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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended March 31, 2011
 
OR
o
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
 
(Exact name of registrant as specified in its charter)

INDIANA
 
35-1068133
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
100 North Michigan Street
South Bend, IN
46614
(Address of principle executive offices) (Zip Code)
 
(574) 235-2000
(Registrant’s telephone number, including area code)
 
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
 
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.                       x Yes        o No
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    o Yes        o No
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

 
Large accelerated filer o
Accelerated filer x
 
Non-accelerated filer o (Do not check if a smaller reporting company)
Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o  Yes   x   No
 
Number of shares of common stock outstanding as of April 15, 2011 – 24,303,656 shares

 
- 1 -

 


TABLE OF CONTENTS
 
PART I. FINANCIAL INFORMATION
 
Page
Item 1.
Financial Statements (Unaudited)
 
 
3
 
4
 
5
 
6
 
7
Item 2.
25
Item 3.
34
Item 4.
34
 
PART II. OTHER INFORMATION
 
Item 1.
34
Item 1A.
34
Item 2.
35
Item 3.
35
Item 4.
35
Item 5.
35
Item 6.
35
 
 
36
 
CERTIFICATIONS
   
     
Exhibit 31.1    
Exhibit 31.2    
Exhibit 32.1    
Exhibit 32.2    



1st SOURCE CORPORATION
           
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
           
(Unaudited - Dollars in thousands)
           
   
March 31,
   
December 31,
 
   
2011
   
2010
 
ASSETS
           
Cash and due from banks
  $ 57,271     $ 62,313  
Federal funds sold and
               
interest bearing deposits with other banks
    81,661       34,559  
Investment securities available-for-sale
               
(amortized cost of $927,522 and $952,101
               
at March 31, 2011 and December 31, 2010, respectively)
    942,221       969,018  
Other investments
    20,503       21,343  
Trading account securities
    146       138  
Mortgages held for sale
    5,467       32,599  
Loans and leases - net of unearned discount
               
Commercial and agricultural loans
    547,381       530,228  
Auto, light truck and environmental equipment
    416,957       396,500  
Medium and heavy duty truck
    156,022       162,824  
Aircraft financing
    601,480       614,357  
Construction equipment financing
    271,490       285,634  
Commercial real estate
    578,648       594,729  
Residential real estate
    386,290       390,951  
Consumer loans
    93,450       95,400  
Total loans and leases
    3,051,718       3,070,623  
Reserve for loan and lease losses
    (86,160 )     (86,874 )
Net loans and leases
    2,965,558       2,983,749  
Equipment owned under operating leases, net
    81,304       78,138  
Net premises and equipment
    36,024       33,881  
Goodwill and intangible assets
    88,650       88,955  
Accrued income and other assets
    133,571       140,588  
Total assets
    4,412,376       4,445,281  
                 
LIABILITIES
               
Deposits:
               
Noninterest bearing
  $ 513,315     $ 524,564  
Interest bearing
    3,095,692       3,098,181  
Total deposits
    3,609,007       3,622,745  
Short-term borrowings:
               
Federal funds purchased and securities
               
sold under agreements to repurchase
    112,914       136,028  
Other short-term borrowings
    19,239       19,961  
Total short-term borrowings
    132,153       155,989  
Long-term debt and mandatorily redeemable securities
    26,717       24,816  
Subordinated notes
    89,692       89,692  
Accrued expenses and other liabilities
    64,340       65,656  
Total liabilities
    3,921,909       3,958,898  
                 
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 25,643,506 at March 31, 2011
               
and December 31, 2010
    346,535       350,282  
Retained earnings
    164,455       157,875  
Cost of common stock in treasury (1,339,860 shares at March 31, 2011 and
               
1,470,696 shares at December 31, 2010)
    (29,655 )     (32,284 )
Accumulated other comprehensive income
    9,132       10,510  
Total shareholders' equity
    490,467       486,383  
Total liabilities and shareholders' equity
  $ 4,412,376     $ 4,445,281  
                 
The accompanying notes are a part of the consolidated financial statements.
               



1st SOURCE CORPORATION
           
CONSOLIDATED STATEMENTS OF INCOME
           
(Unaudited - Dollars in thousands, except per share amounts)
           
   
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Interest income:
           
Loans and leases
  $ 41,299     $ 42,270  
Investment securities, taxable
    4,482       5,401  
Investment securities, tax-exempt
    1,186       1,467  
Other
    243       274  
Total interest income
    47,210       49,412  
                 
Interest expense:
               
Deposits
    8,355       12,405  
Short-term borrowings
    89       188  
Subordinated notes
    1,647       1,647  
Long-term debt and mandatorily redeemable securities
    259       270  
Total interest expense
    10,350       14,510  
                 
Net interest income
    36,860       34,902  
Provision for loan and lease losses
    2,198       4,388  
Net interest income after provision for
               
loan and lease losses
    34,662       30,514  
                 
Noninterest income:
               
Trust fees
    3,992       3,745  
Service charges on deposit accounts
    4,236       4,620  
Mortgage banking income
    444       777  
Insurance commissions
    1,142       1,465  
Equipment rental income
    6,038       6,745  
Other income
    2,971       2,689  
Investment securities and other investment gains
    130       881  
Total noninterest income
    18,953       20,922  
                 
Noninterest expense:
               
Salaries and employee benefits
    18,638       18,810  
Net occupancy expense
    2,320       2,487  
Furniture and equipment expense
    3,349       2,800  
Depreciation - leased equipment
    4,805       5,364  
Professional fees
    1,096       1,514  
Supplies and communication
    1,394       1,369  
FDIC and other insurance
    1,676       1,674  
Business development and marketing expense
    622       567  
Loan and lease collection and repossession expense
    1,324       1,106  
Other expense
    3,252       1,419  
Total noninterest expense
    38,476       37,110  
                 
Income before income taxes
    15,139       14,326  
Income tax expense
    4,531       4,647  
                 
Net income
    10,608       9,679  
Preferred stock dividends and discount accretion
    -       (1,711 )
Net income available to common shareholders
  $ 10,608     $ 7,968  
                 
Per common share
               
Basic net income per common share
  $ 0.43     $ 0.33  
Diluted net income per common share
  $ 0.43     $ 0.33  
Dividends
  $ 0.16     $ 0.15  
Basic weighted average common shares outstanding
    24,271,366       24,210,242  
Diluted weighted average common shares outstanding
    24,279,517       24,215,506  
                 
The accompanying notes are a part of the consolidated financial statements.
               



1st SOURCE CORPORATION
                                   
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
                         
(Unaudited - Dollars in thousands, except per share amounts)
                               
                                     
                           
Cost of
   
Accumulated
 
                           
Common
   
Other
 
         
Preferred
   
Common
   
Retained
   
Stock
   
Comprehensive
 
   
Total
   
Stock
   
Stock
   
Earnings
   
in Treasury
   
Income (Loss), Net
 
Balance at January 1, 2010
  $ 570,320     $ 104,930     $ 350,269     $ 142,407     $ (32,380 )   $ 5,094  
Comprehensive Income, net of tax:
                                               
Net Income
    9,679       -       -       9,679       -       -  
Change in unrealized appreciation
                                               
of available-for-sale securities, net of tax
    1,578       -       -       -       -       1,578  
Reclassification adjustment for gains
                                               
included in net income, net of tax
    (174 )     -       -       -       -       (174 )
Total Comprehensive Income
    11,083       -       -       -       -       -  
Issuance of 182,934 common shares
                                               
under stock based compensation awards,
                                               
including related tax effects
    2,778       -       -       632       2,146       -  
Cost of 7,269 shares of common
                                               
stock acquired for treasury
    (114 )     -       -       -       (114 )     -  
Preferred stock discount accretion
    -       324       -       (324 )     -       -  
Preferred stock dividend (paid and/or accrued)
    (1,387 )     -       -       (1,387 )     -       -  
Common stock dividend ($0.15 per share)
    (3,626 )     -       -       (3,626 )     -       -  
Stock based compensation
    3       -       3       -       -       -  
Balance at March 31, 2010
  $ 579,057     $ 105,254     $ 350,272     $ 147,381     $ (30,348 )   $ 6,498  
                                                 
Balance at January 1, 2011
  $ 486,383     $ -     $ 350,282     $ 157,875     $ (32,284 )   $ 10,510  
Comprehensive Income, net of tax:
                                               
Net Income
    10,608       -       -       10,608       -       -  
Change in unrealized appreciation
                                               
of available-for-sale securities, net of tax
    (1,250 )     -       -       -       -       (1,250 )
Reclassification adjustment for gains
                                               
included in net income, net of tax
    (128 )     -       -       -       -       (128 )
Total Comprehensive Income
    9,230       -       -       -       -       -  
Issuance of 139,736 common shares
                                               
under stock based compensation awards,
                                               
including related tax effects
    2,666       -       -       (126 )     2,792       -  
Cost of 8,900 shares of common
                                               
stock acquired for treasury
    (163 )     -       -       -       (163 )     -  
Repurchase of common stock warrant
    (3,750 )     -       (3,750 )     -       -       -  
Common stock dividend ($0.16 per share)
    (3,902 )     -       -       (3,902 )     -       -  
Stock based compensation
    3       -       3       -       -       -  
Balance at March 31, 2011
  $ 490,467     $ -     $ 346,535     $ 164,455     $ (29,655 )   $ 9,132  
                                                 
The accompanying notes are a part of the consolidated financial statements.
                                 



1st SOURCE CORPORATION
           
CONSOLIDATED STATEMENTS OF CASH FLOWS
           
(Unaudited - Dollars in thousands)
           
   
Three Months Ended March 31,
 
   
2011
   
2010
 
Operating activities:
           
Net income
  $ 10,608     $ 9,679  
Adjustments to reconcile net income to net cash
               
provided (used) by operating activities:
               
Provision for loan and lease losses
    2,198       4,388  
Depreciation of premises and equipment
    873       1,182  
Depreciation of equipment owned and leased to others
    4,805       5,364  
Amortization of investment security premiums
               
and accretion of discounts, net
    485       668  
Amortization of mortgage servicing rights
    734       761  
Mortgage servicing asset impairment (recovery)
    5       (1 )
Deferred income taxes
    (297 )     948  
Investment securities and other investment gains
    (130 )     (881 )
Originations/purchases of loans held for sale, net of principal collected
    (25,343 )     (50,208 )
Proceeds from the sales of loans held for sale
    52,560       54,303  
Net gain on sale of loans held for sale
    (85 )     (512 )
Change in trading account securities
    (8 )     (5 )
Change in interest receivable
    (116 )     75  
Change in interest payable
    1,905       1,110  
Change in other assets
    6,701       (1,337 )
Change in other liabilities
    (2,083 )     8,573  
Other
    1,696       15  
Net change in operating activities
    54,508       34,122  
                 
Investing activities:
               
Proceeds from sales of investment securities
    66,989       71,579  
Proceeds from maturities of investment securities
    67,756       123,734  
Purchases of investment securities
    (110,522 )     (180,063 )
Net change in other investments
    840       1,403  
Loans sold or participated to others
    4,010       4,586  
Net change in loans and leases
    11,983       (22,348 )
Net change in equipment owned under operating leases
    (7,971 )     (586 )
Purchases of premises and equipment
    (3,047 )     (857 )
Net change in investing activities
    30,038       (2,552 )
                 
Financing activities:
               
Net change in demand deposits, NOW
               
accounts and savings accounts
    (33,730 )     (69,419 )
Net change in certificates of deposit
    19,992       (43,915 )
Net change in short-term borrowings
    (23,836 )     (8,964 )
Proceeds from issuance of long-term debt
    417       5,303  
Payments on long-term debt
    (114 )     (139 )
Net proceeds from issuance of treasury stock
    2,666       2,778  
Acquisition of treasury stock
    (163 )     (114 )
Repurchase of common stock warrant
    (3,750 )     -  
Cash dividends paid on preferred stock
    -       (1,387 )
Cash dividends paid on common stock
    (3,968 )     (3,690 )
Net change in financing activities
    (42,486 )     (119,547 )
                 
Net change in cash and cash equivalents
    42,060       (87,977 )
                 
Cash and cash equivalents, beginning of year
    96,872       210,102  
                 
Cash and cash equivalents, end of period
  $ 138,932     $ 122,125  
                 
Non-cash transactions:
               
Loans transferred to other real estate and repossessed assets
  $ 3,931     $ 4,242  
Common stock matching contribution to KSOP plan
    2,420       2,545  
                 
The accompanying notes are a part of the consolidated financial statements.
               

 

1ST SOURCE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1.              Basis of Presentation

The accompanying unaudited consolidated financial statements reflect all adjustments (all of which are normal and recurring in nature) which are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, the results of operations, changes in shareholders’ equity, and cash flows for the periods presented.  These unaudited consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) have been omitted.  The Notes to the Consolidated Financial Statements appearing in 1st Source Corporation’s Annual Report on Form 10-K (2010 Annual Report), which include descriptions of significant accounting policies, should be read in conjunction with these interim financial statements.  The balance sheet at December 31, 2010 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements.  Certain amounts in the prior period consolidated financial statements have been reclassified to conform with the current year presentation.

Cash Flow – For purposes of the consolidated statements of cash flow, we consider cash and due from banks, federal funds sold and interest bearing deposits with other banks with original maturities of three months or less as cash and cash equivalents.

Note 2.              Recent Accounting Pronouncements

Receivables:  In April 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-02 “Receivables (Topic 310) – A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.”  ASU 2011-02 clarifies whether loan modifications constitute troubled debt restructuring.  In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties.  ASU 2011-02 is effective for the first interim and annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption.  We are assessing the impact of ASU 2011-02 on our financial condition, results of operations, and disclosures.

Business Combinations: In December 2010, the FASB issued ASU No. 2010-29 "Business Combinations (Topic 805) - Disclosure of Supplementary Pro Forma Information for Business Combinations."  If a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only.  ASU 2010-29 also expands the supplementary pro forma disclosures.  ASU 2010-29 was effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010.  ASU 2010-29 will only affect us if there are future business combinations.

Intangibles - Goodwill and Other:  In December 2010, the FASB issued ASU No. 2010-28 "Intangibles - Goodwill and Other (Topic 350) - When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts."  ASU 2010-28 affects all entities that have recognized goodwill and have one or more reporting units whose carrying amount for purposes of performing Step 1 of the goodwill impairment test is zero or negative.  ASU 2010-28 was effective for fiscal years and interim periods within those years, beginning after December 15, 2010.  ASU 2010-28 did not have an impact on our financial condition, results of operations, or disclosures.
 

 
Note 3.              Investment Securities

Investment securities available-for-sale were as follows:
 
(Dollars in thousands)
 
Amortized
   
Gross
   
Gross
       
   
Cost
   
Unrealized Gains
   
Unrealized Losses
   
Fair Value
 
March 31, 2011
                       
U.S. Treasury and Federal agencies securities
  $ 434,510     $ 4,461     $ (1,328 )   $ 437,643  
U.S. States and political subdivisions securities
    120,814       4,153       (1,103 )     123,864  
Mortgage-backed securities Federal agencies
    327,458       6,741       (441 )     333,758  
Corporate debt securities
    35,677       167       (249 )     35,595  
Foreign government and other securities
    6,717       23       (51 )     6,689  
Total debt securities
    925,176       15,545       (3,172 )     937,549  
Marketable equity securities
    2,346       2,329       (3 )     4,672  
Total investment securities available-for-sale
  $ 927,522     $ 17,874     $ (3,175 )   $ 942,221  
                                 
December 31, 2010
                               
U.S. Treasury and Federal agencies securities
  $ 442,612     $ 5,546     $ (849 )   $ 447,309  
U.S. States and political subdivisions securities
    147,679       4,381       (1,753 )     150,307  
Mortgage-backed securities – Federal agencies
    309,046       7,854       (232 )     316,668  
Corporate debt securities
    45,778       182       (345 )     45,615  
Foreign government and other securities
    5,732       18       (34 )     5,716  
Total debt securities
    950,847       17,981       (3,213 )     965,615  
Marketable equity securities
    1,254       2,152       (3 )     3,403  
Total investment securities available-for-sale
  $ 952,101     $ 20,133     $ (3,216 )   $ 969,018  
 
At March 31, 2011, the residential mortgage-backed securities we held consisted primarily of GNMA, FNMA and FHLMC pass-through certificates which are guaranteed by those respective agencies of the United States government (or Government Sponsored Enterprise, GSEs).

The contractual maturities of debt securities available-for-sale at March 31, 2011 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
  $ 40,341     $ 40,737  
Due after one year through five years
    437,823       442,361  
Due after five years through ten years
    108,324       110,481  
Due after ten years
    11,230       10,212  
Mortgage-backed securities
    327,458       333,758  
Total debt securities available-for-sale
  $ 925,176     $ 937,549  
 
The following table shows the gross realized gains and losses on sale of securities from the securities available-for-sale portfolio, including marketable equity securities.  Realized gains and losses on the sales of all securities are computed using the specific identification cost basis.  The gross gains and losses in the first three months of 2011 primarily reflect the sale of municipal, FHLB and FFCB debt securities.  The sale of municipal securities was to reduce credit risk exposure in certain states.  The action to sell agency securities was to improve future yield. There was no impact to other than temporary impairment (OTTI) as a result of the first quarter 2011 sales. The gross gains and losses in the first three months of 2010 reflect the disposition of FNMA and FHLMC debt securities.  There were no OTTI write-downs in 2011.


 
(Dollars in thousands)
 
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Gross realized gains
  $ 445     $ 292  
Gross realized losses
    (238 )     (12 )
Net realized gains (losses)
  $ 207     $ 280  
 
There were net gains of $8 thousand for the three months ended March 31, 2011 and net gains of $5 thousand recorded for the three months ended March 31, 2010 on $0.15 million in trading securities outstanding at March 31, 2011 and $0.14 million at December 31, 2010.

The following tables summarize our gross unrealized losses and fair value by investment category and age:
 
   
Less than 12 Months
   
12 months or Longer
   
Total
 
(Dollars in thousands)
 
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
March 31, 2011
                                   
U.S. Treasury and Federal agencies securities
  $ 156,626     $ (1,328 )   $ -     $ -     $ 156,626     $ (1,328 )
U.S. States and political subdivisions securities
    7,447       (132 )     9,591       (971 )     17,038       (1,103 )
Mortgage-backed securities - Federal agencies
    36,872       (408 )     4,450       (33 )     41,322       (441 )
Corporate debt securities
    26,398       (249 )     -       -       26,398       (249 )
Foreign government and other securities
    2,962       (51 )     -       -       2,962       (51 )
Total debt securities
    230,305       (2,168 )     14,041       (1,004 )     244,346       (3,172 )
Marketable equity securities
    -       -       5       (3 )     5       (3 )
Total investment securities available-for-sale
  $ 230,305     $ (2,168 )   $ 14,046     $ (1,007 )   $ 244,351     $ (3,175 )
                                                 
December 31, 2010
                                               
U.S. Treasury and Federal agencies securities
  $ 158,497     $ (849 )   $ -     $ -     $ 158,497     $ (849 )
U.S. States and political subdivisions securities
    9,226       (246 )     9,055       (1,507 )     18,281       (1,753 )
Mortgage-backed securities - Federal agencies
    23,351       (213 )     4,887       (19 )     28,238       (232 )
Corporate debt securities
    26,407       (345 )     -       -       26,407       (345 )
Foreign government and other securities
    3,015       (34 )     -       -       3,015       (34 )
Total debt securities
    220,496       (1,687 )     13,942       (1,526 )     234,438       (3,213 )
Marketable equity securities
    -       -       5       (3 )     5       (3 )
Total investment securities available-for-sale
  $ 220,496     $ (1,687 )   $ 13,947     $ (1,529 )   $ 234,443     $ (3,216 )
 
The initial indication of OTTI for both debt and equity securities is a decline in fair value below amortized cost.  Quarterly, the impaired securities are analyzed on a qualitative and quantitative basis in determining OTTI.  Declines in the fair value of available-for-sale debt securities below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses.  The amount of impairment related to other factors is recognized in other comprehensive income.  In estimating OTTI impairment losses, we consider among other things, (i) the length of time and the extent to which fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) whether it is more likely than not that we will not have to sell any such securities before a recovery of cost.

At March 31, 2011, we do not have the intent to sell any of the available-for-sale securities in the table above and believe that it is more likely than not that we will not have to sell any such securities before an anticipated recovery of cost.  The unrealized losses are due to increases in market interest rates over the yields available at the time the underlying securities were purchased and market illiquidity on auction rate securities which are reflected in U.S. States and Political subdivisions securities.  The fair value is expected to recover on all debt securities as they approach their maturity date or repricing date or if market yields for such investments decline.  
 
 
 
We do not believe any of the securities are impaired due to reasons of credit quality.  Accordingly, as of March 31, 2011, we believe the impairments detailed in the table above are temporary and no impairment loss has been realized in our consolidated statements of income.

At March 31, 2011 and December 31, 2010, investment securities with carrying values of $256.64 million and $299.88 million, respectively, were pledged as collateral to secure government deposits, security repurchase agreements, and for other purposes.

Note 4.              Loan and Lease Financings

We evaluate loans and leases for credit quality on a monthly basis.  All loans and leases, except residential real estate loans and consumer loans, are assigned credit quality ratings on a scale from 1 to 12 with grade 1 representing superior credit quality.  The criteria used to assign quality ratings to extensions of credit that exhibit potential problems or well-defined weaknesses are primarily based upon the degree of risk and the likelihood of orderly repayment, and their effect on the Bank's safety and soundness.  Loans graded 7 or weaker are considered "special attention" credits and, as such, relationships in excess of $100,000 are reviewed quarterly as part of management's evaluation of the adequacy of the reserve for loan and lease losses.  Grade 7 credits are defined as "watch" and contain greater than average credit risk and thus warrant timely follow-up to limit the Bank's exposure to increased risk; grade 8 credits are "special mention" and, following regulatory guidelines, are defined as having potential weaknesses that deserve management's close attention.  Credits that exhibit well-defined weaknesses and a distinct possibility of loss are considered ''classified'' and are graded 9 through 12 corresponding to the regulatory definitions of "substandard" (grades 9 and 10) and the more severe ''doubtful'' (grade 11) and ''loss'' (grade 12).

The table below presents the credit quality category of the recorded investment in loans and leases, segregated by class.
                   
(Dollars in thousands)
 
Grade:
 
      1-6       7-12    
Total
 
March 31, 2011
                     
Commercial and agricultural loans
  $ 504,137     $ 43,244     $ 547,381  
Auto, light truck,
                       
and environmental equipment
    412,155       4,802       416,957  
Medium and heavy duty truck
    135,750       20,272       156,022  
Aircraft financing
    546,740       54,740       601,480  
Construction equipment financing
    240,214       31,276       271,490  
Commercial real estate
    518,801       59,847       578,648  
Total
  $ 2,357,797     $ 214,181     $ 2,571,978  
                         
December 31, 2010
                       
Commercial and agricultural loans
  $ 483,603     $ 46,625     $ 530,228  
Auto, light truck,
                       
and environmental equipment
    389,774       6,726       396,500  
Medium and heavy duty truck
    143,431       19,393       162,824  
Aircraft financing
    555,106       59,251       614,357  
Construction equipment financing
    246,644       38,990       285,634  
Commercial real estate
    532,581       62,148       594,729  
Total
  $ 2,351,139     $ 233,133     $ 2,584,272  

 
- 10 -



The table below presents the recorded investment in residential real estate and consumer loans by performing or non-performing status.  Non-performing loans are those loans which are on nonaccrual status or are 90 days or more past due.
 
(Dollars in thousands)
                 
   
Performing
   
Nonperforming
   
Total
 
March 31, 2011
                 
Residential real estate
  $ 380,796     $ 5,494     $ 386,290  
Consumer
    92,882       568       93,450  
Total
  $ 473,678     $ 6,062     $ 479,740  
                         
December 31, 2010
                       
Residential real estate
  $ 385,729     $ 5,222     $ 390,951  
Consumer
    94,973       427       95,400  
Total
  $ 480,702     $ 5,649     $ 486,351  
 
The table below presents the recorded investment of loans and leases, segregated by class, with delinquency aging and nonaccrual status.
                               
Recorded
 
           
90 Days
              Total   
Investment
 
(Dollars in thousands)
 
30-59 Days
 
60-89 Days
 
or More
 
Total Past
         
 Financing
 
> 90 Days
 
   
Past Due
 
Past Due
 
Past Due
 
Due
 
Nonaccrual
 
Current
 
Receivables
 
and Accruing
 
March 31, 2011
                                 
Commercial and agricultural loans
  $ 498   $ 202   $ -   $ 700   $ 7,987   $ 538,694   $ 547,381   $ -  
Auto, light truck and
                                                 
environmental equipment
    726     216     -     942     2,825     413,190     416,957     -  
Medium and heavy duty truck
    51     -     -     51     4,662     151,309     156,022     -  
Aircraft financing
    5,297     713     -     6,010     15,945     579,525     601,480     -  
Construction equipment financing
    3,463     29     -     3,492     8,077     259,921     271,490     -  
Commercial real estate
    328     943     -     1,271     28,995     548,382     578,648     -  
Residential real estate
    2,477     595     434     3,506     5,060     377,724     386,290     434  
Consumer
    859     341     81     1,281     487     91,682     93,450     81  
Total
  $ 13,699   $ 3,039   $ 515   $ 17,253   $ 74,038   $ 2,960,427   $ 3,051,718   $ 515  
                                                   
December 31, 2010
                                                 
Commercial and agricultural loans
  $ 760   $ 22   $ -   $ 782   $ 8,083   $ 521,363   $ 530,228   $ -  
Auto, light truck and
                                                 
environmental equipment
    528     715     -     1,243     3,332     391,925     396,500     -  
Medium and heavy duty truck
    33     -     -     33     5,068     157,723     162,824     -  
Aircraft financing
    16,097     188     -     16,285     17,898     580,174     614,357     -  
Construction equipment financing
    1,254     601     -     1,855     8,575     275,204     285,634     -  
Commercial real estate
    759     94     -     853     26,622     567,254     594,729     -  
Residential real estate
    3,781     580     264     4,625     4,958     381,368     390,951     264  
Consumer
    1,152     531     98     1,781     329     93,290     95,400     98  
Total
  $ 24,364   $ 2,731   $ 362   $ 27,457   $ 74,865   $ 2,968,301   $ 3,070,623   $ 362  
 
As of March 31, 2011 and December 31, 2010, we had $7.36 million and $7.31 million, respectively of performing loans classified as troubled debt restructuring.
 
 
- 11 -

 
 
Note 5.              Reserve for Loan and Lease Losses

The reserve for loan and lease loss methodology has been consistently applied for several years, with enhancements instituted periodically. Reserve ratios are reviewed quarterly and revised periodically to reflect recent loss history and to incorporate current risks and trends which may not be recognized in historical data. As we update our historical charge-off analysis, we review the look-back periods for each business loan portfolio. Furthermore, we perform a thorough analysis of charge-offs, non-performing asset levels, special attention outstandings and delinquency in order to review portfolio trends and other factors, including specific industry risks and economic conditions, which may have an impact on the reserves and reserve ratios applied to various portfolios. We adjust the calculated historical based ratio as a result of our analysis of environmental factors, principally economic risk and concentration risk. Key economic factors affecting our portfolios are growth in gross domestic product, unemployment rates, housing market trends, commodity prices and inflation. Concentration risk is impacted primarily by geographic concentration in Northern Indiana and Southwestern Lower Michigan in our business banking and commercial real estate portfolios and by collateral concentration in our specialty finance portfolios.

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.  For purposes of determining the reserve, we have segmented our loans and leases into classes based on the associated risks within these segments.  We have determined that eight classes exist within our loan and lease portfolio.  The methodology for assessing the appropriateness of the reserve consists of several key elements, which include: specific reserves for impaired loans, percentage allocations for special attention loans and leases (classified loans and leases and internal watch list credits) without specific reserves, formula reserves for each business lending division portfolio, and reserves for pooled homogeneous loans and leases.  Management’s evaluation is based upon a continuing review of these portfolios, estimates of customer performance, collateral values and dispositions, and assessments of economic and geopolitical events, all of which are subject to judgment and will change.

 
- 12 -



Changes in the reserve for loan and lease losses, segregated by class, for the three months ended March 31, 2011 and 2010 are shown below.

   Commercial     Auto, light     Medium                          
   and  
 truck and
  and      
Construction
                 
(Dollars in thousands)
agricultural
 
environmental
 
heavy duty
 
Aircraft
 
equipment
 
Commercial
 
Residential
 
Consumer
     
 
loans
 
equipment
 
 truck
 
financing
 
financing
 
real estate
 
real estate
 
loans
 
Total
 
March 31, 2011
                                   
Reserve for loan and lease losses
                                   
Balance, beginning of period
$ 20,544   $ 7,542   $ 5,768   $ 29,811   $ 8,439   $ 11,177   $ 2,518   $ 1,075   $ 86,874  
Charge-offs
  422     68     -     1,098     585     1,231     34     595     4,033  
Recoveries
  124     45     1     674     35     105     3     134     1,121  
Net charge-offs (recoveries)
  298     23     (1 )   424     550     1,126     31     461     2,912  
Provision (recovery of provision)
  (3,941 )   405     (704 )   1,516     (1,091 )   5,484     55     474     2,198  
Balance, end of period
$ 16,305   $ 7,924   $ 5,065   $ 30,903   $ 6,798   $ 15,535   $ 2,542   $ 1,088   $ 86,160  
Ending balance: individually
                                                     
evaluated for impairment
$ 4,025   $ 308   $ 171   $ 2,174   $ 47   $ 1,348   $ -   $ -   $ 8,073  
Ending balance: collectively
                                                     
evaluated for impairment
$ 12,280   $ 7,616   $ 4,894   $ 28,729   $ 6,751   $ 14,187   $ 2,542   $ 1,088   $ 78,087  
                                                       
Financing receivables:
                                                     
Ending balance
$ 547,381   $ 416,957   $ 156,022   $ 601,480   $ 271,490   $ 578,648   $ 386,290   $ 93,450   $ 3,051,718  
Ending balance: individually
                                                     
evaluated for impairment
$ 12,769   $ 1,993   $ 4,692   $ 16,462   $ 8,065   $ 31,489   $ -   $ -   $ 75,470  
Ending balance: collectively
                                                     
evaluated for impairment
$ 534,612   $ 414,964   $ 151,330   $ 585,018   $ 263,425   $ 547,159   $ 386,290   $ 93,450   $ 2,976,248  
                                                       
March 31, 2010
                                                     
Reserve for loan and lease losses
                                                     
Balance, beginning of period
$ 24,017   $ 9,630   $ 6,186   $ 24,807   $ 8,875   $ 10,453   $ 880   $ 3,388   $ 88,236  
Charge-offs
  348     472     601     2,567     509     340     165     377     5,379  
Recoveries
  245     34     39     72     42     -     1     149     582  
Net charge-offs (recoveries)
  103     438     562     2,495     467     340     164     228     4,797  
Provision (recovery of provision)
  (2,798 )   (28 )   1,745     (615 )   982     4,649     1,834     (1,381 )   4,388  
Balance, end of period
$ 21,116   $ 9,164   $ 7,369   $ 21,697   $ 9,390   $ 14,762   $ 2,550   $ 1,779   $ 87,827  
Ending balance: individually
                                                     
evaluated for impairment
$ 1,357   $ 543   $ 2,134   $ 75   $ 1,731   $ 4,232   $ -   $ -   $ 10,072  
Ending balance: collectively
                                                     
evaluated for impairment
$ 19,759   $ 8,621   $ 5,235   $ 21,622   $ 7,659   $ 10,530   $ 2,550   $ 1,779   $ 77,755  
                                                       
Financing receivables:
                                                     
Ending balance
$ 546,826   $ 364,445   $ 200,228   $ 608,643   $ 303,866   $ 584,756   $ 392,911   $ 104,440   $ 3,106,115  
Ending balance: individually
                                                     
evaluated for impairment
$ 8,274   $ 3,935   $ 15,310   $ 2,786   $ 11,617   $ 31,699   $ -   $ -   $ 73,621  
Ending balance: collectively
                                                     
evaluated for impairment
$ 538,552   $ 360,510   $ 184,918   $ 605,857   $ 292,249   $ 553,057   $ 392,911   $ 104,440   $ 3,032,494  

 
- 13 -



The table below presents impaired loans and leases, segregated by class, and the corresponding reserve for impaired loan and lease losses.
 
         
Unpaid
         
Average
 
(Dollars in thousands)
 
Recorded
   
Principal
   
Related
   
Recorded
 
   
Investment
   
Balance
   
Allowance
   
Investment
 
March 31, 2011
                       
With no related allowance recorded:
                       
Commercial and agricultural loans
  $ 4,737     $ 4,737     $ -     $ 5,010  
Auto, light truck and environmental equipment
    1,099       1,099       -       1,378  
Medium and heavy duty truck
    1,596       1,596       -       1,657  
Aircraft financing
    5,743       5,743       -       7,506  
Construction equipment financing
    7,251       7,250       -       7,558  
Commercial real estate
    22,437       22,437       -       22,354  
Total with no related allowance recorded
    42,863       42,862       -       45,463  
With an allowance recorded:
                               
Commercial and agricultural loans
    8,032       8,031       4,025       7,960  
Auto, light truck and environmental equipment
    894       894       308       859  
Medium and heavy duty truck
    3,096       3,096       171       3,153  
Aircraft financing
    10,719       10,718       2,174       8,771  
Construction equipment financing
    814       814       47       753  
Commercial real estate
    9,052       9,057       1,348       7,509  
Total with an allowance recorded
    32,607       32,610       8,073       29,005  
Total:
                               
Commercial and agricultural loans
    12,769       12,768       4,025       12,970  
Auto, light truck and environmental equipment
    1,993       1,993       308       2,237  
Medium and heavy duty truck
    4,692       4,692       171       4,810  
Aircraft financing
    16,462       16,461       2,174       16,277  
Construction equipment financing
    8,065       8,064       47       8,311  
Commercial real estate
    31,489       31,494       1,348       29,863  
Total impaired loans
  $ 75,470     $ 75,472     $ 8,073     $ 74,468  
                                 
December 31, 2010
                               
With no related allowance recorded:
                               
Commercial and agricultural loans
  $ 4,930     $ 4,930     $ -     $ 4,848  
Auto, light truck and environmental equipment
    1,596       1,597       -       1,632  
Medium and heavy duty truck
    1,748       1,748       -       2,922  
Aircraft financing
    4,509       4,509       -       3,315  
Construction equipment financing
    5,534       5,535       -       5,107  
Commercial real estate
    21,071       21,071       -       20,301  
Total with no related allowance recorded
    39,388       39,390       -       38,125  
With an allowance recorded:
                               
Commercial and agricultural loans
    8,282       8,281       4,190       11,210  
Auto, light truck and environmental equipment
    1,136       1,136       377       1,714  
Medium and heavy duty truck
    3,347       3,347       1,049       5,591  
Aircraft financing
    13,913       13,913       2,050       8,626  
Construction equipment financing
    3,374       3,379       648       5,485  
Commercial real estate
    8,625       8,630       893       9,489  
Total with an allowance recorded
    38,677       38,686       9,207       42,115  
Total:
                               
Commercial and agricultural loans
    13,212       13,211       4,190       16,058  
Auto, light truck and environmental equipment
    2,732       2,733       377       3,346  
Medium and heavy duty truck
    5,095       5,095       1,049       8,513  
Aircraft financing
    18,422       18,422       2,050       11,941  
Construction equipment financing
    8,908       8,914       648       10,592  
Commercial real estate
    29,696       29,701       893       29,790  
Total impaired loans
  $ 78,065     $ 78,076     $ 9,207     $ 80,240  

 
- 14 -



(Dollars in thousands)
 
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Commercial and agricultural loans
  $ 116     $ 25  
Auto, light truck and environmental equipment
    1       -  
Medium and heavy duty truck
    1       2  
Aircraft financing
    9       -  
Construction equipment financing
    9       88  
Commercial real estate
    65       24  
Total impaired loans
  $ 201     $ 139  
 
Note 6.              Mortgage Servicing Assets

We recognize the rights to service residential 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.  We allocate a portion of the total proceeds of a mortgage loan to servicing rights based on the fair value.

Mortgage servicing assets are evaluated for impairment.  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.  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.

Changes in the carrying value of mortgage servicing assets and the associated valuation allowance follow:
 
   
Three Months Ended
 
(Dollars in thousands)
 
March 31,
 
   
2011
   
2010
 
Mortgage servicing assets:
           
Balance at beginning of period
  $ 7,556     $ 8,749  
Additions
    146       571  
Amortization
    (734 )     (761 )
Sales
    -       (443 )
Carrying value before valuation allowance at end of period
    6,968       8,116  
Valuation allowance:
               
Balance at beginning of period
    -       (1 )
Impairment (charges) recoveries
    (5 )     1  
Balance at end of period
  $ (5 )   $ -  
Net carrying value of mortgage servicing assets at end of period
  $ 6,963     $ 8,116  
Fair value of mortgage servicing assets at end of period
  $ 10,194     $ 10,575  
 
During the three months ended March 31, 2011 and 2010, management determined that it was not necessary to permanently write-down any previously established valuation allowance.  At March 31, 2011, the fair value of mortgage servicing assets exceeded the carrying value reported in the consolidated statement of financial condition by $3.23 million.  This difference represents increases in the fair value of certain mortgage servicing assets that could not be recorded above cost basis.

 
- 15 -

 

The key economic assumptions used to estimate the fair value of the mortgage servicing rights follow:
 
   
March 31,
 
   
2011
 
2010
 
Expected weighted-average life (in years)
   3.46      3.55    
Weighted-average constant prepayment rate (CPR)
   18.00 %    17.64 %  
Weighted-average discount rate
   9.56 %    8.48 %  

Mortgage loan contractual servicing fees, including late fees and ancillary income, were $1.02 million for both the three months ended March 31, 2011 and 2010.  Mortgage loan contractual servicing fees are included in mortgage banking income in the consolidated statements of income.

Note 7.              Financial Instruments with Off-Balance-Sheet Risk and Derivative Transactions

To meet the financing needs of our customers, 1st Source Corporation 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.  Our 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.  We use the same credit policies and collateral requirements in making commitments and conditional obligations as we do for on-balance-sheet instruments.

We have certain interest rate derivative positions that are not designated as hedging instruments.  These derivative positions relate to transactions in which we enter into an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution. In connection with each transaction, we agree to pay interest to the client on a notional amount at a variable interest rate and receive interest from the client on the same notional amount at a fixed interest rate.  At the same time, we agree to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount.  The transaction allows our client to effectively convert a variable rate loan to a fixed rate.  Because the terms of the swaps with our customers and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact our results of operations.

1st Source Bank (Bank), a subsidiary of 1st Source Corporation, grants 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.  Loan commitments generally 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.  Commitments to originate or purchase residential mortgage loans held for sale and forward commitments to sell residential mortgage loans are considered derivative instruments.

 
- 16 -

 

At March 31, 2011 and December 31, 2010, the amounts of non-hedging derivative financial instruments are shown in the chart below:
 
(Dollars in thousands)
     
Asset derivatives
 
Liability derivatives
   
Notional or
 
Statement of
     
Statement of
   
   
contractual
 
Financial Condition
 
Fair
 
Financial Condition
 
Fair
   
amount
 
location
 
value
 
location
 
value
                           
March 31, 2011
                         
Interest rate swap contracts
  $ 436,745    
Other assets
  $ 12,391    
Other liabilities
  $ 12,781  
Loan commitments
    13,263    
Mortgages held for sale
    71     N/A     -  
Forward contracts
    9,500     N/A     -    
Mortgages held for sale
    42  
                                     
Total
  $ 459,508           $ 12,462           $ 12,823  
                                     
December 31, 2010
                                   
Interest rate swap contracts
  $ 446,224    
Other assets
  $ 14,959    
Other liabilities
  $ 15,384  
Loan commitments
    28,666    
Mortgages held for sale
    30     N/A     -  
Forward contracts
    40,320    
Mortgages held for sale
    451     N/A     -  
                                     
Total
  $ 515,210           $ 15,440           $ 15,384  
 
 
For the three months ended March 31, 2011 and 2010, the amounts included in the consolidated statements of income for non-hedging derivative financial instruments are shown in the chart below:
 
     
Gain (loss)
 
     
Three Months Ended
 
 
Statement of
 
March 31,
 
(Dollars in thousands)
Income location
 
2011
   
2010
 
               
Interest rate swap contracts
Other expense
  $ 2     $ (35 )
Interest rate swap contracts
Other income
    27       77  
Loan commitments
Mortgage banking income
    41       107  
Forward contracts
Mortgage banking income
    (493 )     (325 )
Total
    $ (423 )   $ (176 )

We issue letters of credit which are conditional commitments that guarantee the performance of a customer to a third party.  The credit risk involved and collateral obtained in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.  Standby letters of credit totaled $17.80 million and $17.84 million at March 31, 2011 and December 31, 2010, respectively.  Standby letters of credit generally have terms ranging from six months to one year.

Note 8.              Earnings Per Share

Earnings per common share is computed using the two-class method.  Basic earnings per common share is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during the applicable period, excluding outstanding participating securities.  Participating securities include non-vested restricted stock awards.  Non-vested restricted stock awards are considered participating securities to the extent the holders of these securities receive non-forfeitable dividends at the same rate as holders of common stock.  Diluted earnings per common share is computed using the weighted-average number of shares determined for the basic earnings per common share computation plus the dilutive effect of stock compensation using the treasury stock method.  Stock options, where the exercise price was greater than the average market price of the common shares, were excluded from the computation of diluted earnings per common share because the result would have been antidilutive.  Stock options of 33,000 and 49,763 were considered antidilutive as of March 31, 2011 and 2010.  Stock warrants of 837,947 were considered antidilutive as of March 31, 2010.  No stock warrants were outstanding as of March 31, 2011.

 
- 17 -

 

The following table presents a reconciliation of the number of shares used in the calculation of basic and diluted earnings per common share for the three months ended March 31, 2011 and 2010.
 
   
Three Months Ended
 
(Dollars in thousands - except per share amounts)
 
March 31,
 
   
2011
   
2010
 
Distributed earnings allocated to common stock
  $ 3,888     $ 3,616  
Undistributed earnings allocated to common stock
    6,612       4,278  
Net earnings allocated to common stock
    10,500       7,894  
Net earnings allocated to participating securities
    108       74  
Net income allocated to common stock and participating securities
  $ 10,608     $ 7,968  
                 
Weighted average shares outstanding for basic earnings per common share
    24,271,366       24,210,242  
Dilutive effect of stock compensation
    8,151       5,264  
Weighted average shares outstanding for diluted earnings per common share
    24,279,517       24,215,506  
                 
Basic earnings per common share
  $ 0.43     $ 0.33  
Diluted earnings per common share
  $ 0.43     $ 0.33  
 
Note 9.              Stock-Based Compensation

As of March 31, 2011, we had four active stock-based employee compensation plans, which are more fully described in Note 16 of the Consolidated Financial Statements in 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2010.  These plans include the 2001 Stock Option Plan, the Employee Stock Purchase Plan, the Executive Incentive Plan, and the Restricted Stock Award Plan.

Stock-based compensation expense for all stock-based compensation awards granted is based on the grant-date fair value.  For all awards except stock option awards, the grant date fair value is either the fair market value per share or book value per share (corresponding to the type of stock awarded) as of the grant date.  For stock option awards, the grant date fair value is estimated using the Black-Scholes option pricing model.  For all awards we recognize these compensation costs only for those shares expected to vest on a straight-line basis over the requisite service period of the award, for which we use the related vesting term.  We estimate forfeiture rates based on historical employee option exercise and employee termination experience.  We have identified separate groups of awardees that exhibit similar option exercise behavior and employee termination experience and have considered them as separate groups in the valuation models and expense estimates.
 
The stock-based compensation expense recognized in the condensed consolidated statement of income for the three months ended March 31, 2011 and 2010 was based on awards ultimately expected to vest, and accordingly has been adjusted by the amount of estimated forfeitures.  GAAP requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.  Forfeitures were estimated based partially on historical experience.

 
- 18 -


 
The aggregate intrinsic value in the table below represents the total pretax intrinsic value (the difference between 1st Source’s closing stock price on the last trading day of the first quarter of 2011 (March 31, 2011) and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on March 31, 2011.  This amount changes based on the fair market value of 1st Source’s stock.  Total fair value of options vested and expensed was $3 thousand, net of tax, for both the three months ended March 31, 2011 and 2010.
 
               
Average
       
         
Weighted
   
Remaining
   
Total
 
         
Average
   
Contractual
   
Intrinsic
 
   
Number of
   
Exercise
   
Term
   
Value
 
   
Shares
   
Price
   
(in years)
   
(in 000's)
 
                         
Options outstanding, beginning of year
    62,508     $ 17.18              
Granted
    -       -              
Exercised
    -       -              
Forfeited
    (7,508 )     17.31              
Options outstanding, March 31, 2011
    55,000     $ 17.16       1.01     $ 181  
                                 
                                 
Vested and expected to vest at March 31, 2011
    55,000     $ 17.16       1.01     $ 181  
Exercisable at March 31, 2011
    52,250     $ 17.43       0.95     $ 159  
 
No options were granted during the three months ended March 31, 2011.
 
As of March 31, 2011, there was $5.00 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements.  That cost is expected to be recognized over a weighted-average period of 3.72 years.
 
The following table summarizes information about stock options outstanding at March 31, 2011:
 
     
Options Outstanding
   
Options Exercisable
 
           
Weighted
                   
           
Average
   
Weighted
         
Weighted
 
Range of
   
Number
   
Remaining
   
Average
   
Number
   
Average
 
Exercise
   
of shares
   
Contractual
   
Exercise
   
of shares
   
Exercise
 
Prices
   
Outstanding
   
Life
   
Price
   
Exercisable
   
Price
 
$ 12.04 to $17.99     22,000     2.06     $ 12.04     19,250     $ 12.04  
$ 18.00 to $26.99     33,000     0.31       20.58     33,000       20.58  
 
The fair value of each stock option was estimated on the date of grant using the Black-Scholes option-pricing model.

Note 10.            Income Taxes

The total amount of unrecognized tax benefits that would affect the effective tax rate if recognized was $1.04 million at March 31, 2011 and $1.52 million at December 31, 2010.  Interest and penalties were recognized through the income tax provision.  For the three months ending March 31, 2011 and the twelve months ending December 31, 2010, we recognized approximately $(0.12) million and $0.05 million in interest, net of tax effect, and penalties, respectively.  Interest and penalties of approximately $0.48 million and $0.60 million were accrued at March 31, 2011 and December 31, 2010, respectively.
 
 
- 19 -

 

Tax years that remain open and subject to audit include the federal 2007-2010 years and the Indiana 2007-2010 years.  Additionally, during the first quarter of 2011 we reached a state tax settlement for the 2008 year and as a result recorded a reduction of unrecognized tax benefits in the amount of $0.84 million that affected the effective tax rate and increased earnings in the amount of $0.47 million. We do not anticipate a significant change in the amount of uncertain tax positions within the next 12 months.
 
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 March 31, 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 March 31, 2011:

 
- 20 -


(Dollars in thousands)
 
Fair value carrying amount
   
Aggregate unpaid principal
   
Excess of fair value carrrying amount over (under) unpaid principal
   
                     
Mortgages held for sale reported at fair value:
                   
Total loans
  $ 5,467     $ 5,307     $ 160 (1 )
Nonaccrual loans
    -       -       -    
Loans 90 days or more past due and still accruing
    -       -       -    
 
(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.
 
 
- 21 -


 
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 March 31, 2011, measured at fair value on a recurring basis:
 
(Dollars in thousands)
 
Level 1
   
Level 2
   
Level 3
   
Total
 
                         
Assets:
                       
Investment securities available-for-sale:
                       
U.S. Treasury and Federal agencies securities
  $ 20,159     $ 417,484     $ -     $ 437,643  
U.S. States and political subdivisions securities
    -       107,326       16,538       123,864  
Mortgage-backed securities Federal agencies
    -       333,758       -       333,758  
Corporate debt securities
    -       35,595       -       35,595  
Foreign government and other securities
    -       6,014       675       6,689  
Total debt securities
    20,159       900,177       17,213       937,549  
Marketable equity securities
    4,672       -       -       4,672  
Total investment securities available-for-sale
    24,831       900,177       17,213       942,221  
Trading account securities
    146       -       -       146  
Mortgages held for sale
    -       5,467       -       5,467  
Accrued income and other assets (Interest rate swap agreements)
    -       12,391       -       12,391  
Total
  $ 24,977     $ 918,035     $ 17,213     $ 960,225  
                                 
Liabilities
                               
Accrued expenses and other liabilities (Interest rate swap agreements)
  $ -     $ 12,781     $ -     $ 12,781  
Total
  $ -     $ 12,781     $ -     $ 12,781  
 
 
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the quarter ended March 31, 2011 are summarized as follows:
 
(Dollars in thousands)
 
U.S. States and political subdivisions securities
   
Corporate debt securities
   
Foreign government and other securities
   
Investment securities available-for-sale
 
Beginning balance January 1, 2011
  $ 16,306     $ 9,992     $ 675     $ 26,973  
Total gains or losses (realized/unrealized):
                               
Included in earnings
    -       -       -       -  
Included in other comprehensive income
    577       -       -       577  
Purchases
    350       -       -       350  
Issuances
    -       -       -       -  
Settlements
    -       -       -       -  
Maturities
    (695 )     (9,992 )     -       (10,687 )
Transfers into Level 3
    -       -       -       -  
Transfers out of Level 3
    -       -       -       -  
Ending balance March 31, 2011
  $ 16,538     $ -     $ 675     $ 17,213  
 
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 March 31, 2011.
 
 
- 22 -

 

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 March 31, 2011:  impaired loans - $0.50 million; partnership investments – $(0.12) million; mortgage servicing rights - $0.00 million; repossessions - $0.18 million, and other real estate - $0.08 million.

The table below presents the carrying value of assets at March 31, 2011, measured at fair value on a non-recurring basis:

(Dollars in thousands)
 
Level 1
   
Level 2
   
Level 3
   
Total
 
                         
Loans
  $ -     $ -     $ 75,472     $ 75,472  
Accrued income and other assets (partnership investments)
    -       -       2,006       2,006  
Accrued income and other assets (mortgage servicing rights)
    -       -       6,963       6,963  
Accrued income and other assets (repossessions)
    -       -       5,482       5,482  
Accrued income and other assets (other real estate)
    -       -       8,013       8,013  
    $ -     $ -     $ 97,936     $ 97,936  
 
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.

 
- 23 -



The fair values of our financial instruments as of March 31, 2011, and December 31, 2010, are summarized in the table below.
 
   
March 31, 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
  $ 57,271     $ 57,271     $ 62,313     $ 62,313  
Federal funds sold and interest bearing deposits with other banks
    81,661       81,661       34,559       34,559  
Investment securities, available-for-sale
    942,221       942,221       969,018       969,018  
Other investments and trading account securities
    20,649       20,649       21,481       21,481  
Mortgages held for sale
    5,467       5,467       32,599       32,599  
Loans and leases, net of reserve for loan and lease losses
    2,965,558       3,076,930       2,983,749       3,040,895  
Cash surrender value of life insurance policies
    53,599       53,599       54,182       54,182  
Mortgage servicing rights
    6,963       10,194       7,556       8,785  
Interest rate swaps
    12,391       12,391       14,959       14,959  
Liabilities:
                               
Deposits
  $ 3,609,007     $ 3,636,660     $ 3,622,745     $ 3,654,067  
Short-term borrowings
    132,153       132,153       155,989       155,989  
Long-term debt and mandatorily redeemable securities
    26,717       26,955       24,816       25,072  
Subordinated notes
    89,692       87,951       89,692       79,811  
Interest rate swaps
    12,781       12,781       15,384       15,384  
Off-balance-sheet instruments *
    -       146       -       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 approximate fair values.

 
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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.

Note 12.            Subsequent Events

We have evaluated subsequent events through the date our financial statements were issued.  We do not believe any subsequent events have occurred that would require further disclosure or adjustment to our financial statements.



MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Except for historical information contained herein, the matters discussed in this document express “forward-looking statements.”  Generally, the words “believe,” “contemplate,” “seek,” “plan,” “possible,” “assume,” “expect,” “intend,” “targeted,” “continue,” “remain,” “estimate,” “anticipate,” “project,” “will,” “should,” “indicate,” “would,” “may” 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.  We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made.  We may make other written or oral forward-looking statements from time to time.  Readers are advised that various important factors could cause our actual results or circumstances for future periods to differ

 
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materially from those anticipated or projected in such forward-looking statements.  Such factors include, but are not limited to, changes in law, regulations or U.S. generally accepted accounting principles; our competitive position within the markets we serve; increasing consolidation within the banking industry; unforeseen changes in interest rates; unforeseen changes in loan prepayment assumptions; unforeseen downturns in or major events affecting the local, regional or national economies or the industries in which we have credit concentrations; and other matters discussed in our filings with the SEC, including our Annual Report on Form 10-K  for 2010, which filings are available from the SEC.  We undertake no obligation to publicly update or revise any forward-looking statements.

The following management’s discussion and analysis is presented to provide information concerning our financial condition as of March 31, 2011, as compared to December 31, 2010, and the results of operations for the three months ended March 31, 2011 and 2010.  This discussion and analysis should be read in conjunction with our consolidated financial statements and the financial and statistical data appearing elsewhere in this report and our 2010 Annual Report.

FINANCIAL CONDITION

Our total assets at March 31, 2011, were $4.41 billion, a decrease of $32.91 million or 0.74% from December 31, 2010.  Total loans and leases were $3.05 billion, a decrease of $18.91 million or 0.62% from December 31, 2010.  Fed funds sold and interest bearing deposits with other banks were $81.66 million, an increase of $47.10 million or 136.29% from December 31, 2010.  Total investment securities, available for sale were $942.22 million which represented a decrease of $26.80 million or 2.77% and total deposits were $3.61 billion, a decrease of $13.74 million or 0.38% over the comparable figures at the end of 2010.

Nonperforming assets at March 31, 2011, were $88.35 million, which was a decrease of $0.36 million or 0.41% from the $88.71 million reported at December 31, 2010.  At March 31, 2011 and December 31, 2010, nonperforming assets were 2.81% of net loans and leases.

Accrued income and other assets were as follows:
 
(Dollars in thousands)
 
March 31,
   
December 31,
 
   
2011
   
2010
 
Accrued income and other assets:
           
Bank owned life insurance cash surrender value
  $ 53,599     $ 54,182  
Accrued interest receivable
    14,334       14,218  
Mortgage servicing assets
    6,963       7,556  
Other real estate
    6,813       6,392  
Former bank premises held for sale
    1,200       1,200  
Repossessions
    5,482       5,670  
All other assets
    45,180       51,370  
Total accrued income and other assets
  $ 133,571     $ 140,588  
 
CAPITAL

As of March 31, 2011, total shareholders' equity was $490.47 million, up $4.08 million or 0.84% from the $486.38 million at December 31, 2010.  In addition to net income of $10.61 million, other significant changes in shareholders’ equity during the first three months of 2011 included $3.90 million of dividends paid and $3.75 million of a common stock warrant repurchased.  The accumulated other comprehensive income/(loss) component of shareholders’ equity totaled $9.13 million at March 31, 2011, compared to $10.51 million at December 31, 2010.  The decrease in accumulated other comprehensive income/(loss) during 2011 was primarily a result of changes in unrealized gain/(loss) on securities in the available-for-sale portfolio.  Our equity-to-assets ratio was 11.12% as of March 31, 2011, compared to 10.94% at December 31, 2010.  Book value per common share rose to $20.18 at March 31, 2011, from $20.12 at December 31, 2010.

 
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We declared and paid dividends per common share of $0.16 during the first quarter of 2011.  The trailing four quarters dividend payout ratio, representing dividends per common share divided by diluted earnings per common share, was 47.33%.  The dividend payout is continually reviewed by management and the Board of Directors subject to the Corporation’s capital and dividend policy.

The banking regulators have established guidelines for leverage capital requirements, expressed in terms of Tier 1 or core capital as a percentage of average assets, to measure the soundness of a financial institution.  In addition, banking regulators have established risk-based capital guidelines for U.S. banking organizations.  The actual capital amounts and ratios of 1st Source Corporation and 1st Source Bank as of March 31, 2011, 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):
                               
1st Source Corporation
  $ 522,933       15.68 %   $ 266,750       8.00 %   $ 333,438       10.00 %
1st Source Bank
    516,652       15.55       265,845       8.00       332,306       10.00  
Tier 1 Capital (to Risk-Weighted Assets):
                                         
1st Source Corporation
    479,637       14.38       133,375       4.00       200,063       6.00  
1st Source Bank
    474,425       14.28       132,922       4.00       199,383       6.00  
Tier 1 Capital (to Average Assets):
                                               
1st Source Corporation
    479,637       11.07       173,272       4.00       216,589       5.00  
1st Source Bank
    474,425       10.99       172,682       4.00       215,852       5.00  
 
 
LIQUIDITY AND INTEREST RATE SENSITIVITY

Effective liquidity management ensures that the cash flow requirements of depositors and borrowers, as well as the operating cash needs of 1st Source Corporation, are met.  Funds are available from a number of sources, including the securities portfolio, the core deposit base, Federal Home Loan Bank (FHLB) borrowings, Federal Reserve Bank (FRB) borrowings, and the capability to package loans for sale.

We have borrowing sources available to supplement deposits and meet our funding needs. 1st Source Bank has established relationships with several banks to provide short term borrowings in the form of federal funds purchased. While at March 31, 2011 there were no amounts outstanding, management believes we could borrow approximately $255.00 million for a short time from these banks on a collective basis. As of March 31, 2011, the Bank had $15.93 million outstanding in FHLB advances and could borrow an additional $208.46 million. We also had $330.99 million available to borrow from the FRB with no amounts outstanding as of March 31, 2011.

Our loan to asset ratio was 69.16% at March 31, 2011 compared to 69.08% at December 31, 2010 and 69.88% at March 31, 2010.  Cash and cash equivalents totaled $57.27 million at March 31, 2011 compared to $62.31 million at December 31, 2010 and $53.52 million at March 31, 2010.  At March 31, 2011, the consolidated statement of financial condition was rate sensitive by $344.33 million more liabilities than assets scheduled to reprice within one year, or approximately 0.87%.  Management believes that the present funding sources provide adequate liquidity to meet our cash flow needs.

 
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In addition, the State of Indiana recently changed the law governing the collateralization of public fund deposits. Under the new law, the Indiana Board of Depositories will determine what financial institutions are required to pledge collateral. We have been informed that no collateral is necessary through March 31, 2011 for our Indiana public fund deposits.  However, pending legislation could alter this requirement in the future. Our potential liquidity exposure if we must pledge collateral is approximately $600.00 million.


RESULTS OF OPERATIONS

Net income for the three month period ended March 31, 2011 was $10.61 million, compared to $9.68 million for the same period in 2010.  Diluted net income per common share was $0.43 for the three month period ended March 31, 2011, compared to $0.33 for the same period in 2010.  Return on average common shareholders' equity was 8.73% for the three months ended March 31, 2011, compared to 6.82% in 2010.  The return on total average assets was 0.97% for the three months ended March 31, 2011, compared to 0.88% in 2010.

The increase in net income for the three months ended March 31, 2011, over the first three months of 2010, was primarily the result of a decrease in provision for loan and lease losses and an increase in net interest income.  This positive impact to net income was partially offset by an increase in noninterest expense and a decrease in noninterest income.  Details of the changes in the various components of net income are discussed further below.

NET INTEREST INCOME

The taxable equivalent net interest income for the three months ended March 31, 2011 was $37.57 million, an increase of 5.00% over the same period in 2010.  The net interest margin on a fully taxable equivalent basis was 3.71% for the three months ended March 31, 2011, compared to 3.50% for the three months ended March 31, 2010.

During the three month period ended March 31, 2011, average earning assets decreased $36.96 million or 0.89% over the comparable period in 2010.  Average interest-bearing liabilities decreased $48.06 million or 1.41% for the three month period ended March 31, 2011 over the comparable period one year ago.  The yield on average earning assets decreased 19 basis points to 4.73% for the first quarter of 2011 from 4.92% for the first quarter of 2010.  The rate earned on assets decreased due to the reduction in short-term market interest rates from a year ago.  Total cost of average interest-bearing liabilities decreased 48 basis points to 1.25% for the first quarter 2011 from 1.73% for the first quarter 2010.  The result to the net interest margin, or the difference between interest income on earning assets and interest expense on interest-bearing liabilities, was an increase of 21 basis points for the three month period ended March 31, 2011 from March 31, 2010.

The largest contributor to the decrease in the yield on average earning assets for the three months ended March 31, 2011, compared to the three months ended March 31, 2010, was a reduction in yields on taxable investment securities of 84 basis points.  Total average investment securities increased $63.96 million or 7.17% for the three month period over one year ago.  Average mortgages held for sale decreased $3.42 million or 16.58% for the three month period ended March 31, 2011, over the comparable periods a year ago due to the elimination of our wholesale broker activity.  Average net loans and leases decreased $46.13 million or 1.49% for the first quarter of 2011 from the first quarter of 2010.  Average other investments, which include federal funds sold, time deposits with other banks, Federal Reserve Bank excess balances, Federal Reserve Bank and Federal Home Loan Bank stock and commercial paper, decreased $51.37 million or 38.82% for the three month period ended March 31, 2011, over the comparable period a year ago.

 
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Average interest-bearing deposits decreased $41.49 million or 1.33%, for the first quarter of 2011 over the same period in 2010.  The effective rate paid on average interest-bearing deposits decreased 51 basis points to 1.10% for the first quarter 2011 compared to 1.61% for the first quarter 2010.  The decline in the average cost of interest-bearing deposits during the first quarter of 2011 as compared to the first quarter of 2010 was primarily the result of interest rate re-pricing on maturing certificates of deposit.

Average short-term borrowings decreased $11.92 million or 7.42% for the first quarter of 2011, compared to the same period in 2010.  The decrease in average short-term borrowings was primarily due to lower repurchase agreements and lower secured borrowings.  Interest paid on short-term borrowings decreased 23 basis points for the first quarter of 2011 due to the interest rate decrease on adjustable rate borrowings.  Average long-term debt increased $5.36 million or 26.69% during the first quarter of 2011 as compared to the first quarter of 2010.  The increase in long-term borrowings was the result of higher borrowings with the Federal Home Loan Bank offset by lower borrowings on a line of credit.  Interest paid on long-term borrowings decreased 133 basis points for the first quarter due to lower effective rates on new Federal Home Loan Bank borrowings.

The following table provides an analysis of net interest income and illustrates the interest earned and interest expense charged for each major component of interest-earning assets and interest-bearing liabilities.  Yields/rates are computed on a tax-equivalent basis, using a 35% rate.  Nonaccrual loans and leases are included in the average loan and lease balance outstanding.

DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY
             
INTEREST RATES AND INTEREST DIFFERENTIAL
             
(Dollars in thousands)
             
 
Three months ended March 31,
 
 
2011
   
2010
 
                                   
       
Interest
               
Interest
       
 
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
 
 
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
ASSETS:
                                 
Investment securities:
     
 
                         
Taxable
$ 815,564     $ 4,482       2.23 %   $ 712,824     $ 5,401       3.07 %
Tax exempt
  141,004       1,734       4.99 %     179,782       2,145       4.84 %
Mortgages - held for sale
  17,213       179       4.22 %     20,634       273       5.37 %
Net loans and leases
  3,054,013       41,278       5.48 %     3,100,144       42,194       5.52 %
Other investments
  80,949       243       1.22 %     132,323       274       0.84 %
                                               
Total Earning Assets
  4,108,743       47,916       4.73 %     4,145,707       50,287       4.92 %
                                               
Cash and due from banks
  58,710                       57,891                  
Reserve for loan and lease losses
  (88,263 )                     (89,223 )                
Other assets
  340,974                       371,019                  
                                               
Total
$ 4,420,164                     $ 4,485,394                  
                                               
LIABILITIES AND SHAREHOLDERS' EQUITY:
                                         
Interest-bearing deposits
$ 3,084,779     $ 8,355       1.10 %   $ 3,126,268     $ 12,405       1.61 %
Short-term borrowings
  148,729       89       0.24 %     160,652       188       0.47 %
Subordinated notes
  89,692       1,647       7.45 %     89,692       1,647       7.45 %
Long-term debt and
                                             
mandatorily redeemable securities
  25,426       259       4.13 %     20,070       270       5.46 %
                                               
Total Interest-Bearing Liabilities
  3,348,626       10,350       1.25 %     3,396,682       14,510       1.73 %
                                               
Noninterest-bearing deposits
  515,236                       447,861                  
Other liabilities
  63,629                       62,239                  
Shareholders' equity
  492,673                       578,612                  
                                               
Total
$ 4,420,164                     $ 4,485,394                  
                                               
Net Interest Income
        $ 37,566                     $ 35,777          
                                               
Net Yield on Earning Assets on a Taxable
                                             
Equivalent Basis
                  3.71 %                     3.50 %

 
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PROVISION AND RESERVE FOR LOAN AND LEASE LOSSES

The provision for loan and lease losses for the three month period ended March 31, 2011 was $2.20 million, compared to a provision for loan and lease losses in the three month period ended March 31, 2010 of $4.39 million.  Net charge-offs of $2.91 million were recorded for the first quarter 2011, compared to $4.80 million for the same quarter a year ago.

On March 31, 2011, 30 day and over loan and lease delinquencies were 0.56% as compared to 0.84% on March 31, 2010.  The decrease in delinquencies was primarily in construction equipment, auto, light truck and environmental equipment and commercial loans.  The reserve for loan and lease losses as a percentage of loans and leases outstanding at the end of the period was 2.82% as compared to 2.83% one year ago.  A summary of loan and lease loss experience during the three months ended March 31, 2011 and 2010 is located in Note 5 of the Consolidated Financial Statements.

A loan or lease is considered impaired, based on current information and events, if it is probable that we 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. We evaluate loans and leases exceeding $100,000 for impairment and establish an allowance as a component of the reserve for loan and lease losses when it is probable all amounts due will not be collected pursuant to the contractual terms of the loan and lease and the recorded investment in the loan or lease exceeds its fair value.

NONPERFORMING ASSETS

Nonperforming assets were as follows:
 
(Dollars in thousands)
                 
   
March 31,
   
December 31,
   
March 31,
 
   
2011
   
2010
   
2010
 
                   
Loans and leases past due 90 days or more
  $ 515     $ 361     $ 272  
Nonaccrual loans and leases
    74,038       74,853       78,094  
Other real estate
    6,813       6,392       5,205  
Former bank premises held for sale
    1,200       1,200       2,363  
Repossessions
    5,482       5,670       9,886  
Equipment owned under operating leases
    300       236       150  
                         
Total nonperforming assets
  $ 88,348     $ 88,712     $ 95,970  

Nonperforming assets as a percentage of total loans and leases were 2.81% at March 31, 2011 and December 31, 2010, and 2.98% at March 31, 2010.  Nonperforming assets totaled $88.35 million at March 31, 2011, a decrease of 0.41% from the $88.71 million reported at December 31, 2010, and a 7.94% decrease from the $95.97 million reported at March 31, 2010.  The decrease during the first three months of 2011 compared to the same period in 2010 was primarily related to decreases in nonaccrual loans and leases and repossessions as the economy slowly improves.

The decrease in nonaccrual loans and leases at March 31, 2011 from March 31, 2010 was spread among the various loan portfolios except for increases in aircraft.  The largest dollar decrease at March 31, 2011 from December 31, 2010 occurred in the aircraft portfolio, with notable decreases also occurring in the medium and heavy duty truck and construction equipment portfolios, and was offset by increases in commercial real estate loans.  A summary of nonaccrual loans and leases and past due aging for the period ended March 31, 2011 and December 31, 2010 is located in Note 4 of the Consolidated Financial Statements.

 
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As of March 31, 2011, the industry with the largest dollar exposure was with borrowers whose primary source of income was derived from commercial real estate.  These impaired loans totaled approximately $27.59 million which were comprised of $21.02 million secured by commercial real estate and included in loans secured by real estate and $6.57 million secured by aircraft and included in aircraft financing.  We have limited exposure to commercial real estate.  However, our borrowers with commercial real estate exposure, whether local real estate developers in our commercial portfolio or customers in our niche portfolios such as aircraft whose underlying business is dependent on developing, marketing and managing real estate properties, have suffered as a result of declining real estate values and minimal sales activity.  Furthermore, aircraft values declined during 2009 and 2010, increasing the risk in aircraft secured transactions.

The increase over the past year in other real estate is due to foreclosing on real estate in the local market for which we have a current appraisal and is well secured.

Repossessions consisted mainly of aircraft at March 31, 2011.  At the time of repossession, the recorded amount of the loan or lease is written down, if necessary, to the estimated value of the equipment or vehicle by a charge to the reserve for loan and lease losses, unless the equipment is in the process of immediate sale.  Any subsequent write-downs are included in noninterest expense.

A summary of other real estate and repossessions as of March 31, 2011 and 2010 is shown in the table below:
 
   
March 31,
 
(Dollars in thousands)
 
2011
   
2010
 
             
Commercial and agricultural loans
  $ -     $ 146  
Auto, light truck and environmental equipment
    261       325  
Medium and heavy duty truck
    60       315  
Aircraft financing
    4,946       8,858  
Construction equipment financing
    200       195  
Commercial real estate
    6,083       4,475  
Residential real estate
    730       730  
Consumer loans
    15       47  
                 
Total
  $ 12,295     $ 15,091  
 
For financial statement purposes, nonaccrual loans and leases are included in loan and lease outstandings, whereas repossessions and other real estate are included in other assets.
 
Foreign Outstandings — Our foreign loan and lease outstandings, all denominated in U.S. dollars were $205.03 million and $201.03 million as of March 31, 2011 and December 31, 2010, respectively.  Foreign loans and leases are in aircraft financing. Loan and lease outstandings to borrowers in Brazil and Mexico were $145.09 million and $36.87 million as of March 31, 2011, respectively, compared to $134.34 million and $34.03 million as of December 31, 2010, respectively. Outstanding balances to borrowers in other countries were insignificant.

 
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NONINTEREST INCOME

Noninterest income for the three month period ended March 31, 2011 and 2010 was $18.95 million and $20.92 million, respectively.  Details of noninterest income follow:
 
(Dollars in thousands)
 
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Noninterest income:
           
Trust fees
  $ 3,992     $ 3,745  
Service charges on deposit accounts
    4,236       4,620  
Mortgage banking income
    444       777  
Insurance commissions
    1,142       1,465  
Equipment rental income
    6,038       6,745  
Other income
    2,971       2,689  
Investment securities and other investment gains
    130       881  
                 
Total noninterest income
  $ 18,953     $ 20,922  
 
Noninterest income decreased in all categories for the first quarter 2011 as compared to the same period in 2010 except trust fees and other income.

Trust fees increased $0.25 million or 6.60% for the three month period ended March 31, 2011 over the three month period ended March 31, 2010.  The increase in trust fees was a result of an increase in market values of investment accounts.

Service charges on deposit accounts decreased $0.38 million or 8.31% for the three months ended March 31, 2011 over the comparable period one year ago.  The decline in service charges on deposit accounts reflects a lower volume of nonsufficient fund transactions.

Mortgage banking income decreased $0.33 million or 42.86% in the first quarter of 2011 as compared to the first quarter of 2010.  The first quarter decrease was due to lower gains on loan sales.

Insurance commissions decreased $0.32 million or 22.05% in the three months ended March 31, 2011 over the same period a year ago.  The decrease was due to reduced contingent commissions, primarily as a result of a high level of claims activity in our books of business. We also experienced a loss of commercial business premiums in the Fort Wayne market due to declines in business relationships.

Equipment rental income declined $0.71 million or 10.48% in the first quarter of 2011 compared to the first quarter 2010.  The average equipment rental portfolio decreased 9.65% in 2011 over the same period in 2010 resulting in lower rental income.

Other income increased $0.28 million or 10.49% for the three month period ended March 31, 2011 as compared to the same period in 2010, mainly due to higher earnout fees on the sale of assets of 1st Source Investment Advisors related to the management of the 1st Source Monogram Funds.

The decrease in investment securities and other investments gains of $0.75 million or 85.24% in the three months ended March 31, 2011 was due to a loss on a venture capital investment and lower partnership investment gains in 2011 compared to the same period a year earlier.

 
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NONINTEREST EXPENSE

Noninterest expense for the three month period ended March 31, 2011 and 2010 was $38.48 million and $37.11 million, respectively.  Details of noninterest expense follow:

(Dollars in thousands)
 
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Noninterest expense:
           
  Salaries and employee benefits
  $ 18,638     $ 18,810  
  Net occupancy expense
    2,320       2,487  
  Furniture and equipment expense
    3,349       2,800  
  Depreciation - leased equipment
    4,805       5,364  
  Professional fees
    1,096       1,514  
  Supplies and communication
    1,394       1,369  
  Business development and marketing expense
    622       567  
  Intangible asset amortization
    325       330  
  Loan and lease collection and repossession expense
    1,324       1,106  
  FDIC and other insurance
    1,676       1,674  
  Other expense
    2,927       1,089  
                 
Total noninterest expense
  $ 38,476     $ 37,110  
 
During the first quarter 2011, furniture and equipment expense increased $0.55 million or 19.61% compared to the first quarter 2010.  The higher expense was mainly due to computer processing charges.

Depreciation on leased equipment decreased $0.56 million or 10.42% in conjunction with the decrease in equipment rental income for the three months ended March 31, 2011 as compared to the same period one year ago.

Professional fees decreased $0.42 million or 27.61% for the three month period ended March 31, 2011 as compared to the three month period ended March 31, 2010.  The reduction in professional fees in 2011 was the result of lower consulting fees.

Loan and lease collection and repossession expense increased $0.22 million or 19.71% for the first quarter of 2011 as compared to the same period in 2010 mainly due to increased operating costs on other real estate owned and overall increased collection and repossession activity.

Other expenses increased $1.84 million or 168.78% in the three months ended March 31, 2011 as compared to the three months ended March 31, 2010.  The increase was primarily due to a charge of $1.68 million for provision on unfunded loan commitments.

Salaries and employee benefits, net occupancy, supplies and communication, business development and marketing, intangible asset amortization, and FDIC and other insurance expense all changed slightly in 2011 over the same period in 2010.

INCOME TAXES

The provision for income taxes for the three month period ended March 31, 2011 was $4.53 million, compared to $4.65 million for the same period in 2010.  The effective tax rates were 29.93% and 32.44% for the first quarter ended March 31, 2011 and 2010, respectively.  Additionally, during the first quarter of 2011 we reached a state tax settlement for the 2008 year and as a result recorded a reduction of unrecognized tax benefits in the amount of $0.84 million that affected the effective tax rate and increased earnings in the amount of $0.47 million.

 
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QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no material changes in market risks faced by 1st Source since December 31, 2010.  For information regarding our market risk, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2010.

CONTROLS AND PROCEDURES

As of the end of the period covered by this report an evaluation was carried out, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) pursuant to Exchange Act Rule 13a-14.  Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, at March 31, 2011, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by 1st Source in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and are designed to ensure that information required to be disclosed in those reports is accumulated and communicated to management as appropriate to allow timely decisions regarding required disclosure.

In addition, there were no changes in our internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the first fiscal quarter of 2011 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
 
PART II.  OTHER INFORMATION

Legal Proceedings.

1st Source and its subsidiaries are involved in various legal proceedings incidental to the conduct of our businesses.  Our management does not expect that the outcome of any such proceedings will have a material adverse effect on our consolidated financial position or results of operations.
 
We note that we received notice in April 2011 that the United States Department of Justice has initiated an investigation of 1st Source prompted by pricing practices of certain brokers from whom we purchased mortgages in prior years that were originated by them. The investigation is pursuant to the Equal Credit Opportunity Act and Fair Housing Act. As previously disclosed, we ended our relationships with third-party mortgage brokers in 2010. We are cooperating fully with the investigation and, based on our present understanding, do not expect an outcome that would have any material adverse effect on our consolidated financial position or results of operations.

Risk Factors.

There have been no material changes in risks faced by 1st Source since December 31, 2010.  For information regarding our risk factors, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2010.

 
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Unregistered Sales of Equity Securities and Use of Proceeds
 
ISSUER PURCHASES OF EQUITY SECURITIES
 
     
Total number of
Maximum number (or approximate
 
 
Total number
Average
shares purchased
dollar value) of shares
 
 
of shares
price paid per
as part of publicly announced
that may yet be purchased under
 
Period
purchased
share
plans or programs (1)
the plans or programs
 
January 01 - 31, 2011
-
$      -
-
1,238,372
 
February 01 - 28, 2011
1,900
     18.50
1,900
1,236,472
 
March 01 - 31, 2011
7,000
     18.35
7,000
1,229,472
 
 
(1)  1st Source maintains a stock repurchase plan that was authorized by the Board of Directors on April 26, 2007. Under the terms of the plan, 1st Source may repurchase up to 2,000,000 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 770,528 shares.
 
Defaults Upon Senior Securities.
 
  None
 
(Removed and reserved).
 
Other Information.
 
  None
 
Exhibits
 
  The following exhibits are filed with this report:
 
 
31.1
Certification of Chief Executive Officer required by Rule 13a-14(a).
 
 
31.2
Certification of Chief Financial Officer required by Rule 13a-14(a).

 
32.1
Certification pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer.

 
32.2
Certification pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer.
 
 
- 35 -

 
 

Pursuant to the requirements 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
     
     
     
DATE   April 21, 2011
 
/s/CHRISTOPHER J. MURPHY III
   
Christopher J. Murphy III
   
Chairman of the Board, President and CEO
     
     
DATE  April 21, 2011
 
/s/LARRY E. LENTYCH
   
Larry E. Lentych
   
Treasurer and Chief Financial Officer
   
Principal Accounting Officer

 
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