Fair Value Measurements

6 Months Ended

Jun. 30, 2012

Fair Value Measurements

Fair Value Measurements

Note 12.     Fair Value Measurements

The Company records 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.  The Company uses 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 is 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.

The Company elected fair value accounting for mortgages held for sale.  The Company believes the election for mortgages held for sale (which are economically hedged with free standing derivatives) 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, 2012 and December 31, 2011, all mortgages held for sale are carried at fair value.

The following table reflects the differences between the fair value carrying amount of mortgages held for sale measured at fair value and the aggregate unpaid principal amount the Company is contractually entitled to receive at maturity on June 30, 2012 and December 31, 2011:

(Dollars in thousands)	Fair value carrying amount		Aggregate unpaid principal		Excess of fair value carrrying amount over (under) unpaid principal
June 30, 2012
Mortgages held for sale reported at fair value	$	17,837	$	17,162	$	675	(1)
December 31, 2011
Mortgages held for sale reported at fair value	$	12,644	$	12,265	$	379	(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.  Prices supplied by the independent pricing agent, as well as their pricing methodologies and assumptions, are reviewed by the Company for reasonableness and to ensure such prices are aligned with traditional pricing matrices.  In general, the Company’s investment securities do not possess a complex structure that could introduce greater valuation risk.  The portfolio mainly consists of traditional investments including U.S. Treasury and Federal agencies securities, federal agency mortgage pass-through securities, and general obligation and revenue municipal bonds.  Pricing for such instruments is fairly generic and is easily obtained.  On a quarterly basis, prices supplied by the pricing agent are validated by comparison to prices obtained from other third party sources for a material portion of the portfolio.

The valuation policy and procedures for Level 3 fair value measurements of available for sale debt securities are decided through collaboration between management of the Corporate Accounting and Funds Management departments.  The changes in fair value measurement for Level 3 securities are analyzed on a periodic basis under a collaborative framework with the aforementioned departments.  The methodology and variables used for input are derived from the combination of observable and unobservable inputs.  The unobservable inputs are determined through internal assumptions that may vary from period to period due to external factors, such as market movement and credit rating adjustments.

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.  Validation of third party agent valuations is accomplished by comparing those values to the Company’s swap counterparty valuations.  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 expected 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, 2012 and December 31, 2011 measured at fair value on a recurring basis:

(Dollars in thousands)	Level 1		Level 2		Level 3		Total
June 30, 2012
Assets:
Investment securities available-for-sale:
U.S. Treasury and Federal agencies securities	$	20,349	$	345,738	$	—	$	366,087
U.S. States and political subdivisions securities	—		99,161		8,143		107,304
Mortgage-backed securities — Federal agencies	—		333,008		—		333,008
Corporate debt securities	—		36,265		—		36,265
Foreign government and other securities	—		4,518		—		4,518
Total debt securities	20,349		818,690		8,143		847,182
Marketable equity securities	5,522		—		—		5,522
Total investment securities available-for-sale	25,871		818,690		8,143		852,704
Trading account securities	138		—		—		138
Mortgages held for sale	—		17,837		—		17,837
Accrued income and other assets (Interest rate swap agreements)	—		17,230		—		17,230
Total	$	26,009	$	853,757	$	8,143	$	887,909
Liabilities:
Accrued expenses and other liabilities (Interest rate swap agreements)	$	—	$	17,600	$	—	$	17,600
Total	$	—	$	17,600	$	—	$	17,600
December 31, 2011
Assets:
Investment securities available-for-sale:
U.S. Treasury and Federal agencies securities	$	20,016	$	381,109	$	—	$	401,125
U.S. States and political subdivisions securities	—		96,867		10,493		107,360
Mortgage-backed securities — Federal agencies	—		328,948		—		328,948
Corporate debt securities	—		36,310		—		36,310
Foreign government and other securities	—		4,038		675		4,713
Total debt securities	20,016		847,272		11,168		878,456
Marketable equity securities	4,403		141		—		4,544
Total investment securities available-for-sale	24,419		847,413		11,168		883,000
Trading account securities	132		—		—		132
Mortgages held for sale	—		12,644		—		12,644
Accrued income and other assets (Interest rate swap agreements)	—		17,496		—		17,496
Total	$	24,551	$	877,553	$	11,168	$	913,272
Liabilities:
Accrued expenses and other liabilities (Interest rate swap agreements)	$	—	$	17,945	$	—	$	17,945
Total	$	—	$	17,945	$	—	$	17,945

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the quarter ended June 30, 2012 and 2011 are summarized as follows:

(Dollars in thousands)	U.S. States and political subdivisions securities			Foreign government and other securities			Investment securities available- for-sale
Beginning balance April 1, 2012	$	9,934		$	—		$	9,934
Total gains or losses (realized/unrealized):
Included in earnings	—			—			—
Included in other comprehensive income	209			—			209
Purchases	—			—			—
Issuances	—			—			—
Settlements	—			—			—
Maturities	(2,000		)	—			(2,000		)
Transfers into Level 3	—			—			—
Transfers out of Level 3	—			—			—
Ending balance June 30, 2012	$	8,143		$	—		$	8,143
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

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, 2012 or 2011.  No transfers between levels occurred during the three months ended June 30, 2012.  One transfer between levels occurred during the six months ended June 30, 2012.  No transfers between Level 1 and 2 occurred during the period ended June 30, 2012.  A foreign government debt security was transferred from Level 3 to Level 2 as of March 31, 2012 due to the Company’s periodic review of valuation methodologies and inputs.  The Company determined that the observable inputs used in determining fair value warranted a transfer to Level 2 as the unobservable inputs were deemed to be insignificant to the overall fair value measurement.

The table below presents the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a recurring basis at June 30, 2012.

			Valuation
(Dollars in thousands)	Fair Value		Methodology	Unobservable Inputs	Range of Inputs
Investment securities available-for sale
Adjustable rate securities	$	3,321	Discounted cash flows	Illiquidity adjustment	4% - 8%
				Term assumption (1)	5 years
				Coupon forecast assumption	0.47% - 0.62%
Tax anticipation warrants	4,822		Discounted cash flows	Credit spread assumption	1.27% - 2.34%
Total investment securities available-for-sale	$	8,143

(1) Term assumption is influenced by security call history

The sensitivity to changes in the unobservable inputs and their impact on the fair value measurement can be significant.  The significant unobservable inputs for Adjustable Rate Securities are illiquidity, term and coupon forecast assumptions.  The illiquidity adjustment is negatively correlated to the fair value measure.  An increase (decrease) in the determined illiquidity adjustment will lower (increase) the fair value measure.  The term assumption is negatively correlated to the fair value measure.  An increase (decrease) in the determined term adjustment will decrease (increase) the fair value measure.  The coupon forecast is positively correlated to the fair value measure.  An increase (decrease) in the determined coupon forecast will increase (decrease) the fair value measure.  A permutation that includes a change in the coupon forecast with a change in either or both of the two variables will mitigate the significance of the change to the fair value measure.  The significant unobservable input for Tax Anticipation Warrants is the underlying market level used to determine the fair value measure.  An increase (decrease) in the estimated yield level of the market will decrease (increase) the fair value measure of the securities

Financial Instruments on Non-recurring Basis:

The Company may be required, from time to time, to measure certain other financial assets at fair value on a non-recurring 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.

The Credit Policy Committee, a management committee, is responsible for overseeing the valuation processes and procedures for Level 3 measurements of impaired loans, other real estate and repossessions.  The Committee reviews these assets on a quarterly basis to determine the accuracy of the observable inputs, generally third party appraisals, auction values, values derived from trade publications and data submitted by the borrower, and the appropriateness of the unobservable inputs, generally discounts due to current market conditions and collection issues.  The Committee establishes discounts based on asset type and valuation source; deviations from the standard are documented.  The discounts are reviewed periodically, annually at a minimum, to determine they remain appropriate.  Consideration is given to current trends in market values for the asset categories and gain and losses on sales of similar assets.  The Loan and Funds Management Committee of the Board of Directors is responsible for overseeing the Credit Policy Committee.

Discounts range from 10% to 90% depending on the nature of the assets and the source of value.  Aircraft are generally valued using quarterly trade publications adjusted for engine time, condition, maintenance programs, discounted by 10%.  Likewise, autos are valued using current auction values, discounted by 10%; medium and heavy duty trucks are valued using trade publications and auction values, discounted by 15%.  Construction equipment and environmental equipment is generally valued using trade publications and auction values, discounted by 20%.  Real estate is valued based on appraisals or evaluations, discounted by 20% at a minimum with higher discounts for property in poor condition or property with characteristics which may make it more difficult to market.  Commercial loans subject to borrowing base certificates are generally discounted by 20% for receivables and 40-75% for inventory with higher discounts when monthly borrowing base certificates are not required or received.

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.  Quantitative unobservable inputs are not reasonably available for reporting purposes.

The Company has established mortgage servicing rights (MSRs) valuation policies and procedures based on industry standards and to ensure valuation methodologies are consistent and verifiable.  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.  Prepayment rates and discount rates are derived through a third party pricing agent.  Changes in the most significant inputs, including prepayment rates and discount rates, are compared to the changes in the fair value measurements and appropriate resolution is made.  A fair value analysis is also obtained from an independent third party agent and compared to the internal valuation for reasonableness.  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 the Company’s 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.  Fair values are reviewed quarterly and 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, 2012:  impaired loans - $0.91 million; partnership investments — $(0.02) million; mortgage servicing rights - $0.09 million; repossessions - $0.08 million, and other real estate - $0.03 million.

The table below presents the carrying value of assets at June 30, 2012 and December 31, 2011 measured at fair value on a non-recurring basis:

(Dollars in thousands)	Level 1		Level 2		Level 3		Total
June 30, 2012
Impaired loans	$	—	$	—	$	45,068	$	45,068
Accrued income and other assets (partnership investments)	—		—		1,938		1,938
Accrued income and other assets (mortgage servicing rights)	—		—		4,893		4,893
Accrued income and other assets (repossessions)	—		—		1,177		1,177
Accrued income and other assets (other real estate)	—		—		8,391		8,391
	$	—	$	—	$	61,467	$	61,467
December 31, 2011
Impaired loans	$	—	$	—	$	50,007	$	50,007
Accrued income and other assets (partnership investments)	—		—		2,799		2,799
Accrued income and other assets (mortgage servicing rights)	—		—		5,372		5,372
Accrued income and other assets (repossessions)	—		—		6,792		6,792
Accrued income and other assets (other real estate)	—		—		8,755		8,755
	$	—	$	—	$	73,725	$	73,725

The table below presents the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a non-recurring basis at June 30, 2012.

(Dollars in thousands)	Fair Value		Valuation Methodology	Unobservable Inputs	Range of Inputs
Impaired loans	$	5,851	Discounted cash flows	Probability of default	0% - 50%
	39,217		Collateral based measurements	Discount for lack of marketability	0% - 90%
	45,068
Mortgage servicing rights	5,622		Discounted cash flows	Constant prepayment rate (CPR)	22.6% - 30.8%
				Discount rate	8.5% - 11.4%
Repossessions	1,412		Appraisals, trade publications and auction values	Discount for lack of marketability	0% - 69%
Other real estate	10,756		Appraisals	Discount for lack of marketability	0% - 51%

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 the Company’s financial instruments as of June 30, 2012 and December 31, 2011 are summarized in the table below.

	Carrying or
(Dollars in thousands)	Contract Value		Fair Value		Level 1		Level 2		Level 3
June 30, 2012
Assets:
Cash and due from banks	$	88,729	$	88,729	$	88,729	$	—	$	—
Federal funds sold and interest bearing deposits with other banks	1,351		1,351		1,351		—		—
Investment securities, available-for-sale	852,704		852,704		25,871		818,690		8,143
Other investments and trading account securities	20,072		20,072		20,072		—		—
Mortgages held for sale	17,837		17,837		—		17,837		—
Loans and leases, net of reserve for loan and lease losses	3,187,293		3,304,080		—		3,258,303		45,777
Cash surrender value of life insurance policies	55,724		55,724		55,724		—		—
Mortgage servicing rights	4,893		5,622		—		—		5,622
Interest rate swaps	17,230		17,230		—		17,230		—
Liabilities:
Deposits	$	3,586,017	$	3,607,533	$	2,425,899	$	1,181,634	$	—
Short-term borrowings	133,928		133,928		125,397		8,531		—
Long-term debt and mandatorily redeemable securities	65,506		65,926		—		65,926		—
Subordinated notes	89,692		111,264		—		111,264		—
Interest rate swaps	17,600		17,600		—		17,600		—
Off-balance-sheet instruments *	—		144		—		144		—
December 31, 2011
Assets:
Cash and due from banks	$	61,406	$	61,406
Federal funds sold and interest bearing deposits with other banks	52,921		52,921
Investment securities, available-for-sale	883,000		883,000
Other investments and trading account securities	19,106		19,106
Mortgages held for sale	12,644		12,644
Loans and leases, net of reserve for loan and lease losses	3,008,899		3,125,581
Cash surrender value of life insurance policies	54,729		54,729
Mortgage servicing rights	5,372		6,725
Interest rate swaps	17,496		17,496
Liabilities:
Deposits	$	3,520,141	$	3,546,366
Short-term borrowings	125,234		125,234
Long-term debt and mandatorily redeemable securities	37,156		37,865
Subordinated notes	89,692		87,527
Interest rate swaps	17,945		17,945
Off-balance-sheet instruments *	—		131

* 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, other investments, 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 the 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 the current estimated incremental borrowing rates for similar types of borrowing arrangements.  The carrying values of mandatorily redeemable securities are based on the 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 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 the 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 the Company’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 the Company 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 the Company 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.