Fair Value Measurements

6 Months Ended

Jun. 30, 2011

Fair Value Measurements

Fair Value Measurements

Note 11. Fair Value Measurements

We record certain assets and liabilities at fair value.  Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  Fair value measurements are also utilized to determine the initial value of certain assets and liabilities, to perform impairment assessments, and for disclosure purposes.  We use quoted market prices and observable inputs to the maximum extent possible when measuring fair value.  In the absence of quoted market prices, various valuation techniques are utilized to measure fair value.  When possible, observable market data for identical or similar financial instruments are used in the valuation.  When market data is not available, fair value is determined using valuation models that incorporate management’s estimates of the assumptions a market participant would use in pricing the asset or liability.

Fair value measurements are classified within one of three levels based on the observability of the inputs used to determine fair value, as follows:

· Level 1 — The valuation is based on quoted prices in active markets for identical instruments.

· Level 2 — The valuation is based on observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

· Level 3 — The valuation is based on unobservable inputs that are supported by minimal or no market activity and that are significant to the fair value of the instrument.  Level 3 valuations are typically performed using pricing models, discounted cash flow methodologies, or similar techniques that incorporate management’s own estimates of assumptions that market participants would use in pricing the instrument, or valuations that require significant management judgment or estimation.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

We elected fair value accounting for mortgages held for sale.  We believe the election for mortgages held for sale (which are hedged with free-standing derivatives [economic hedges]) will reduce certain timing differences and better match changes in the value of these assets with changes in the value of derivatives used as economic hedges for these assets.  At June 30, 2011 and December 31, 2010, all mortgages held for sale are carried at fair value.

The following table reflects the differences between fair value carrying amount of mortgages held for sale measured at fair value and the aggregate unpaid principal amount we are contractually entitled to receive at maturity on June 30, 2011 and December 31, 2010:

(Dollars in thousands)	Fair value carrying amount		Aggregate unpaid principal		Excess of fair value carrrying amount over (under) unpaid principal
June 30, 2011
Mortgages held for sale reported at fair value	$	7,805	$	7,531	$	274	(1)
December 31, 2010
Mortgages held for sale reported at fair value	$	32,599	$	32,285	$	314	(1)

(1) The excess of fair value carrying amount over unpaid principal is included in mortgage banking income and includes changes in fair value at and subsequent to funding, gains and losses on the related loan commitment prior to funding, and premiums on acquired loans.

Financial Instruments on Recurring Basis:

The following is a description of the valuation methodologies used for financial instruments measured at fair value on a recurring basis:

Investment securities available for sale are valued primarily by a third party pricing agent and both the market and income valuation approaches are implemented using the following types of inputs:

· U.S. treasuries are priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.

· Government-sponsored agency debt securities and corporate bonds are primarily priced using available market information through processes such as benchmark curves, market valuations of like securities, sector groupings and matrix pricing.

· Other government-sponsored agency securities, mortgage-backed securities and some of the actively traded REMICs and CMOs, are primarily priced using available market information including benchmark yields, prepayment speeds, spreads and volatility of similar securities.

· Other inactive government-sponsored agency securities are primarily priced using consensus pricing and dealer quotes.

· State and political subdivisions are largely grouped by characteristics, i.e., geographical data and source of revenue in trade dissemination systems.  Since some securities are not traded daily and due to other grouping limitations, active market quotes are often obtained using benchmarking for like securities.  Local tax anticipation warrants, with very little market activity, are priced using an appropriate market yield curve.

· Marketable equity (common) securities are primarily priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.

Trading account securities are priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.

Mortgages held for sale and the related loan commitments and forward contracts (hedges) are valued using a market value approach and utilizing an appropriate current market yield and a loan commitment closing rate based on historical analysis.

Interest rate swap positions, both assets and liabilities, are valued by a third-party pricing agent using an income approach and utilizing models that use as their basis readily observable market parameters.  This valuation process considers various factors including interest rate yield curves, time value and volatility factors.  Management believes an adjustment is required to “mid-market” valuations for derivatives tied to its performing loan portfolio to recognize the imprecision and related exposure inherent in the process of estimating credit losses as well as velocity of deterioration evident with systemic risks imbedded in these portfolios.

The table below presents the balance of assets and liabilities at June 30, 2011 and December 31, 2010 measured at fair value on a recurring basis:

(Dollars in thousands)	Level 1		Level 2		Level 3		Total
June 30, 2011
Assets:
Investment securities available-for-sale:
U.S. Treasury and Federal agencies securities	$	20,124	$	363,051	$	—	$	383,175
U.S. States and political subdivisions securities	—		104,969		12,455		117,424
Mortgage-backed securities — Federal agencies	—		349,256		—		349,256
Corporate debt securities	—		40,674		675		41,349
Foreign government and other securities	—		6,020		—		6,020
Total debt securities	20,124		863,970		13,130		897,224
Marketable equity securities	5,518		—		—		5,518
Total investment securities available-for-sale	25,642		863,970		13,130		902,742
Trading account securities	143		—		—		143
Mortgages held for sale	—		7,805		—		7,805
Accrued income and other assets (Interest rate swap agreements)	—		13,651		—		13,651
Total	$	25,785	$	885,426	$	13,130	$	924,341
Liabilities:
Accrued expenses and other liabilities (Interest rate swap agreements)	$	—	$	14,055	$	—	$	14,055
Total	$	—	$	14,055	$	—	$	14,055
December 31, 2010
Assets:
Investment securities available-for-sale:
U.S. Treasury and Federal agencies securities	$	20,186	$	427,123	$	—	$	447,309
U.S. States and political subdivisions securities	—		134,001		16,306		150,307
Mortgage-backed securities — Federal agencies	—		316,668		—		316,668
Corporate debt securities	—		35,623		9,992		45,615
Foreign government and other securities	—		5,041		675		5,716
Total debt securities	20,186		918,456		26,973		965,615
Marketable equity securities	3,403		—		—		3,403
Total investment securities available-for-sale	23,589		918,456		26,973		969,018
Trading account securities	138		—		—		138
Mortgages held for sale	—		32,599		—		32,599
Accrued income and other assets (Interest rate swap agreements)	—		14,959		—		14,959
Total	$	23,727	$	966,014	$	26,973	$	1,016,714
Liabilities:
Accrued expenses and other liabilities (Interest rate swap agreements)	$	—	$	15,384	$	—	$	15,384
Total	$	—	$	15,384	$	—	$	15,384

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the quarter ended June 30, 2011 and 2010 are summarized as follows:

(Dollars in thousands)	U.S. States and political subdivisions securities			Marketable equity securities		Foreign government and other securities			Investment securities available- for-sale
Beginning balance April 1, 2011	$	16,538		$	—	$	675		$	17,213
Total gains or losses (realized/unrealized):
Included in earnings	—			—		—			—
Included in other comprehensive income	317			—		—			317
Purchases	—			—		100			100
Issuances	—			—		—			—
Settlements	—			—		—			—
Maturities	(4,400		)	—		(100		)	(4,500		)
Transfers into Level 3	—			—		—			—
Transfers out of Level 3	—			—		—			—
Ending balance June 30, 2011	$	12,455		$	—	$	675		$	13,130
Beginning balance April 1, 2010	$	9,801		$	9	$	675		$	10,485
Total gains or losses (realized/unrealized):
Included in earnings	—			—		—			—
Included in other comprehensive income	(23		)	—		—			(23		)
Purchases	42			—		—			42
Issuances	—			—		—			—
Settlements	—			—		—			—
Maturities	(496		)	—		—			(496		)
Transfers into Level 3	—			—		—			—
Transfers out of Level 3	—			—		—			—
Ending balance June 30, 2010	$	9,324		$	9	$	675		$	10,008

There were no gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at June 30, 2011 or 2010.  No transfers between levels occurred during the six months ended June 30, 2011.

Financial Instruments on Non-recurring Basis:

We may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with GAAP.  These adjustments to fair value usually result from application of lower of cost or market accounting or impairment charges of individual assets.

Impaired loans and related write-downs are based on the fair value of the underlying collateral if repayment is expected solely from the collateral.  Collateral values are reviewed quarterly and estimated using customized discounting criteria, appraisals and dealer and trade magazine quotes which are used in a market valuation approach.

Partnership investments and the adjustments to fair value primarily result from application of lower of cost or fair value accounting.  The partnership investments are priced using financial statements provided by the partnerships.

Mortgage servicing rights (MSRs) and related adjustments to fair value result from application of lower of cost or fair value accounting.  For purposes of impairment, MSRs are stratified based on the predominant risk characteristics of the underlying servicing, principally by loan type and interest rate.  The fair value of each tranche of the servicing portfolio is estimated by calculating the present value of estimated future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates, servicing costs, and other economic factors.  A fair value analysis is also obtained from an independent third party agent.  MSRs do not trade in an active, open market with readily observable prices and though sales of MSRs do occur, precise terms and conditions typically are not readily available and the characteristics of our servicing portfolio may differ from those of any servicing portfolios that do trade.

Other real estate is based on the lower of cost or fair value of the underlying collateral less expected selling costs.  Collateral values are estimated primarily using appraisals and reflect a market value approach.  New appraisals are obtained annually.  Repossessions are similarly valued.

For assets measured at fair value on a nonrecurring basis the following represents impairment charges (recoveries) recognized on these assets during the quarter ended June 30, 2011:  impaired loans - $1.77 million; partnership investments — $0.03 million; mortgage servicing rights - $0.01 million; repossessions - $0.00 million, and other real estate - $0.05 million.

The table below presents the carrying value of assets at June 30, 2011 and December 31, 2010 measured at fair value on a non-recurring basis:

(Dollars in thousands)	Level 1		Level 2		Level 3		Total
June 30, 2011
Loans	$	—	$	—	$	66,292	$	66,292
Accrued income and other assets (partnership investments)	—		—		1,806		1,806
Accrued income and other assets (mortgage servicing rights)	—		—		6,403		6,403
Accrued income and other assets (repossessions)	—		—		1,302		1,302
Accrued income and other assets (other real estate)	—		—		9,458		9,458
	$	—	$	—	$	85,261	$	85,261
December 31, 2010
Loans	$	—	$	—	$	78,076	$	78,076
Accrued income and other assets (partnership investments)	—		—		1,964		1,964
Accrued income and other assets (mortgage servicing rights)	—		—		7,556		7,556
Accrued income and other assets (repossessions)	—		—		5,670		5,670
Accrued income and other assets (other real estate)	—		—		7,592		7,592
	$	—	$	—	$	100,858	$	100,858

GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring or non-recurring basis.

The fair values of our financial instruments as of June 30, 2011 and December 31, 2010 are summarized in the table below.

	June 30, 2011				December 31, 2010
	Carrying or				Carrying or
(Dollars in thousands)	Contract Value		Fair Value		Contract Value		Fair Value
Assets:
Cash and due from banks	$	59,249	$	59,249	$	62,313	$	62,313
Federal funds sold and interest bearing deposits with other banks	100		100		34,559		34,559
Investment securities, available-for-sale	902,742		902,742		969,018		969,018
Other investments and trading account securities	19,117		19,117		21,481		21,481
Mortgages held for sale	7,805		7,805		32,599		32,599
Loans and leases, net of reserve for loan and lease losses	3,033,147		3,152,053		2,983,749		3,040,895
Cash surrender value of life insurance policies	53,713		53,713		54,182		54,182
Mortgage servicing rights	6,403		10,241		7,556		8,785
Interest rate swaps	13,651		13,651		14,959		14,959
Liabilities:
Deposits	$	3,523,316	$	3,551,737	$	3,622,745	$	3,654,067
Short-term borrowings	130,123		130,123		155,989		155,989
Long-term debt and mandatorily redeemable securities	36,785		37,214		24,816		25,072
Subordinated notes	89,692		87,632		89,692		79,811
Interest rate swaps	14,055		14,055		15,384		15,384
Off-balance-sheet instruments *	—		143		—		134

* Represents estimated cash outflows required to currently settle the obligations at current market rates.

The methodologies for estimating fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above.  The estimated fair value approximates carrying value for cash and due from banks, federal funds sold and interest bearing deposits with other banks, and cash surrender value of life insurance policies.  The methodologies for other financial assets and financial liabilities are discussed below:

Loans and Leases — For variable rate loans and leases that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.  The fair values of other loans and leases are estimated using discounted cash flow analyses which use interest rates currently being offered for loans and leases with similar terms to borrowers of similar credit quality.

Deposits — The fair values for all deposits other than time deposits are equal to the amounts payable on demand (the carrying value).  Fair values of variable rate time deposits are equal to their carrying values.  Fair values for fixed rate time deposits are estimated using discounted cash flow analyses using interest rates currently being offered for deposits with similar remaining maturities.

Short-Term Borrowings — The carrying values of Federal funds purchased, securities sold under repurchase agreements, and other short-term borrowings, including our liability related to mortgage loans available for repurchase under GNMA optional repurchase programs, approximate their fair values.

Long-Term Debt and Mandatorily Redeemable Securities — The fair values of long-term debt are estimated using discounted cash flow analyses, based on our current estimated incremental borrowing rates for similar types of borrowing arrangements.  The carrying values of mandatorily redeemable securities are based on our current estimated cost of redeeming these securities which approximate their fair values.

Subordinated Notes — Fair values are based on quoted market prices, where available.  If quoted market prices are not available, fair values are estimated based on calculated market prices of comparable securities.

Off-Balance-Sheet Instruments — Contract and fair values for certain of our off-balance-sheet financial instruments (guarantees) are estimated based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

Limitations — Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments.  Because no market exists for a significant portion of our 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 our 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 we could realize in a current market exchange, nor are they intended to represent the fair value of 1st Source as a whole.  The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.  The fair value estimates presented herein are based on pertinent information available to management as of the respective balance sheet date.  Although 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 premises and equipment, other assets, and liabilities not defined as financial instruments, are not included in the above disclosures.  Also, the fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.