net income $ 24,775 $ 18,924 $ 9,706
- --------------------------------------------------------------------------------- -------------------- ----------------- -----------
Earnings per share:
Basic -- as reported $ 1.21 $ 0.92 $ 0.48
Basic -- pro forma $ 1.20 $ 0.91 $ 0.46
- --------------------------------------------------------------------------------- -------------------- ----------------- -----------
Diluted -- as reported $ 1.19 $ 0.91 $ 0.47
Diluted -- pro forma $ 1.18 $ 0.90 $ 0.46
====================================================================================================================================
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 earnings recognition 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
THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO
CERTAIN INVESTMENTS -- In March 2004, the Financial Accounting Standards Board
(FASB) issued Emerging Issues Task Force (EITF) 03-01. The EITF reached a
consensus about the criteria that should be used to determine when an investment
is considered impaired, whether that impairment is other-than-temporary, and the
measurement of an impairment loss and how that criteria should be applied to
investments accounted for under SFAS No 115, "Accounting in Certain Investments
in Debt and Equity Securities." EITF 03-01 also included 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. Additionally, EITF
03-01 includes new disclosure requirements for investments that are deemed to be
temporarily impaired. In September 2004, the FASB delayed the accounting
provisions of EITF 03-01; however, the disclosure requirements remain effective
for annual reports ending after June 15, 2004. 1st Source will evaluate the
impact of the accounting provisions of EITF 03-01 once final guidance is issued.
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 July 1, 2005. Early
adoption is permitted in periods in which financial statements have not yet been
issued. We expect to adopt SFAS No. 123(R) on July 1, 2005.
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 has not made a determination as to which method it will utilize 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 and, as
such, generally recognizes no compensation cost for employee stock options.
Accordingly, the adoption of SFAS No. 123(R)'s fair value method will have a
significant impact on our results of operations, although it will have no impact
on our overall financial position. The impact of adoption of SFAS No. 123(R)
cannot be predicted at this time because it will depend on levels of share-based
payments granted in the future. However, had we adopted SFAS No. 123(R) in prior
periods, the impact of the standard would have approximated the impact of SFAS
No. 123 as described in the disclosure of pro forma net income and earnings per
share in Note K of the consolidated financial statements. 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 $1.09 million, $0, and $0.70 million in
2004, 2003, and 2002, respectively.
APPLICATION OF ACCOUNTING PRINCIPLES TO LOAN COMMITMENTS -- SEC Staff
Accounting Bulletin (SAB) No. 105, "Application of Accounting Principles to Loan
Commitments," summarizes the views of the staff of the SEC regarding the
application of generally accepted accounting principles to loan commitments
accounted for as derivative instruments. SAB No.105 provides that the fair value
of recorded loan commitments that are accounted for as derivatives under FASB
No. 133, "Accounting for Derivative Instruments and Hedging Activities," should
not incorporate the expected future cash flows related to the associated
servicing of the future loan. In addition, SAB No. 105 requires registrants to
disclose their accounting policy for loan commitments. The provisions of SAB No.
105 must be applied to loan commitments accounted for as derivatives that are
entered into after March 31, 2004. The adoption of this accounting standard did
not have any impact on 1st Source's financial statements.
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.
ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH
LIABILITIES AND EQUITY -- In May 2003, the FASB issued SFAS No. 150, "Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity." This Statement establishes standards on the classification and
measurement of certain financial instruments with characteristics of both
liability and equity. SFAS No. 150 is effective for all financial instruments
entered into or modified after May 31, 2003, and to all other instruments that
exist as of the beginning of the first interim period beginning after June 15,
2003. SFAS No. 150 requires the redemption value of mandatorily redeemable
securities to be classified as liabilities. As a result of the implementation of
SFAS No. 150, 1st Source reclassified $5.90 million of shareholder's equity to
mandatorily redeemable securities effective July 1, 2003. The mandatorily
35
redeemable securities are due to common stock issued under the 1st Source
Executive Incentive Plan. Awards under the plan include "book value" shares of
common stock. These shares are awarded annually based on weighted performance
criteria and vest over a period of five years. The plan shares may only be sold
to 1st Source and such sale is mandatory in the event of death, retirement,
disability or termination of employment. The adoption of SFAS No. 150 did not
have a material impact on the results of operations.
CONSOLIDATION OF VARIABLE INTEREST ENTITIES -- In January 2003, the FASB
issued FASB Interpretation No. (FIN) 46, "Consolidation of Variable Interest
Entities." The objective of this interpretation is to provide guidance on how to
identify a variable interest entity (VIE) and determine when the assets,
liabilities, noncontrolling interests, and results of operations of a VIE need
to be included in a company's consolidated financial statements. FIN 46 requires
a company that holds variable interests in an entity to consolidate the entity
if the company's interest in the VIE is such that the company will absorb a
majority of the VIE's expected losses and/or receive a majority of the entity's
expected residual returns, if they occur. FIN 46 also requires additional
disclosures by primary beneficiaries and other significant variable interest
holders. FIN 46, as originally issued, was effective immediately for entities
created after January 21, 2003, and applied to previously existing entities in
quarters beginning after June 15, 2003. On October 9, 2003, FASB issued a Staff
Position deferring the effective date for variable interests held prior to
February 1, 2003; however, early adoption was permitted.
1st Source adopted FIN 46 early on July 1, 2003. 1st Source determined that it
was not the primary beneficiary of its investment in 1st Source Capital Trust I,
II, and III and was required to deconsolidate 1st Source Capital Trust I, II,
and III. 1st Source owns the common stock of 1st Source Capital Trust I, II, and
III, which issued mandatorily redeemable preferred capital securities to third
party investors. The only assets of 1st Source Capital Trust I, II, and III,
which totaled $56.44 million at July 1, 2003, consisted of debentures which were
acquired by the Capital Trusts using proceeds from the issuance of the preferred
securities and common stock. As a result of the deconsolidation, the debentures
are included in "subordinated notes" and 1st Source's equity interests in the
1st Source Capital Trust I, II, III, and IV are included in "other assets" on
the balance sheet.
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:
Gross Gross
Amortized Unrealized Unrealized
(Dollars in thousands) Cost Gains Losses Fair Value
- -----------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2004
DEBT SECURITIES:
U.S. TREASURY AND AGENCY SECURITIES $ 498,507 $ 70 $ (4,424) $ 494,153
OBLIGATIONS OF STATES AND POLITICAL SUBDIVISIONS 171,338 1,496 (318) 172,516
MORTGAGE-BACKED SECURITIES 54,442 412 (353) 54,501
OTHER SECURITIES 4,431 - (141) 4,290
- ---------------------------------------------------------- ------------ ---------------- ----------------- ------------
TOTAL DEBT SECURITIES 728,718 1,978 (5,236) 725,460
EQUITY SECURITIES 61,686 2,821 (44) 64,463
- ---------------------------------------------------------- ------------ ---------------- ----------------- ------------
TOTAL INVESTMENT SECURITIES $ 790,404 $ 4,799 $ (5,280) $ 789,923
- ---------------------------------------------------------- ------------ ---------------- ----------------- ------------
December 31, 2003
Debt securities:
U.S. Treasury and agency securities $ 439,295 $ 1,646 $ (1,373) $ 439,568
Obligations of states and political subdivisions 168,383 3,295 (163) 171,515
Mortgage-backed securities 65,453 238 (537) 65,154
Other securities 14,404 76 (131) 14,349
- ---------------------------------------------------------- ------------ ---------------- ----------------- ------------
Total debt securities 687,535 5,255 (2,204) 690,586
Equity securities 72,410 3,479 (2,712) 73,177
- ---------------------------------------------------------- ------------ ---------------- ----------------- ------------
Total investment securities $ 759,945 $ 8,734 $ (4,916) $ 763,763
=======================================================================================================================
The contractual maturities of investments in debt securities available-for-sale
at December 31, 2004, are shown below. Expected maturities will differ from
contractual maturities, because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
(Dollars in thousands) Amortized Cost Fair Value
- --------------------------------------------------------- ---------------
Due in one year or less $ 218,529 $ 218,208
Due after one year through five years 442,863 439,855
Due after five years through ten years 12,568 12,580
Due after ten years 316 316
Mortgage-backed securities 54,442 54,501
- --------------------------------------------------------- ---------------
Total debt securities $ 728,718 $ 725,460
=========================================================================
36
The mortgage-backed securities held by 1st Source consist primarily of
GNMA, FNMA, and FHLMC pass-through certificates which are guaranteed by those
respective agencies of the United States government.
Gross losses of $4.62 million, $3.03 million, and $1.75 million and gross gains
of $0.15 million, $0.01 million, and $0 were recognized on investment securities
available-for-sale, in 2004, 2003, and 2002, respectively. The gross loss in
2004 includes $4.58 million in other-than-temporary impairment on preferred
stock issued by the FNMA and the FHLMC. The gross loss in 2003 and 2002 includes
$2.99 million and $1.49 million, respectively, of impairment charges on the
securitization retained interest. Realized and unrealized (losses)/gains of
($0.04) million, and $0.60 million, and $0.56 million, on trading account
securities were included in earnings in 2004, 2003, and 2002, respectively.
There were no trading securities outstanding at December 31, 2004 or 2003.
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, 2004
DEBT SECURITIES:
U.S. TREASURY AND AGENCY SECURITIES $ 443,597 $ (3,419) $ 40,487 $ (1,005) $ 484,084 $(4,424)
OBLIGATIONS OF 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 - - 3,409 (141) 3,409 (141)
- -----------------------------------------------------------------------------------------------------------------------------
TOTAL DEBT SECURITIES 506,318 (3,788) 64,830 (1,448) 571,148 (5,236)
EQUITY SECURITIES 5,827 (44) - - 5,827 (44)
- -----------------------------------------------------------------------------------------------------------------------------
TOTAL TEMPORARILY IMPAIRED SECURITIES $ 512,145 $ (3,832) $ 64,830 $ (1,448) $ 576,975 $(5,280)
- -----------------------------------------------------------------------------------------------------------------------------
December 31, 2003
Debt securities:
U.S. Treasury and agency securities $ 191,475 $ (1,373) $ - $ - $ 191,475 $(1,373)
Obligations of states and political subdivisions 24,076 (156) 501 (7) 24,577 (163)
Mortgage-backed securities 45,774 (536) 123 (1) 45,897 (537)
Other securities 3,425 (131) - - 3,425 (131)
- -----------------------------------------------------------------------------------------------------------------------------
Total debt securities 264,750 (2,196) 624 (8) 265,374 (2,204)
Equity securities 13,807 (840) 13,815 (1,872) 27,622 (2,712)
- -----------------------------------------------------------------------------------------------------------------------------
Total temporarily impaired securities $ 278,557 $ (3,036) $ 14,439 $ (1,880) $ 292,996 $(4,916)
==============================================================================================================================
At December 31, 2004, 1st Source did not believe any individual unrealized loss
represents 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. The unrealized losses on equity securities as of December 31,
2003, were determined to be other-than-temporary and were recognized in the
income statement as investment losses during 2004.
At December 31, 2004 and 2003, investment securities with carrying values of
$329.41 million and $332.18 million, respectively, were pledged as collateral to
secure government and public deposits, and for other purposes.
NOTE D -- LOANS AND LEASE FINANCINGS
Total loans and leases outstanding, recorded net of unearned income and deferred
loan fees and costs, at December 31, 2004 and 2003, were $2.28 billion and $2.23
billion, respectively.
The loan 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, 2004, follows:
(Dollars in thousands) 2004
- --------------------------------------------------------------------
Direct finance leases $ 188,244
- --------------------------------------------------------------------
Rentals receivable, net of principal and interest
on nonrecourse debt 130,930
Estimated residual value of leased assets 57,314
- --------------------------------------------------------------------
Gross investment in lease financing 188,244
Unearned income (17,219)
- --------------------------------------------------------------------
Net investment in lease financing $ 171,025
====================================================================
37
At December 31, 2004, the minimum future lease payments receivable for each of
the years 2005 through 2009 were $47.21 million, $33.80 million, $22.68 million,
$13.88 million, and $6.78 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
amount of these loans was $23.44 million and $29.98 million at December 31, 2004
and 2003, respectively. During 2004, $20.56 million of new loans were made and
repayments and other reductions totaled $27.10 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) 2004 2003 2002
- ----------------------------------------------------------------------------------- ---------------------------------------
Balance, beginning of year $ 70,045 $ 59,218 $ 57,624
Provision for loan and lease losses 229 17,361 39,657
Charge-offs, net of recoveries of $8,079 in 2004, $4,181 in 2003, and $3,658 in 2002 (6,602) (13,357) (38,063)
Reserves related to loans acquired - 6,823 -
- ----------------------------------------------------------------------------------- ---------------------------------------
Balance, end of year $ 63,672 $ 70,045 $ 59,218
===========================================================================================================================
At December 31, 2004 and 2003, nonaccrual and restructured loans and leases,
substantially all of which are collateralized, were $25.25 million and $27.09
million, respectively. Interest income for the years ended December 31, 2004,
2003, and 2002, would have increased by approximately $2.27 million, $2.64
million, and $2.63 million, respectively, if these loans and leases had earned
interest at their full contract rate.
As of December 31, 2004 and 2003, impaired loans and leases totaled $47.22
million and $60.04 million, respectively, of which $22.30 million and $9.74
million had corresponding specific reserves for loan and lease losses totaling
$10.43 million and $5.18 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, 2004, a total of $22.50 million of the
impaired loans and leases were nonaccrual loans and leases. For 2004, 2003, and
2002 the average recorded investment in impaired loans and leases was $53.21
million, $60.36 million and $64.30 million, respectively, and interest income
recognized on impaired loans and leases totaled $2.65 million, $2.63 million,
and $2.84 million, respectively.
NOTE F -- OPERATING LEASES
1st Source finances various types of construction equipment, medium and
heavy duty trucks, and automobiles 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 vehicles, net of accumulated depreciation, are
recorded as operating lease assets 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, 2004 and 2003, was $47.26 million and
$70.31 million, respectively, net of accumulated depreciation of $35.37 million
and $49.39 million, respectively. Depreciable lives for operating lease
equipment generally range from three to seven years.
The minimum future lease rental payments due from customers on operating lease
equipment at December 31, 2004, totaled $31.33 million, of which $15.20 million
is due in 2005, $8.74 million in 2006, $3.90 million in 2007, $2.19 million in
2008, $1.06 million in 2009, $0.17 million in 2010 and $0.07 million in 2011.
Depreciation expense related to operating lease equipment for the year ended
December 31, 2004 was $15.32 million.
NOTE G -- PREMISES AND EQUIPMENT
Premises and equipment as of December 31 consisted of the following:
(Dollars in thousands) 2004 2003
- --------------------------------------------------------------------------------
Land $ 6,719 $ 6,759
Buildings and improvements 40,905 40,205
Furniture and equipment 32,476 32,437
- ------------------------------------------------------------------ ------------
Total premises and equipment 80,100 79,401
Accumulated depreciation and amortization (42,786) (40,970)
- ------------------------------------------------------------------ ------------
Net premises and equipment $ 37,314 $ 38,431
================================================================================
Depreciation and amortization of properties and equipment totaled $4.81 million
in 2004, $5.09 million in 2003, and $5.12 million in 2002.
38
NOTE H - MORTGAGE SERVICING ASSETS
The unpaid principal balance of residential mortgage loans serviced for third
parties was $1.91 billion at December 31, 2004, compared to $2.06 billion at
December 31, 2003, and $1.93 billion at December 31, 2002.
Changes in the carrying value of mortgage servicing assets and the
associated valuation allowance follow:
Year Ended December 31 (Dollars in thousands) 2004 2003
- ----------------------------------------------------------------------------------------------------------
Mortgage servicing assets:
Balance at beginning of period $ 27,601 $ 28,086
Additions 9,985 18,196
Amortization (7,384) (8,007)
Application of valuation allowance to directly write-down servicing assets (700) (4,633)
Sales (5,787) (6,041)
- -------------------------------------------------------------------------------------------- -------------
Carrying value before valuation allowance at end of period 23,715 27,601
- -------------------------------------------------------------------------------------------- -------------
Valuation allowance:
Balance at beginning of period (3,276) (7,328)
Impairment recoveries (charges) 275 (581)
Application of valuation allowance to directly write-down servicing assets 700 4,633
- -------------------------------------------------------------------------------------------- -------------
Balance at end of period $ (2,301) $ (3,276)
- -------------------------------------------------------------------------------------------- -------------
Net carrying value of mortgage servicing assets at end of period $ 21,414 $ 24,325
- -------------------------------------------------------------------------------------------- -------------
Fair value of mortgage servicing assets at end of period $ 23,521 $ 24,936
==========================================================================================================
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 2004, management
determined that $0.70 million of previously established valuation allowance was
not recoverable and reduced both the asset and the valuation allowance. At
December 31, 2004, the fair value of mortgage servicing assets exceeded the
carrying value reported in the consolidated balance sheet by $2.11 million. This
difference represents increases in the fair value of certain mortgage servicing
assets accounted for under SFAS No. 140 that could not be recorded above cost
basis.
Funds held in trust at 1st Source for the payment of principal, interest, taxes
and insurance premiums applicable to mortgage loans being serviced for others,
aggregated were approximately $37.96 million and $41.19 million at December 31,
2004 and December 31, 2003, respectively.
NOTE I -- INTANGIBLE ASSETS AND GOODWILL
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. At December 31, 2003, intangible assets consisted of goodwill of
$18.66 million and other intangible assets of $7.08 million, net of accumulated
amortization of $5.14 million. Intangible asset amortization was $2.63 million,
$2.75 million, and $2.14 million for 2004, 2003, and 2002, respectively.
Amortization of other intangible assets is expected to total $2.61 million,
$1.85 million, $0.15 million, and $0.05 million in 2005, 2006, 2007, and 2008,
respectively.
A summary of core deposit intangible and other intangible assets follows:
Year Ended December 31 (Dollars in thousands) 2004 2003
- --------------------------------------------------------------------------
Core deposit intangibles:
Gross carrying amount $ 5,307 $ 5,017
Less: accumulated amortization (3,244) (2,260)
- ------------------------------------------------------------- ------------
Net carrying amount $ 2,063 $ 2,757
- ------------------------------------------------------------- ------------
Other intangibles:
Gross carrying amount $ 7,201 $ 7,201
Less: accumulated amortization (4,527) (2,881)
- ------------------------------------------------------------- ------------
Net carrying amount $ 2,674 $ 4,320
==========================================================================
39
NOTE J -- LONG-TERM DEBT AND MANDATORILY REDEEMABLE SECURITIES
Details of long-term debt and mandatorily redeemable securities as of December
31 are as follows:
(Dollars in thousands) 2004 2003
- ---------------------------------------------------------------------- ---------
Term loan * $ 10,000 $ 15,000
Federal Home Loan Bank borrowings (5.04%-6.98%) 1,008 1,027
Mandatorily redeemable securities 6,093 6,064
Other long-term debt 863 711
- ---------------------------------------------------------------------- ---------
Total long-term debt and mandatorily redeemable securities $ 17,964 $ 22,802
================================================================================
*Fixed rate at December 31, 2004 and 2003, was 4.76%. Variable rate at December
31, 2003 was 2.57%.
Annual maturities of long-term debt outstanding at December 31, 2004, for the
next five years beginning in 2005, are as follows (in thousands): $234; $222;
$10,217; $162; and $164.
At December 31, 2004, the term loan included $10.00 million contractually based
on 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, 2004, the Federal Home Loan Bank borrowings represent a source
of funding for certain residential mortgage activities and consist of five fixed
rate notes with maturities ranging from 2006 to 2022. These notes are
collateralized by $1.61 million of certain real estate loans.
Mandatorily redeemable securities as of December 31, 2004, of $6.09 million
reflect 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 2004
and 2003 was $0.38 million and $0.24 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 $2.26
million, $2.19 million, and $0 for the years ended December 31, 2004, 2003, and
2002, 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, 2004, an aggregate 2,478,791 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 and 2002 (no
options were granted in 2004): a risk-free interest rate of 3.39% for 2003, and
3.61% for 2002; an expected dividend yield of 2.32% for 2003, and 1.74% for
2002; an expected volatility factor 37.02% for 2003, and 35.32% for 2002, and an
expected option life of 6.39 years for 2003, and 5.29 years for 2002. The
weighted-average grant date fair value of options granted for 2003 and 2002 was
$4.94, and $6.81, respectively.
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, 2002, 2003 and 2004:
Number of Weighted-Average
Shares Exercise Price
- -------------------------------------------------------------- -----------------
Options outstanding, January 1, 2002 977,648 $ 18.07
- -------------------------------------------------------------- -----------------
Options granted 23,673 19.93
Options exercised (175,039) 7.59
Options forfeited - -
- ----------------------------------------------------------------- --------------
Options outstanding, December 31, 2002 826,282 20.34
- ----------------------------------------------------------------- --------------
Options granted 20,000 13.24
Options exercised (71,528) 8.71
Options forfeited (4,235) 19.24
- ----------------------------------------------------------------- --------------
Options outstanding, December 31, 2003 770,519 21.24
- ----------------------------------------------------------------- --------------
Options granted - -
Options exercised (207,753) 8.39
Options forfeited (3,027) 24.00
- ----------------------------------------------------------------- --------------
OPTIONS OUTSTANDING, DECEMBER 31, 2004 559,739 26.00
- ----------------------------------------------------------------- --------------
OPTIONS EXERCISABLE, DECEMBER 31, 2004 524,739 $ 26.56
- ----------------------------------------------------------------- --------------
The following table summarizes information about stock options outstanding at
December 31, 2004:
Options Outstanding Options Exercisable
----------------- -----------------
Weighted-Average
Remaining
Number of Contractual Weighted-Average Number of Weighted-Average
Range of Exercise Prices Shares Life (Years) Exercise Price Shares Exercise Price
- ----------------------------- ---------- --------------------------------------------------- -----------------
$ 12.44 to $ 19.99 135,574 3.53 $ 14.05 113,074 $ 13.93
$ 20.00 to $ 29.99 65,793 5.58 22.74 53,293 22.69
$ 30.00 to $ 31.99 358,372 3.55 31.12 358,372 31.12
==============================================================================================================
EMPLOYEE STOCK PURCHASE PLAN -- 1st Source also has an employee stock
purchase plan for substantially all employees with at least two years of service
on the effective date of an offering under the plan. Eligible employees may
elect to purchase any dollar amount of stock, so long as such amount does not
exceed 25% of their base rate of pay and the aggregate stock accrual rate for
all offerings does not exceed $25,000 in any calendar year. The purchase price
for shares offered is the lower of the closing market bid price for the offering
date or the average market bid price for the five business days preceding the
offering date. The purchase price and discount to the actual market closing
price for the 2004, 2003, and 2002 offerings were $22.38 (3.69%), $16.47
(4.96%), and $22.85 (0.17%), 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, 2004 and runs through May 31,
2006, with $312,796 in stock value to be purchased at $22.38 per share. The fair
value of the employees' purchase rights for the 2004, 2003, and 2002 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 2.52%
for 2004 and 1.38% for 2003, and 3.19% for 2002; an expected dividend yield of
1.66% for 2004 and 2.72% for 2003, and 1.52% for 2002; an expected volatility
factor of 44.20% for 2004 and 49.56% for 2003, and 43.07% for 2002; and an
expected life of 2.00 years for 2004, 2003, and 2002. The fair value for shares
offered in 2004, 2003, and 2002 was $5.81, $4.61, and $5.58, 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:
2004 2003 2002
- --------------------------------------------------------------------------------
Net income (dollars in thousands):
As reported $ 24,965 $ 19,154 $ 10,039
Pro forma 24,775 18,924 9,706
Diluted net income per common share:
As reported $ 1.19 $ 0.91 $ 0.47
Pro forma 1.18 0.90 0.46
================================================================================
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 2004, 2003,
and 2002 are summarized as follows:
2004 2003 2002
- --------------------------------------------------------------------------------
Number of shares 31,973 13,776 59,824
Weighted-average grant-date fair value $15.19 $14.77 $14.73
================================================================================
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 2004, 2003, and 2002 are summarized below:
2004 2003 2002
- --------------------------------------------------------------------------------
Number of shares 2,000 15,158 1,000
Weighted-average grant-date fair value $20.84 $19.37 $22.89
================================================================================
NOTE L --SUBORDINATED NOTES
As of December 31, 2004, 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. On September 16, 2004, 1st
Source redeemed the capital securities of Capital Trust I.
Distributions on the capital securities issued by Capital Trust II and III are
payable semi-annually at a rate per annum equal to the interest rate being
earned by the Capital Trust on the subordinated notes held by that Capital
Trust. Distributions on the capital securities issued by Capital Trust IV are
payable quarterly at a rate per annum equal to the interest rate being earned by
Capital Trust IV on the subordinated notes held by Capital Trust IV. 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. The Federal Reserve has
issued final rules that retain Tier 1 capital treatment for trust preferred
securities but with stricter limits. Under the rules, after a three-year
transition period, the aggregate amount of trust preferred securities and
certain other capital elements will retain its current limit of 25 percent 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 rules had no impact on 1st
Source's Tier 1 capital.
The subordinated notes are summarized as follows, at December 31, 2004:
Amount of
Subordinated Interest Maturity
Notes Rate Date
(Dollars in thousands)
- --------------------------------------------------------------------------------
March 1997 issuance-floating rate $ 17,784 4.47% 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, 2004, 2003,
and 2002, amounted to $1.65 million, $1.99 million, and $1.88 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,
2004, 2003, and 2002, total pension expense for this plan amounted to $0.72
million, $0.87 million, and $0.70 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, 2004, 2003, and 2002, amounted to
$0.13 million, $0.16 million, and $0.15 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 $3,000 for life insurance.
1st Source's accrued postretirement benefit cost and net periodic postretirement
benefit cost recognized in the consolidated financial statements for the years
ended December 31, 2004, 2003, and 2002 were not material.
NOTE N -- INCOME TAXES
Income tax expense is comprised of the following:
(Dollars in thousands) 2004 2003 2002
- ----------------------------------------------------- -------- ----------------- ------------
Current:
Federal $ 2,920 $ 9,226 $ (12,133)
State 870 2,315 (1,952)
- ----------------------------------------------------- -------- ----------------- ------------
Total current 3,790 11,541 (14,085)
- ----------------------------------------------------- -------- ----------------- ------------
Deferred:
Federal 4,610 (2,697) 13,616
State 736 (815) 1,835
- ----------------------------------------------------- -------- ----------------- ------------
Total deferred 5,346 (3,512) 15,451
- ----------------------------------------------------- -------- ----------------- ------------
Total provision $ 9,136 $ 8,029 $ 1,366
=============================================================================================
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:
2004 2003 2002
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 $ 11,935 35.0% $ 9,514 35.0% $ 3,992 35.0%
(Decrease) increase in income taxes resulting from:
Tax-exempt interest income (1,782) (5.2) (1,969) (7.3) (2,069) (18.1)
State taxes, net of federal income tax benefit 1,044 3.1 975 3.6 (76) (0.7)
Dividends received deduction (1,607) (4.7) (48) (0.2) (46) (0.4)
Other (454) (1.4) (443) (1.6) (435) (3.8)
- ---------------------------------------------------- ------------------ ----------- ---------- ----------- ---------- --------
Total $ 9,136 26.8% $ 8,029 29.5% $ 1,366 12.0%
==============================================================================================================================
The tax expense (benefit) applicable to securities gains and losses for the
years 2004, 2003 and 2002 was $(1,808,000), $(1,508,000) and $(1,076,000),
respectively.
43
Deferred tax assets and liabilities as of December 31, 2004 and 2003 consisted
of the following:
(Dollars in thousands) 2004 2003
- ----------------------------------------------------------------------------------------- ------------
Deferred tax assets:
Reserve for loan and lease losses $ 26,396 $ 27,075
Accruals for employee benefits 3,680 3,884
Net unrealized losses on securities available-for-sale 184 -
Alternative minimum tax 2,567 -
Other 1,503 2,010
- ----------------------------------------------------------------------------------------- ------------
Total deferred tax assets 34,330 32,969
- ----------------------------------------------------------------------------------------- ------------
Deferred tax liabilities:
Differing depreciable bases in premises and leased equipment 40,141 36,824
Mortgage servicing 8,278 8,154
Net unrealized gains on securities available-for-sale - 1,463
Differing bases in assets related to acquisitions 1,734 809
Other 2,219 62
- ----------------------------------------------------------------------------------------- ------------
Total deferred tax liabilities 52,372 47,312
- ----------------------------------------------------------------------------------------- ------------
Net deferred tax liability $ 18,042 $ 14,343
======================================================================================================
At December 31, 2004, 1st Source had an alternative minimum tax credit
carryforward for income tax purposes of $2.57 million.
NOTE O -- 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. The remaining term of the lease was seven years with options to renew
for up to 15 additional years, at December 31, 2004. Approximately 30% of the
facility is subleased to other tenants.
Future minimum rental commitments for all noncancellable operating leases total
approximately, $2.40 million in 2005, $2.09 million in 2006, $1.88 million in
2007, $1.58 million in 2008, $1.48 million in 2009, and $3.53 million,
thereafter. As of December 31, 2004, future minimum rentals to be received under
noncancellable subleases totaled $3.05 million.
Rental expense of office premises and equipment and related sublease income were
as follows:
Year Ended December 31 (Dollars in thousands) 2004 2003 2002
- -------------------------------------------------------- -----------------------
Gross rental expense $ 3,075 $ 3,216 $ 3,184
Sublease rental income (1,558) (1,502) (1,479)
- -------------------------------------------------------- -----------------------
Net rental expense $ 1,517 $ 1,714 $ 1,705
================================================================================
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 2004 and 2003, 1st Source and its subsidiaries had commitments
outstanding to originate and purchase mortgage loans aggregating $106.61 million
and $143.92 million, respectively. Outstanding commitments to sell loans
aggregated $83.82 million at December 31, 2004, and $99.53 million at December
31, 2003. Standby letters of credit totaled $90.67 million and $101.26 million
at December 31, 2004 and 2003, respectively. Standby letters of credit have
terms ranging from six months to one year.
NOTE P -- 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, as of December 31, 2004, that 1st Source meets all capital
adequacy requirements to which it is subject.
As of December 31, 2004, 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, 2004, 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 $ 395,860 14.59% $ 216,993 8.00% $ 271,242 10.00%
1st Source Bank 369,084 13.93 211,895 8.00 264,868 10.00
Tier I Capital (to Risk-Weighted Assets):
Consolidated 360,559 13.29 108,497 4.00 162,745 6.00
1st Source Bank 335,508 12.67 105,947 4.00 158,921 6.00
Tier I Capital (to Average Assets):
Consolidated 360,559 10.35 139,355 4.00 174,194 5.00
1st Source Bank 335,508 9.91 135,487 4.00 169,358 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, 2004 and 2003, were approximately $4.81 million and $6.36 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 2005 of $43.02 million, plus an additional amount equal to
its net profits for 2005, 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, 2004, Trustcorp met its minimum
net worth capital requirements.
45
NOTE Q -- FAIR VALUES OF FINANCIAL INSTRUMENTS
The fair values of 1st Source's financial instruments as of December 31, 2004
and 2003 are summarized in the table below.
2004 2003
Carrying or Carrying or
(Dollars in thousands) Contract Value Fair Value Contract Value Fair Value
- ------------------------------------------------------------------------------------------------------------------------------------
Assets:
Cash and due from banks $ 78,255 $ 78,255 $ 109,787 $ 109,787
Federal funds sold and interest bearing deposits with other banks 220,131 220,131 1,355 1,355
Investment securities, available-for-sale 789,923 789,923 763,763 763,763
Mortgages held for sale 55,711 55,821 60,215 60,215
Loans and leases, net of reserve for loan and lease losses 2,216,496 2,221,357 2,160,955 2,192,329
- ------------------------------------------------------------------------------------------------------------------------------------
Liabilities:
Deposits 2,807,003 2,816,693 2,487,215 2,508,012
Short-term borrowings 299,662 299,662 390,854 390,854
Long-term debt and mandatorily redeemable securities 17,964 18,033 22,802 22,977
Subordinated notes 59,022 59,767 56,444 54,540
Interest rate swaps 652 652 4,103 4,103
Off-balance-sheet instruments* - (593) - (620)
====================================================================================================================================
*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 quoted market prices of comparable securities.
INTEREST RATE SWAPS -- The carrying values of interest rate swaps are based on
approximate fair values.
GUARANTEES AND LOAN COMMITMENTS -- Contract and fair values for certain of
1st Source's off-balance-sheet financial instruments (guarantees and loan
commitments) are estimated based on fees currently charged to enter into similar
agreements, taking into account the remaining terms of the agreements and the
counterparties' credit standing.
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
realize in a current market exchange, nor are they intended to represent the
46
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 R -- 1ST SOURCE CORPORATION (PARENT COMPANY ONLY) FINANCIAL INFORMATION
STATEMENTS OF FINANCIAL CONDITION
- ---------------------------------
December 31 (Dollars in thousands) 2004 2003
- ----------------------------------------------------------------------------- ----------------------- ------------
ASSETS
Cash $ 2 $ 70
Short-term investments with bank subsidiary 5,233 3,153
Investment securities, available-for-sale
(amortized cost of $17,740 and $25,245 at December 31, 2004 and 2003, respectively) 20,037 27,081
Investments in:
Bank subsidiaries 355,421 338,514
Non-bank subsidiaries 8,134 10,437
Loan receivables:
Non-bank subsidiaries 7,000 6,715
Premises and equipment, net 2,330 2,349
Other assets 5,952 6,627
- ----------------------------------------------------------------------------- ----------------------- ------------
Total assets $ 404,109 $ 394,946
- ----------------------------------------------------------------------------- ----------------------- ------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Commercial paper borrowings $ 836 $ 982
Other liabilities 1,385 1,562
Long-term debt and mandatorily redeemable securities 75,288 77,711
- ----------------------------------------------------------------------------- ----------------------- ------------
Total liabilities 77,509 80,255
Shareholders' equity 326,600 314,691
- ------------------------------------------------------------------------ ---------------------------- ------------
Total liabilities and shareholders' equity $ 404,109 $ 394,946
==================================================================================================================
47
STATEMENTS OF INCOME
- --------------------
Year Ended December 31 (Dollars in thousands) 2004 2003 2002
- ------------------------ ---------------------------------------------------------- ------------------- ----------- ------------
Income:
Dividends from bank and non-bank subsidiaries $ 9,749 $ 8,715 $ 7,578
Rental income from subsidiaries 829 2,668 2,763
Other 2,721 1,306 647
- ----------------------------------------------------------------------------------- ------------------- ----------- ------------
Total income 13,299 12,689 10,988
- ----------------------------------------------------------------------------------- ------------------- ----------- ------------
Expenses:
Interest on long-term debt and mandatorily redeemable securities 4,869 4,725 4,078
Interest on commercial paper and other short-term borrowings 10 26 66
Rent expense 1,059 1,059 1,059
Other 2,705 1,998 1,666
- ----------------------------------------------------------------------------------- ------------------- ----------- ------------
Total expenses 8,643 7,808 6,869
- ----------------------------------------------------------------------------------- ------------------- ----------- ------------
Income before income tax benefit and equity in undistributed income of subsidiaries 4,656 4,881 4,119
Income tax benefit 2,269 1,386 1,332
- ----------------------------------------------------------------------------------- ------------------- ----------- ------------
Income before equity in undistributed income of subsidiaries 6,925 6,267 5,451
Equity in undistributed income of subsidiaries:
Bank subsidiaries 19,832 13,285 10,158
Non-bank subsidiaries (1,792) (398) (5,570)
- ----------------------------------------------------------------------------------- ------------------- ----------- ------------
Net income $ 24,965 $ 19,154 $ 10,039
================================================================================================================================
STATEMENTS OF CASH FLOWS
- ------------------------
Year Ended December 31 (Dollars in thousands) 2004 2003 2002
- ------------------------ ---------------------------------------------------------- ------------------- ---------------- -----------
Operating activities:
Net income $ 24,965 $ 19,154 $ 10,039
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in undistributed income of subsidiaries (18,040) (12,887) (4,588)
Depreciation of premises and equipment 283 338 346
Realized and unrealized investment securities losses 851 1,092 1,349
Other 523 (820) (3)
- ----------------------------------------------------------------------------------- ------------------- ---------------- -----------
Net cash from operating activities 8,582 6,877 7,143
- ----------------------------------------------------------------------------------- ------------------- ---------------- -----------
Investing activities:
Proceeds from sales and maturities of investment securities 6,645 1,895 6,625
Purchases of investment securities - (313) (19,425)
Net change in premises and equipment (264) (262) 184
(Increase) decrease in short-term investments with bank subsidiary (2,080) 1,926 (667)
(Increase) decrease in loans made to subsidiaries, net (285) (1,715) 4,096
Capital contributions to subsidiaries - - (5,501)
Return of capital from subsidiaries 500 - -
- ----------------------------------------------------------------------------------- ------------------- ---------------- -----------
Net cash from (used in) investing activities 4,516 1,531 (14,688)
- ----------------------------------------------------------------------------------- ------------------- ---------------- -----------
Financing activities:
Net decrease in commercial paper and other short-term borrowings (146) (2,456) (1,555)
Proceeds from issuance of subordinated notes 30,929 - 10,000
Payments on subordinated notes (28,351) - -
Proceeds from issuance of long-term debt 18 47 15,048
Payments on long-term debt (5,048) (94) (10,169)
Net proceeds from issuance of treasury stock 3,253 2,598 4,261
Acquisition of treasury stock (4,958) (646) (2,503)
Cash dividends (8,863) (7,789) (7,537)
- ----------------------------------------------------------------------------------- ------------------- ---------------- -----------
Net cash (used in) from financing activities (13,166) (8,340) 7,545
- ----------------------------------------------------------------------------------- ------------------- ---------------- -----------
Net change in cash and cash equivalents (68) 68 0
Cash and cash equivalents, beginning of year 70 2 2
Cash and cash equivalents, end of year $ 2 $ 70 $ 2
====================================================================================================================================
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, 2004. 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, 2004, 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
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 2005 Proxy Statement is
incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION.
The information under the caption "Remuneration of Executive Officers" of the
2005 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 2005 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 478,791 $ 27.12 -
2001 stock option plan 80,948 21.00 1,919,052
1997 employee stock purchase plan 26,192 19.08 176,414
1982 executive incentive plan - - 100,000 (1)(2)
1982 restricted stock award plan - - 183,061 (1)
- ---------------------------------------------------------------------- ----------------------------- ------------------------
Total plans approved by shareholders 585,931 $ 25.92 2,378,527
- ---------------------------------------------------------------------- ----------------------------- ------------------------
Equity compensation plans - - -
not approved by shareholders
- ---------------------------------------------------------------------- ----------------------------- ------------------------
Total equity compensation plans 585,931 $ 25.92 2,378,527
=============================================================================================================================
(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 2005 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 2005 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, 2004 and 2003
Consolidated statements of income --
Years ended December 31, 2004, 2003, and 2002
Consolidated statements of shareholders' equity --
Years ended December 31, 2004, 2003, and 2002
Consolidated statements of cash flows --
Years ended December 31, 2004, 2003, and 2002
Notes to consolidated financial statements --
December 31, 2004, 2003, and 2002
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)(3) Employment Agreement of Allen R. Qualey, dated April 16, 1998,
filed as exhibit to Form 10-K, dated December 31, 1998, and
incorporated herein by reference.
10(a)(4) Employment Agreement of Larry E. Lentych, dated April 16, 1998,
filed as exhibit to Form 10-K, dated December 31, 1998, and
incorporated herein by reference.
10(a)(5) Employment Agreement of Richard Q. Stifel, dated April 16, 1998,
filed as exhibit to Form 10-K, dated December 31, 1998, and
incorporated herein by reference.
10(a)(6) Employment Agreement of John B. Griffith, dated March 31, 2001,
filed as exhibit to Form 10-K, dated December 31, 2002, and
incorporated herein by reference.
10(b)1st Source Corporation Employee Stock Purchase Plan dated April 17,
1997, filed as exhibit to Form 10-K, dated December 31, 1997, and
incorporated herein by reference.
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(f)1st Source Corporation Non-Qualified Stock Option Agreement with
Christopher J. Murphy III, dated January 1, 1992, as amended December
11, 1997, filed as an exhibit to Form 10-K, dated December 31, 1997,
and incorporated herein by reference.
10(g)(1) 1st Source Corporation 1992 Stock Option Plan, dated April 23,
1992, as amended December 11, 1997, filed as exhibit to Form 10-K,
dated December 31, 1997, and incorporated herein by reference.
51
10(g)(2) An amendment to 1st Source Corporation 1992 Stock Option Plan,
dated July 18, 2000, and filed as exhibit to Form 10-K, dated December
31, 2000, and incorporated herein by reference.
10(h)1st Source Corporation 1998 Performance Compensation Plan, dated
February 19, 1998, filed as exhibit to Form 10-K, dated December 31,
1998, and incorporated herein by reference.
10(i)Consulting Agreement of Ernestine M. Raclin, dated April 14, 1998,
filed as exhibit to Form 10-K, dated December 31, 1998, and
incorporated herein by reference.
21 Subsidiaries of Registrant (unless otherwise indicated, each
subsidiary does business under its own name):
Name Jurisdiction
----------------------------------------------------------------------
1st Source Bank Indiana
SFG Equipment Leasing, Inc.* Indiana
1st Source Insurance, Inc.* Indiana
1st Source Specialty Finance, Inc.* Indiana
FBT Capital Corporation (Inactive) Indiana
1st Source Leasing, Inc. Indiana
1st Source Capital Corporation* Indiana
Trustcorp Mortgage Company Indiana
1st Source Capital Trust I (Inactive) Delaware
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
Capstone 557(Proprietary)Limited South Africa *
*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 16, 2005
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 16, 2005
- ------------------------------ President and
Christopher J. Murphy III Chief Executive Officer
/s/ WELLINGTON D. JONES III Executive Vice President March 16, 2005
- ------------------------------- and Director
Wellington D. Jones III
/s/ LARRY E. LENTYCH Treasurer, March 16, 2005
- ------------------------------- Chief Financial Officer
Larry E. Lentych and Principal Accounting Officer
/s/ JOHN B. GRIFFITH Secretary March 16, 2005
- ------------------------------- and General Counsel
John B. Griffith
/s/ DAVID C. BOWERS Director March 16, 2005
- -------------------------------
David C. Bowers
/s/ DANIEL B. FITZPATRICK Director March 16, 2005
- -------------------------------
Daniel B. Fitzpatrick
/s/ TERRY L. GERBER Director March 16, 2005
- -------------------------------
Terry L. Gerber
/s/ LAWRENCE E. HILER Director March 16, 2005
- -------------------------------
Lawrence E. Hiler
/s/ WILLIAM P. JOHNSON Director March 16, 2005
- -------------------------------
William P. Johnson
/s/ CRAIG A. KAPSON Director March 16, 2005
- -------------------------------
Craig A. Kapson
/s/ REX MARTIN Director March 16, 2005
- -------------------------------
Rex Martin
/s/ DANE A. MILLER Director March 16, 2005
- -------------------------------
Dane A. Miller
/s/ TIMOTHY K. OZARK Director March 16, 2005
- -------------------------------
Timothy K. Ozark
/s/ JOHN T. PHAIR Director March 16, 2005
- -------------------------------
John T. Phair
/s/ MARK D. SCHWABERO Director March 16, 2005
- -------------------------------
Mark D. Schwabero
/s/ TOBY S. WILT Director March 16, 2005
- -------------------------------
Toby S. Wilt
53