-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, ElxFWyv00WMKf6m1qL/bd41Bg3OMr+tOAWhCEcLS688icBCsh5AM+BXj1Ol4LhON KVX7WQH1cjlqyvymD6jF4w== 0000034782-05-000025.txt : 20050316 0000034782-05-000025.hdr.sgml : 20050316 20050316162003 ACCESSION NUMBER: 0000034782-05-000025 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20041231 FILED AS OF DATE: 20050316 DATE AS OF CHANGE: 20050316 FILER: COMPANY DATA: COMPANY CONFORMED NAME: 1ST SOURCE CORP CENTRAL INDEX KEY: 0000034782 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 351068133 STATE OF INCORPORATION: IN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-06233 FILM NUMBER: 05685739 BUSINESS ADDRESS: STREET 1: 100 NORTH MICHIGAN STREET CITY: SOUTH BEND STATE: IN ZIP: 46601 BUSINESS PHONE: 5742352702 MAIL ADDRESS: STREET 1: P O BOX 1602 STREET 2: P O BOX 1602 CITY: SOUTH BEND STATE: IN ZIP: 46634 FORMER COMPANY: FORMER CONFORMED NAME: FBT BANCORP INC DATE OF NAME CHANGE: 19820818 10-K 1 ar04.txt FORM 10-K - 2004 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 3 $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 4 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 EX-23 2 exhibit23.txt CONSENT Exhibit 23 Consent of Independent Registered Public Accounting Firm We consent to the incorporation by reference in the Registration Statements listed below of 1st Source Corporation of our reports dated March 15, 2005, with respect to the consolidated financial statements of 1st Source Corporation and subsidiaries, 1st Source Corporation management's assessment of the effectiveness of internal control over financial reporting, and the effectiveness of internal control over financial reporting of 1st Source Corporation, included in this Annual Report (Form 10-K) for the year ended December 31, 2004. Registration Statement No. 333-101712 on Form S-8 dated December 6, 2002 Registration Statement No. 333-101711 on Form S-8 dated December 6, 2002 Registration Statement No. 333-101710 on Form S-8 dated December 6, 2002 Registration Statement No. 333-101709 on Form S-8 dated December 6, 2002 Registration Statement No. 333-64314 on Form S-8 dated July 2, 2001 Registration Statement No. 333-64306 on Form S-8 dated July 2, 2001 Registration Statement No. 333-64304 on Form S-8 dated July 2, 2001 Registration Statement No. 333-26243 dated April 30, 1997 Registration Statement No. 33-81852 dated July 22, 1994 Registration Statement No. 33-8840 dated September 16, 1986 /s/ Ernst & Young LLP Chicago, Illinois March 15, 2005 EX-31.1 3 ceo31_1.txt CERTIFICATION OF CEO EXHIBIT 31.1 CERTIFICATION I, Christopher J. Murphy III, Chief Executive Officer, certify that: 1. I have reviewed this annual report on Form 10-K of 1st Source Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's Board of Directors: a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 16, 2005 By /s/ CHRISTOPHER J. MURPHY III ----------------------------- Christopher J. Murphy III, Chief Executive Officer EX-31.2 4 cfo31_2.txt CERTIFICATION OF CFO EXHIBIT 31.2 CERTIFICATION I, Larry E. Lentych, Chief Financial Officer, certify that: 1. I have reviewed this annual report on Form 10-K of 1st Source Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's Board of Directors: a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 16, 2005 By /s/ LARRY E. LENTYCH -------------------- Larry E. Lentych, Chief Financial Officer EX-32.2 5 ceo32_1.txt CERTIFICATION OF CEO EXHIBIT 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of 1st Source Corporation (1st Source) on Form 10-K for the fiscal year ended December 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Christopher J. Murphy III, Chief Executive Officer of 1st Source, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge: (1) The Report fully complies with the requirements of sections 13(a) or 15(d) of the Securities and Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of 1st Source. Date: March 16, 2005 By /s/ CHRISTOPHER J. MURPHY III ----------------------------- Christopher J. Murphy III, Chief Executive Officer EX-32.2 6 cfo32_2.txt CERTIFICATION OF CFO EXHIBIT 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of 1st Source Corporation (1st Source) on Form 10-K for the fiscal year ended December 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Larry E. Lentych, Chief Financial Officer of 1st Source, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge: (1) The Report fully complies with the requirements of sections 13(a) or 15(d) of the Securities and Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of 1st Source. Date: March 16, 2005 By /s/ LARRY E. LENTYCH -------------------- Larry E. Lentych, Chief Financial Officer -----END PRIVACY-ENHANCED MESSAGE-----