-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, RFWCBI8DqaiKaYWq8vwX/qZKh9c8RMru16BqU1VDakoAqzkrxkurYkM1SQbCn4cW mcGuHmGlIKiQewiFtYibIg== 0000034782-06-000020.txt : 20060303 0000034782-06-000020.hdr.sgml : 20060303 20060303103928 ACCESSION NUMBER: 0000034782-06-000020 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20051231 FILED AS OF DATE: 20060303 DATE AS OF CHANGE: 20060303 FILER: COMPANY DATA: COMPANY CONFORMED NAME: 1ST SOURCE CORP CENTRAL INDEX KEY: 0000034782 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 351068133 STATE OF INCORPORATION: IN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-06233 FILM NUMBER: 06662130 BUSINESS ADDRESS: STREET 1: 100 NORTH MICHIGAN STREET CITY: SOUTH BEND STATE: IN ZIP: 46601 BUSINESS PHONE: 5742352702 MAIL ADDRESS: STREET 1: P O BOX 1602 STREET 2: P O BOX 1602 CITY: SOUTH BEND STATE: IN ZIP: 46634 FORMER COMPANY: FORMER CONFORMED NAME: FBT BANCORP INC DATE OF NAME CHANGE: 19820818 10-K 1 corp10k.txt 1ST SOURCE CORP 2005 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [x] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission File Number 0-6233 1ST SOURCE CORPORATION (Exact name of registrant as specified in its charter) Indiana 35-1068133 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 100 N. Michigan Street South Bend, Indiana 46601 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (574) 235-2000 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: None SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Floating Rate Cumulative Trust Preferred Securities and related guarantee -- $25 par value (Title of Class) Common Stock -- without par value (Title of Class) Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ ] No [x] Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [x] Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [x] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [x] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large Accelerated filer [ ] Accelerated filer [x] Non-accelerated filer [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes [ ] No [x] The aggregate market value of the voting common stock held by non-affiliates of the registrant as of June 30, 2005 was $239,529,019. The number of shares outstanding of each of the registrant's classes of stock as of February 24, 2006: Common Stock, without par value 20,705,899 shares. DOCUMENTS INCORPORATED BY REFERENCE Portions of the annual proxy statement for the 2006 annual meeting of shareholders to be held April 27, 2006, are incorporated by reference into Part III. TABLE OF CONTENTS Part I Item 1. Business..............................................................3 Item 1A. Risk Factors......................................................... 7 Item 1B. Unresolved Staff Comments.............................................9 Item 2. Properties............................................................9 Item 3. Legal Proceedings.....................................................9 Item 4. Submission of Matters to a Vote of Security Holders...................9 Part II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities ..........................9 Item 6. Selected Financial Data..............................................10 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations..........................................10 Item 7A. Quantitative and Qualitative Disclosures About Market Risk...........24 Item 8. Financial Statements and Supplementary Data..........................25 Reports of Independent Registered Public Accounting Firm Consolidated Statements of Financial Condition Consolidated Statements of Income Consolidated Statements of Shareholders' Equity Consolidated Statements of Cash Flow Notes to Consolidated Financial Statements Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure...........................................49 Item 9A. Controls and Procedures..............................................49 Item 9B. Other Information....................................................49 Part III Item 10. Directors and Executive Officers of the Registrant..................50 Item 11. Executive Compensation..............................................50 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters...................................50 Item 13. Certain Relationships and Related Transactions......................50 Item 14. Principal Accounting Fees and Services..............................50 Part IV Item 15. Exhibits and Financial Statement Schedules..........................51 Signatures........................... ........................................53 PART I ITEM 1. BUSINESS. 1st SOURCE CORPORATION - ---------------------- 1st Source Corporation, an Indiana corporation incorporated in 1971, is a bank holding company headquartered in South Bend, Indiana that provides, through its subsidiaries (collectively referred to as "1st Source"), a broad array of financial products and services. 1st Source, through its principal subsidiary 1st Source Bank ("Bank"), offers commercial and consumer banking services, as well as trust and investment management, and insurance, to individual and business clients through 64 banking locations (two new banking centers were opened in 2005 and two banking centers were relocated) in 15 counties in the Northern Indiana-Southwestern Michigan regional market area and 23 locations nationwide for the 1st Source Specialty Finance Group. Through these 23 locations the Bank offers specialized financing services for new and used private and cargo aircraft, automobiles and light trucks for leasing and rental agencies, medium and heavy duty trucks, construction equipment, and environmental equipment. 1st Source is not dependent upon any single industry or client. At December 31, 2005, 1st Source had consolidated total assets of $3.51 billion, loans and leases of $2.46 billion, deposits of $2.75 billion, and total shareholders' equity of $345.58 million. The principal executive office of 1st Source is located at 100 North Michigan Street, South Bend, Indiana 46601 and its telephone number is 574 235-2000. Access to 1st Source's annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports is available at www.1stsource.com soon after the material is electronically filed with the Securities Exchange Commission (SEC). 1st Source will provide a printed copy of any of the aforementioned documents to any requesting shareholder. 1st SOURCE BANK - --------------- 1st Source Bank, is a wholly owned subsidiary of 1st Source Corporation that offers a broad range of consumer and commercial banking services through its lending operations, retail branches, and fee based businesses. COMMERCIAL, AGRICULTURAL, AND REAL ESTATE LOANS -- 1st Source Bank provides commercial and agriculture loans to corporations and other business clients primarily located within 1st Source's regional market area. Loans are made for a wide variety of general corporate purposes, including financing for industrial and commercial properties, financing for equipment, inventories and accounts receivable, and acquisition financing. Other services include commercial leasing and cash management services. CONSUMER SERVICES -- 1st Source Bank provides a full range of consumer banking services, including checking accounts, on-line banking, savings programs, installment and real estate loans, home equity loans and lines of credit, drive-in and night deposit services, safe deposit facilities, automated teller machines, overdraft facilities, and brokerage services. TRUST SERVICES -- 1st Source Bank provides a wide range of trust, investment, agency, and custodial services for individual and corporate clients. These services include the administration of estates and personal trusts, as well as the management of investment accounts for individuals, employee benefit plans, and charitable foundations. SPECIALTY FINANCE GROUP SERVICES -- 1st Source Bank, through its Specialty Finance Group, provides a broad range of comprehensive lease and equipment finance products addressing the financing needs of diverse companies. This Group can be broken down into four areas: auto, light truck, and environmental equipment financing; medium and heavy duty truck financing; aircraft financing; and construction equipment financing. Auto, light truck, and environmental equipment financing consists of financings to automobile rental and leasing companies, light truck rental and leasing companies, and environmental equipment companies. Auto, light truck, and environmental equipment finance receivables generally range from $50,000 to $15 million with fixed or variable interest rates and terms of two to seven years. Medium and heavy duty truck financing consists of financings for highway tractors and trailers and delivery trucks to the commercial trucking industry. Medium and heavy duty truck finance receivables generally range from $50,000 to $15 million with fixed or variable interest rates and terms of two to seven years. Aircraft financing consists of financings for new and used aircraft for individual and corporate aircraft users, aircraft dealers, charter operators, and air cargo carriers. Aircraft finance receivables generally range from $100,000 to $15 million with fixed or variable interest rates and terms of two to ten years. Construction equipment financing includes financing of equipment (i.e., asphalt and concrete plants, bulldozers, excavators, cranes, and loaders, etc.) to the construction industry. Construction equipment finance receivables generally range from $100,000 to $15 million with fixed or variable interest rates and terms of three to seven years. 1st Source also generates equipment rental income through the leasing of construction equipment, various trucks, and other equipment to clients through operating leases. SPECIALTY FINANCE GROUP SUBSIDIARIES - ------------------------------------ The Specialty Finance Group also consists of separate wholly owned subsidiaries of 1st Source Bank which include: Michigan Transportation Finance Corporation, 1st Source Specialty Finance, Inc., SFG Equipment Leasing, Inc., 1st Source Intermediate Holding, LLC, 1st Source Commercial Aircraft Leasing, Inc., and SFG Equipment Leasing Corporation I. 3 TRUSTCORP MORTGAGE COMPANY - -------------------------- Trustcorp Mortgage Company (Trustcorp), is a mortgage banking company with five offices in Indiana and Ohio and a wholly owned subsidiary of 1st Source Corporation. Trustcorp provides real estate mortgage loan services primarily in the one-to-four family residential housing market. Most of the residential mortgages originated and/or purchased are sold into the secondary market and serviced by Trustcorp. 1st SOURCE INSURANCE, INC. - -------------------------- 1st Source Insurance, Inc., is a wholly owned subsidiary of 1st Source Bank that provides insurance services to individuals and businesses covering corporate and personal property products, casualty insurance products, and group health and life insurance products. 1st SOURCE CORPORATION INVESTMENT ADVISORS, INC. - ------------------------------------------------ 1st Source Corporation Investment Advisors, Inc., is a wholly owned subsidiary of 1st Source Bank that provides investment advisory services to trust and investment clients of 1st Source Bank and to the 1st Source Monogram Funds. 1st Source Corporation Investment Advisors, Inc., is registered as an investment advisor under the Securities Exchange Investment Advisors Act of 1940. 1st Source Corporation Investment Advisors, Inc., serves strictly in an advisory capacity and, as such, does not hold any client securities. OTHER CONSOLIDATED SUBSIDIARIES - ------------------------------- 1st Source has various other subsidiaries that are not significant to the consolidated entity. 1st SOURCE CAPITAL TRUST II, III, AND IV - ---------------------------------------- 1st Source's unconsolidated subsidiaries include, 1st Source Capital Trust II, III, and IV (1st Source Capital Trust I was dissolved on May 26, 2005). These subsidiaries were created for the purposes of issuing $17.25 million, $10.00 million, and $30.00 million of trust preferred securities, respectively, and lending the proceeds to 1st Source. 1st Source guarantees, on a limited basis, payments of distributions on the trust preferred securities and payments on redemption of the trust preferred securities. 1st Source Capital Trust II, III, and IV are variable interest entities (VIEs) for which 1st Source is not the primary beneficiary, as defined in Financial Accounting Standards Board Interpretation (FIN) No. 46, "Consolidation of Variable Interest Entities." In accordance with FIN 46, which 1st Source adopted early on July 1, 2003, the accounts of 1st Source Capital Trust II, III, and IV are not included in 1st Source's consolidated financial statements. At December 31, 2005, the balance of 1st Source's total issuance of trust preferred securities was $57.25 million. The subordinated loans from 1st Source Capital Trust II, III, and IV are included in 1st Source's consolidated balance sheet in "subordinated notes" and 1st Source's equity interests in the 1st Source Capital Trust II, III, and IV are included in "other assets" on the balance sheet. See 1st Source's accounting policy related to consolidation in Item 8. Financial Statements and Supplementary Data -- Note A - Accounting Policies of the Notes to Consolidated Financial Statements. COMPETITION - ----------- The activities in which 1st Source and the Bank engage are highly competitive. These activities and the geographic markets served involve competition with other banks, some of which are affiliated with large bank holding companies headquartered outside of 1st Source's principal market. 1st Source generally competes on the basis of client service and responsiveness to client needs, available loan and deposit products, the rates of interest charged on loans and leases, the rates of interest paid for funds, other credit and service charges, the quality of services rendered, the convenience of banking facilities, and in the case of loans and leases to large commercial borrowers, relative lending limits. In addition to competing with other banks within its primary service areas, the Bank also competes with other financial service companies, such as credit unions, industrial loan associations, securities firms, insurance companies, small loan companies, finance companies, mortgage companies, real estate investment trusts, certain governmental agencies, credit organizations, and other enterprises. Additional competition for depositors' funds comes from United States Government securities, private issuers of debt obligations, and suppliers of other investment alternatives for depositors. Many of 1st Source's non-bank competitors are not subject to the same extensive Federal regulations that govern bank holding companies and banks. Such non-bank competitors may, as a result, have certain advantages over 1st Source in providing some services. 1st Source competes against these financial institutions by offering a full array of products and highly personalized services. 1st Source also relies on a history in its core market dating back to 1863, relationships that long-term colleagues have with 1st Source's clients, and the capacity for quick local decision-making. EMPLOYEES - --------- At December 31, 2005, 1st Source had approximately 1,200 employees on a full-time equivalent basis. 1st Source provides a wide range of employee benefits and considers employee relations to be good. REGULATION AND SUPERVISION - -------------------------- GENERAL -- 1st Source and the Bank are extensively regulated under Federal and state law. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. Any change in applicable laws or regulations may have a material effect on the business and prospects of 1st Source. The operations of 1st Source may be affected by legislative changes and by the policies of various regulatory authorities. 1st Source is unable to predict the nature or the extent of the effects on its business and earnings that fiscal or monetary policies, economic controls, or new Federal or state legislation may have in the future. 1st Source is a registered bank holding company under the Bank Holding Company Act of 1956 (BHCA) and, as such, is subject to regulation, supervision, and examination by the Board of Governors of the Federal Reserve System (Federal Reserve). 1st Source is required to file annual reports with the Federal Reserve and to provide the Federal Reserve such additional information as it may require. 4 The Bank, as an Indiana state bank and member of the Federal Reserve System, is supervised by the Indiana Department of Financial Institutions (DFI) and the Federal Reserve. As such, the Bank is regularly examined by and subject to regulations promulgated by the DFI and the Federal Reserve. Because the Federal Deposit Insurance Corporation (FDIC) provides deposit insurance to the Bank, the Bank is also subject to supervision and regulation by the FDIC (even though the FDIC is not its primary Federal regulator). BANK HOLDING COMPANY ACT -- Under the BHCA, as amended, the activities of a bank holding company, such as 1st Source, are limited to business so closely related to banking, managing, or controlling banks as to be a proper incident thereto. 1st Source is also subject to capital requirements applied on a consolidated basis in a form substantially similar to those required of the Bank. The BHCA also requires a bank holding company to obtain approval from the Federal Reserve before (i) acquiring, or holding more than 5% voting interest in any bank or bank holding company, (ii) acquiring all or substantially all of the assets of another bank or bank holding company, or (iii) merging or consolidating with another bank holding company. The BHCA also restricts non-bank activities to those which, by statute or by Federal Reserve regulation or order, have been identified as activities closely related to the business of banking or of managing or controlling banks. As discussed below, the Gramm-Leach-Bliley Act, which was enacted in 1999, established a new type of bank holding company known as a "financial holding company," that has powers that are not otherwise available to bank holding companies. FINANCIAL INSTITUTIONS REFORM, RECOVERY AND ENFORCEMENT ACT OF 1989 -- The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) reorganized and reformed the regulatory structure applicable to financial institutions generally. THE FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT OF 1991 -- The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was adopted to supervise and regulate a wide variety of banking issues. In general, FDICIA provides for the recapitalization of the Bank Insurance Fund (BIF), deposit insurance reform, including the implementation of risk-based deposit insurance premiums, the establishment of five capital levels for financial institutions ("well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized") that would impose more scrutiny and restrictions on less capitalized institutions, along with a number of other supervisory and regulatory issues. At December 31, 2005, the Bank was categorized as "well capitalized," meaning that its total risk-based capital ratio exceeded 10.00%, its Tier 1 risk-based capital ratio exceeded 6.00%, its leverage ratio exceeded 5.00%, and it was not subject to a regulatory order, agreement, or directive to meet and maintain a specific capital level for any capital measure. FEDERAL DEPOSIT INSURANCE REFORM ACT -- On February 1, 2006, Congress approved the Federal Deposit Insurance Reform Act of 2005 (FDIRA). Among other things, the FDIRA provides for the merger of the Bank Insurance Fund with the Savings Association Insurance Fund and for an immediate increase in Federal deposit insurance for certain retirement accounts up to $250,000. The statute further provides for the indexing of the maximum deposit insurance coverage for all types of deposit accounts in the future to account for inflation. The FDIRA also requires the FDIC to provide certain banks and thrifts that were in existence prior to December 31, 1996 with one-time credits against future premiums based on the amount of their payments to the Bank Insurance Fund or Savings Association Insurance Fund prior to that date. SECURITIES AND EXCHANGE COMMISSION (SEC) AND NATIONAL ASSOCIATION OF SECURITIES DEALERS AUTOMATED QUOTATIONS (NASDAQ) -- 1st Source is under the jurisdiction of the SEC and certain state securities commissions for matters relating to the offering and sale of its securities. 1st Source is subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, as administered by the SEC. 1st Source is listed on the NASDAQ Stock Market under the trading symbol "SRCE," and is subject to the rules of NASDAQ for listed companies. RIEGLE-NEAL INTERSTATE BANKING AND BRANCHING EFFICIENCY ACT OF 1994 -- Congress enacted the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (Interstate Act) in September 1994. Beginning in September 1995, bank holding companies have the right to expand, by acquiring existing banks, into all states, even those which had theretofore restricted entry. The legislation also provides that, subject to future action by individual states, a holding company has the right to convert the banks which it owns in different states to branches of a single bank. The states of Indiana and Michigan have adopted the interstate branching provisions of the Interstate Act. ECONOMIC GROWTH AND REGULATORY PAPERWORK REDUCTION ACT OF 1996 -- The Economic Growth and Regulatory Paperwork Reduction Act of 1996 (EGRPRA) was signed into law on September 30, 1996. Among other things, EGRPRA streamlined the non-banking activities application process for well-capitalized and well-managed bank holding companies. GRAMM-LEACH-BLILEY ACT OF 1999 -- The Gramm-Leach-Bliley Act of 1999 (GLBA) is intended to modernize the banking industry by removing barriers to affiliation among banks, insurance companies, the securities industry, and other financial service providers. It provides financial organizations with the flexibility of structuring such affiliations through a holding company structure or through a financial subsidiary of a bank, subject to certain limitations. The GLBA establishes a new type of bank holding company, known as a financial holding company, that may engage in an expanded list of activities that are "financial in nature," which include securities and insurance brokerage, securities underwriting, insurance underwriting, and merchant banking. The GLBA also sets forth a system of functional regulation that makes the Federal Reserve the "umbrella supervisor" for holding companies, while providing for the supervision of the holding company's subsidiaries by other Federal and state agencies. A bank holding company may not become a financial holding company if any of its subsidiary financial institutions are not well-capitalized or well-managed. Further, each bank subsidiary of the holding company must have received at least a satisfactory Community Reinvestment Act (CRA) rating. The GLBA also expands the types of financial activities a national bank may conduct through a financial subsidiary, addresses state regulation of insurance, generally prohibits unitary thrift holding companies organized after May 4, 1999, from participating in new activities that are not financial in nature, provides privacy protection for nonpublic customer information of financial institutions, modernizes the Federal Home Loan Bank system, and makes miscellaneous regulatory improvements. The Federal Reserve and the Secretary of the Treasury must coordinate their supervision regarding approval of new financial activities to be conducted through a financial holding company or through a financial subsidiary of a bank. While the provisions of the GLBA regarding activities that may be conducted through a financial subsidiary directly apply only to national banks, those provisions indirectly apply to state-chartered banks. In addition, the Bank is subject to other provisions of the GLBA, including those relating to CRA and privacy, regardless of whether 1st Source elects to become a financial 5 holding company or to conduct activities through a financial subsidiary of the Bank. 1st Source does not, however, currently intend to file notice with the Board to become a financial holding company or to engage in expanded financial activities through a financial subsidiary of the Bank. FINANCIAL PRIVACY -- In accordance with the GLBA, Federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about customers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. The privacy provisions of the GLBA affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. USA PATRIOT ACT OF 2001 -- The USA Patriot Act of 2001 (USA Patriot Act) was signed into law primarily as a result of the terrorist attacks of September 11, 2001. The USA Patriot Act is comprehensive anti-terrorism legislation that, among other things, substantially broadened the scope of anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations on financial institutions. The regulations adopted by the United States Treasury Department under the USA Patriot Act impose new obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering, and terrorist financing. Additionally, the regulations require that 1st Source, upon request from the appropriate Federal regulatory agency, provide records related to anti-money laundering, perform due diligence of private banking and correspondent accounts, establish standards for verifying customer identity, and perform other related duties. Failure of a financial institution to comply with the USA Patriot Act's requirements could have serious legal and reputational consequences for the institution. REGULATIONS GOVERNING CAPITAL ADEQUACY -- The Federal bank regulatory agencies use capital adequacy guidelines in their examination and regulation of bank holding companies and banks. If capital falls below the minimum levels established by these guidelines, a bank holding company or bank will be required to submit an acceptable plan for achieving compliance with the capital guidelines and will be subject to denial of applications and appropriate supervisory enforcement actions. The various regulatory capital requirements that 1st Source is subject to are disclosed in Part II, Item 8, Financial Statements and Supplementary Data -- Note Q of the Notes to Consolidated Financial Statements. Management of 1st Source believes that the risk-weighting of assets and the risk-based capital guidelines do not have a material adverse impact on 1st Source's operations or on the operations of the Bank. COMMUNITY REINVESTMENT ACT -- The Community Reinvestment Act of 1977 requires that, in connection with examinations of financial institutions within their jurisdiction, the Federal banking regulators must evaluate the record of the financial institutions in meeting the credit needs of their local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of those banks. Federal banking regulators are required to consider a financial institution's performance in these areas as they review applications filed by the institution to engage in mergers or acquisitions or to open a branch or facility. REGULATIONS GOVERNING EXTENSIONS OF CREDIT -- The Bank is subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to 1st Source or its subsidiaries, or investments in its securities and on the use of its securities as collateral for loans to any borrowers. These regulations and restrictions may limit the ability of 1st Source to obtain funds from the Bank for its cash needs, including funds for acquisitions and for payment of dividends, interest and operating expenses. Further, the BHCA, certain regulations of the Federal Reserve, state laws and many other Federal laws govern the extensions of credit and generally prohibit a bank from extending credit, engaging in a lease or sale of property, or furnishing services to a customer on the condition that the customer obtain additional services from the bank's holding company or from one of its subsidiaries. The Bank is also subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to executive officers, directors, principal shareholders, or any related interest of such persons. Extensions of credit (i) must be made on substantially the same terms, including interest rates and collateral, and following credit underwriting procedures that are at least as stringent as those prevailing at the time for comparable transactions with persons not covered above and who are not employees, and (ii) must not involve more than the normal risk of repayment or present other unfavorable features. The Bank is also subject to certain lending limits and restrictions on overdrafts to such persons. RESERVE REQUIREMENTS -- The Federal Reserve requires all depository institutions to maintain reserves against their transaction accounts and non-personal time deposits. Reserves of 3.00% must be maintained against net transaction accounts greater than $7.00 million and less than $47.6 million (subject to adjustment by the Federal Reserve) and reserves of 10.00% must be maintained against that portion of net transaction accounts in excess of $47.6 million. DIVIDENDS -- The ability of the Bank to pay dividends and management fees is limited by various state and Federal laws, by certain covenant agreements, by the regulations promulgated by its primary regulators, and by the principles of prudent bank management. MONETARY POLICY AND ECONOMIC CONTROL -- The commercial banking business in which 1st Source engages is affected not only by general economic conditions, but also by the monetary policies of the Federal Reserve. Changes in the discount rate on member bank borrowing, availability of borrowing at the "discount window," open market operations, the imposition of changes in reserve requirements against member banks deposits and assets of foreign branches, and the imposition of, and changes in, reserve requirements against certain borrowings by banks and their affiliates are some of the instruments of monetary policy available to the Federal Reserve. These monetary policies are used in varying combinations to influence overall growth and distributions of bank loans, investments, and deposits, and such use may affect interest rates charged on loans and leases or paid on deposits. The monetary policies of the Federal Reserve have had a significant effect on the operating results of commercial banks and are expected to do so in the future. The monetary policies of the Federal Reserve are influenced by various factors, including inflation, unemployment, short-term and long-term changes in the international trade balance, and in the fiscal policies of the U.S. Government. Future monetary policies and the effect of such policies on the future business and earnings of 1st Source and the Bank cannot be predicted. SARBANES-OXLEY ACT OF 2002 -- On July 30, 2002, the Sarbanes-Oxley Act of 2002 (SOA) was signed into law. The SOA's stated goals include enhancing corporate responsibility, increasing penalties for accounting and auditing improprieties at publicly traded companies and protecting investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The SOA generally applies to all companies that file or are required to file periodic reports with the SEC under the Securities Exchange Act of 1934 (Exchange Act.) 6 Among other things, the SOA creates the Public Company Accounting Oversight Board as an independent body subject to SEC supervision with responsibility for setting auditing, quality control, and ethical standards for auditors of public companies. The SOA also requires public companies to make faster and more-extensive financial disclosures, requires the chief executive officer and the chief financial officer of public companies to provide signed certifications as to the accuracy and completeness of financial information filed with the SEC, and provides enhanced criminal and civil penalties for violations of the Federal securities laws. The SOA also addresses functions and responsibilities of audit committees of public companies. The statute makes the audit committee directly responsible for the appointment, compensation, and oversight of the work of the company's outside auditor, and requires the auditor to report directly to the audit committee. The SOA authorizes each audit committee to engage independent counsel and other advisors, and requires a public company to provide the appropriate funding, as determined by its audit committees, to pay the company's auditors and any advisors that its audit committee retains. The SOA also requires public companies to include an internal control report and assessment by management, along with an attestation to this report prepared by the company's registered public accounting firm, in their annual reports to stockholders. PENDING LEGISLATION -- Because of concerns relating to competitiveness and the safety and soundness of the banking industry, Congress often considers a number of wide-ranging proposals for altering the structure, regulation, and competitive relationships of the nation's financial institutions. It cannot be predicted whether or in what form any proposals will be adopted or the extent to which the business of 1st Source may be affected thereby. ITEM 1A. RISK FACTORS. An investment in 1st Source's common stock is subject to risks inherent to 1st Source's business. The material risk and uncertainties that management believes affect 1st Source are described below. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair 1st Source's business operations. FLUCTUATIONS IN INTEREST RATES COULD REDUCE 1st SOURCE'S PROFITABILITY AND AFFECT THE VALUE OF ITS ASSETS -- Like other financial institutions, 1st Source is subject to interest rate risk. 1st Source's primary source of income is net interest income, which is the difference between interest earned on loans and leases and investments, and interest paid on deposits and borrowings. 1st Source expects that it will periodically experience imbalances in the interest rate sensitivities of its assets and liabilities and the relationships of various interest rates to each other. Over any defined period of time, 1st Source's interest-earning assets may be more sensitive to changes in market interest rates than its interest-bearing liabilities, or vice-versa. In addition, the individual market interest rates underlying 1st Source's loan and lease and deposit products may not change to the same degree over a given time period. In any event, if market interest rates should move contrary to 1st Source's position, earnings may be negatively affected. In addition, loan and lease volume and quality and deposit volume and mix can be affected by market interest rates as can the businesses of 1st Source's clients. Changes in levels of market interest rates could have a material adverse affect on 1st Source's net interest spread, asset quality, origination volume, and overall profitability. Until recently, interest rates have been at historically low levels. However, since June 30, 2004, the Federal Reserve has increased its target for Federal funds rate numerous times. While these short-term market interest rates (which are used as a guide for pricing deposits) have increased, longer-term market interest rates (which are used as a guide for pricing longer-term loans and leases) have not. This "flattening" of the market yield curve has had a negative impact on 1st Source's interest rate spread and net interest margin to date. If short-term interest rates continue to rise, and if rates on its deposits and borrowings continue to reprice upwards faster than the rates on long-term loans and leases and investments, 1st Source could experience compression of its interest rate spread and net interest margin, which could have a negative effect on 1st Source's profitability. 1st Source principally manages interest rate risk by managing the volume and mix of its earning assets and funding liabilities. In a changing interest rate environment, 1st Source may not be able to manage this risk effectively. If 1st Source is unable to manage interest rate risk effectively, its business, financial condition and results of operations could be materially harmed. Changes in the level of interest rates also may negatively affect 1st Source's ability to originate loans and leases, the value of its assets and its ability to realize gains from the sale of its assets, all of which ultimately could affect 1st Source's earnings. FUTURE EXPANSION INVOLVES RISKS -- In the future, 1st Source may acquire all or part of other financial institutions and 1st Source may establish de novo branch offices. There could be considerable costs involved in executing 1st Source's growth strategy. For instance, new branches generally require a period of time to generate sufficient revenues to offset their costs, especially in areas in which 1st Source does not have an established presence. Accordingly, any new branch expansion could be expected to negatively impact earnings for some period of time until the branch reaches certain economies of scale. Acquisitions and mergers involve a number or risks, including the risk that: o 1st Source may incur substantial costs identifying and evaluating potential acquisitions and merger partners, or in evaluating new markets, hiring experienced local managers, and opening new offices; o 1st Source's estimates and judgments used to evaluate credit, operations, management, and market risks relating to target institutions may not be accurate; o There may be substantial lag-time between completing an acquisition or opening a new office and generating sufficient assets and deposits to support costs of the expansion; o 1st Source may not be able to finance an acquisition, or the financing 1st Source obtains may have an adverse effect on its operating results or dilution of its existing shareholders; o 1st Source's management's attention in negotiating a transaction and integrating the operations and personnel of the combining businesses may be diverted from its existing business; o 1st Source may enter new markets where it lacks local experience; o 1st Source may incur goodwill in connection with an acquisition, or the goodwill it incurs may become impaired, which results in adverse short-term effects on 1st Source's operating results; or o 1st Source may lose key employees and clients. 7 COMPETITION FROM OTHER FINANCIAL SERVICES PROVIDERS COULD ADVERSELY IMPACT 1st SOURCE'S RESULTS OF OPERATIONS -- The banking and financial services business is highly competitive. 1st Source faces competition in making loans and leases, attracting deposits and providing insurance, investment, trust, and other financial services. Increased competition in the banking and financial services businesses may reduce 1st Source's market share, impair its growth or cause the prices 1st Source charges for its services to decline. 1st Source's results of operations may be adversely impacted in future periods depending upon the level and nature of competition it encounters in its various market areas. 1st SOURCE IS DEPENDENT UPON THE SERVICES OF ITS MANAGEMENT TEAM -- 1st Source's future success and profitability is substantially dependent upon the management and banking abilities of its senior executives. 1st Source believes that its future results will also depend in part upon its ability to attract and retain highly skilled and qualified management. 1st Source is especially dependent on a limited number of key management personnel, many of whom do not have employment agreements with 1st Source. The loss of the chief executive officer and other senior management and key personnel could have a material adverse impact on 1st Source's operations because other officers may not have the experience and expertise to readily replace these individuals. Many of these senior officers have primary contact with 1st Source's clients and are extremely important in maintaining personalized relationships with 1st Source's client base. The unexpected loss of services of one or more of these key employees could have a material adverse effect on 1st Source's operations and possibly result in reduced revenues if 1st Source was unable to find suitable replacements promptly. Competition for senior personnel is intense, and 1st Source may not be successful in attracting and retaining such personnel. Changes in key personnel and their responsibilities may be disruptive to 1st Source's business and could have a material adverse effect on 1st Source's business, financial condition, and results of operations. TECHNOLOGY SECURITY BREACHES COULD EXPOSE 1st SOURCE TO POSSIBLE LIABILITY AND DAMAGE ITS REPUTATION -- Any compromise of 1st Source's security also could deter clients from using 1st Source's internet banking services that involve the transmission of confidential information. 1st Source relies on standard internet security systems to provide the security and authentication necessary to effect secure transmission of data. These precautions may not protect 1st Source's systems from compromises or breaches of its security measures that could result in damage to 1st Source's reputation and business. FAILURE TO PROPERLY MANAGE THE REPLACEMENT OF THE MAJORITY OF 1st SOURCE'S CORE AND ANCILLARY DATA PROCESSING SYSTEMS COULD ADVERSELY IMPACT 1st SOURCE'S RESULTS OF OPERATIONS -- 1st Source is in the process of replacing the majority of its core and ancillary data processing systems. 1st Source and its affiliates are licensing integrated core technology and ancillary systems. The core technology licensing includes a loan system, deposit system, general ledger system, and customer information file system. The target period for completion of the installation of the technology is March 2007. Failure to meet this deadline may be disruptive to 1st Source's business and could have a material adverse effect on 1st Source's financial condition and results of operations. 1st SOURCE IS SUBJECT TO CREDIT RISKS RELATING TO ITS LOAN AND LEASE PORTFOLIOS - -- 1st Source has certain lending policies and procedures in place that are designed to maximize loan and lease income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan and lease production, loan quality, concentrations of credit, loan and lease delinquencies, and nonperforming and potential problem loans and leases. Diversification in the loan and lease portfolios is a means of managing risk associated with fluctuations and economic conditions. 1st Source maintains an independent loan review department that reviews and validates the credit risk program on a periodic basis. Results of these reviews are presented to management. The loan and lease review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as 1st Source's policies and procedures. In the financial services industry, there is always a risk that certain borrowers may not repay borrowings. 1st Source's reserve for loan and lease losses may not be sufficient to cover the loan and lease losses that it may actually incur. If 1st Source experiences defaults by borrowers in any of its businesses, 1st Source's earnings could be negatively affected. Changes in local economic conditions could adversely affect credit quality, particularly in its local business loan and lease portfolio. Changes in national economic conditions could also adversely affect the quality of its loan and lease portfolio and negate, to some extent, the benefits of national diversification through its Specialty Finance Group's portfolio. Commercial and commercial real estate loans generally involve higher credit risks than residential real estate and consumer loans. Because payments on loans secured by commercial real estate or equipment are often dependent upon the successful operation and management of the underlying assets, repayment of such loans may be influenced to a great extent by conditions in the market or the economy. 1st Source seeks to minimize these risks through its underwriting standards. 1st Source obtains financial information and performs credit risk analysis on its customers. Credit criteria may include, but are not limited to, assessments of income, cash flows, and net worth; asset ownership; bank and trade credit reference; credit bureau report; and operational history. Commercial real estate or equipment loans are underwritten after evaluating and understanding the borrower's ability to operate profitably and generate positive cash flows. 1st Source's management examines current and projected cash flows of the borrower to determine the ability of the borrower to repay their obligations as agreed. Underwriting standards are designed to promote relationship banking rather than transactional banking. Most commercial and industrial loans are secured by the assets being financed or other business assets; however, some loans may be made on an unsecured basis. 1st Source's credit policy sets different maximum exposure limits both by business sector and its current and historical relationship and previous experience with each customer. 1st Source offers both fixed-rate and adjustable-rate consumer mortgage loans secured by properties, substantially all of which are located in 1st Source's primary market area. Adjustable-rate mortgage loans help reduce 1st Source's exposure to changes in interest rates; however, during periods of rising interest rates, the risk of default on adjustable-rate mortgage loans may increase as a result of repricing and the increased payments required from the borrower. Additionally, most residential mortgages are sold into the secondary market and serviced by 1st Source's mortgage subsidiary, Trustcorp. Consumer loans are primarily all other non-real estate loans to individuals in 1st Source's regional market area. Consumer loans can entail risk, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets. In these cases, any repossessed collateral may not provide an adequate source of repayment of the outstanding loan balance. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness, or personal bankruptcy. The 1st Source Specialty Finance Group loan and lease portfolio consists of commercial loans and leases secured by construction and transportation equipment, including aircraft, autos, trucks, and vans. Finance receivables for this Group generally provide for monthly payments and may include prepayment penalty provisions. 8 1st Source's construction and transportation related businesses could be adversely affected by slow downs in the economy. Clients who rely on the use of assets financed through the Specialty Finance Group to produce income could be negatively affected, and 1st Source could experience substantial loan and lease losses. By the nature of the businesses these clients operate in, 1st Source could be adversely affected by continued rapid increases of fuel costs. Since some of the relationships in these industries are large (up to $15 million), a slow down could have a significant adverse impact on 1st Source's performance. 1st Source's construction and transportation related businesses could be adversely impacted by the negative effects caused by high fuel costs, terrorist attacks, potential attacks, and other destabilizing events. These factors could contribute to the deterioration of the quality of 1st Source's loan and lease portfolio, as they could have a negative impact on the travel sensitive businesses for which 1st Source's specialty finance businesses provide financing. In addition, 1st Source's leasing and equipment financing activity is subject to the risk of cyclical downturns, industry concentration and clumping, and other adverse economic developments affecting these industries and markets. This area of lending, with transportation in particular, is dependent upon general economic conditions and the strength of the travel, construction, and transportation industries. ITEM 1B. UNRESOLVED STAFF COMMENTS. None ITEM 2. PROPERTIES. 1st Source's headquarters building is located in downtown South Bend. In 1982, the land was leased from the City of South Bend on a 49-year lease, with a 50-year renewal option. The building is part of a larger complex, including a 300-room hotel and a 500-car parking garage. Also, in 1982, 1st Source sold the building and entered into a leaseback agreement with the purchaser for a term of 30 years. The building is a structure of approximately 160,000 square feet, with 1st Source and its subsidiaries occupying approximately 70% of the available office space and approximately 30% subleased to unrelated tenants. At December 31, 2005, 1st Source also owned property and/or buildings on which 46 of the Bank subsidiary's 64 banking centers were located, including the facilities in Allen, Elkhart, Fulton, Huntington, Kosciusko, LaPorte, Marshall, Porter, St. Joseph, Starke, and Wells Counties in the State of Indiana and Berrien County in the State of Michigan, as well as an operations center, training facility, warehouse, and its former headquarters building, which is utilized for additional business operations. The Bank leases additional property and/or buildings from third parties under lease agreements negotiated at arms-length. ITEM 3. LEGAL PROCEEDINGS. 1st Source and its subsidiaries are involved in various legal proceedings incidental to the conduct of their businesses. Management does not expect that the outcome of any such proceedings will have a material adverse effect on 1st Source's consolidated financial position or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES. 1st Source's common stock is traded on the Nasdaq Stock Market under the symbol "SRCE." The following table sets forth for each quarter the high and low sales prices for the common stock of 1st Source, as reported by Nasdaq, and the cash dividends paid per share for each quarter.
2005 Sales Price Cash Dividends 2004 Sales Price Cash Dividends Common Stock Prices (quarter ended) High Low Paid High Low Paid - ------------------------------------------------------------------------------------------------------------------------- March 31 $ 25.84 $ 20.39 $ .120 $ 24.90 $ 20.96 $ .100 June 30 23.80 19.41 .120 25.50 20.35 .100 September 30 25.89 22.06 .120 26.04 22.30 .110 December 31 26.10 20.92 .130 28.09 25.15 .110 =========================================================================================================================
As of December 31, 2005, there were 1,071 holders of record of 1st Source common stock. 9 The following table summarizes share repurchase activity of 1st Source during the three months ended December 31, 2005.
Issuer Purchases of Equity Securities (a) (b) (c) (d) Total Number of Maximum Number(or Approximate Shares Purchased as Dollar Value) of Shares that Total Number of Average Price Part of Publicly Announced may yet be Purchased Under Period Shares Purchased Paid Per Share Plans or Programs* the Plans or Program - ------------------ --------------------------- --------------------- ---------------------- -- --- ---- ---------------------------- October 01-31, 2005 - $ - - 538,078 November 01-30, 2005 894 24.80 894 537,184 December 01-31, 2005 - - - 537,184 ====================================================================================================================================
* 1st Source maintains a stock repurchase plan that was authorized by the Board of Directors on October 23, 2001. Under the terms of the plan, 1st Source may repurchase up to 1,038,990 shares of its common stock when favorable conditions exist on the open market or through private transactions at various prices from time to time. Since the inception of the plan, 1st Source has repurchased a total of 501,806 shares. Federal laws and regulations contain restrictions on the ability of 1st Source and the Bank to pay dividends. For information regarding restrictions on dividends, see Part I, Item 1, Business -- Regulation and Supervision -- Dividends and Part II, Item 8, Financial Statements and Supplementary Data -- Note Q of the Notes to Consolidated Financial Statements. ITEM 6. SELECTED FINANCIAL DATA. The following selected financial data should be read in conjunction with 1st Source's Consolidated Financial Statements and the accompanying notes presented elsewhere herein.
(Dollars in thousands, except per share amounts) 2005 2004 2003 2002 2001 - ---------------------------------------------- -------------------------------------------------------------------- Interest income $ 168,532 $ 151,437 $ 162,322 $ 199,503 $ 245,566 Interest expense 70,104 52,749 59,070 80,817 126,957 - ---------------------------------------------- -------------------------------------------------------------------- Net interest income 98,428 98,688 103,252 118,686 118,609 (Recovery of) provision for loan and lease losses (5,855) 229 17,361 39,657 25,745 - ---------------------------------------------- -------------------------------------------------------------------- Net interest income after (recovery of) provision for loan and lease losses 104,283 98,459 85,891 79,029 92,864 Noninterest income 68,533 62,733 80,196 73,117 87,026 Noninterest expense 123,439 127,091 138,904 140,741 121,683 - -------------------------------------------- ---------------------------------------------------------------------- Income before income taxes 49,377 34,101 27,183 11,405 58,207 Income taxes 15,626 9,136 8,029 1,366 19,709 - -------------------------------------------- ---------------------------------------------------------------------- Net income $ 33,751 $ 24,965 $ 19,154 $ 10,039 $ 38,498 - -------------------------------------------- ---------------------------------------------------------------------- Assets at year-end $ 3,511,277 $ 3,563,715 $ 3,330,153 $ 3,407,468 $ 3,562,691 Long-term debt and mandatorily redeemable securities at year-end 23,237 17,964 22,802 16,878 11,939 Shareholders' equity at year-end 345,576 326,600 314,691 309,429 306,190 Basic net income per common share * 1.63 1.21 0.92 0.48 1.85 Diluted net income per common share * 1.61 1.19 0.91 0.47 1.82 Cash dividends per common share* .490 .420 .370 .360 .351 Dividend payout ratio 30.43% 35.29% 40.66% 76.60% 19.29% Return on average assets 1.00% 0.75% 0.59% 0.29% 1.14% Return on average common equity 10.12% 7.81% 6.12% 3.23% 13.14% Average common equity to average assets 9.89% 9.55% 9.60% 8.95% 8.69% ====================================================================================================================
* All per share amounts have been restated for stock dividends. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The purpose of this analysis is to provide the reader with information relevant to understanding and assessing 1st Source's results of operations for each of the past three years and financial condition for each of the past two years. In order to fully appreciate this analysis the reader is encouraged to review the consolidated financial statements and statistical data presented in this document. FORWARD-LOOKING STATEMENTS - -------------------------- This report, including Management's Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements. Forward-looking statements include statements with respect to 1st Source's beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond 1st Source's control, and which may cause actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. 10 All statements other than statements of historical fact are statements that could be forward-looking statements. Words such as "believe", "contemplate", "seek", "estimate", "plan", "project", "anticipate", "assume", "expect", "intend", "targeted", "continue", "remain", "will", "should", "indicate", "would", "may" and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements provide current expectations or forecasts of future events and are not guarantees of future performance, nor should they be relied upon as representing management's views as of any subsequent date. The forward-looking statements are based on 1st Source's expectations and are subject to a number of risks and uncertainties. All written or oral forward-looking statements that are made by or attributable to 1st Source are expressly qualified in their entirety by this cautionary notice. 1st Source has no obligation and does not undertake to update, revise, or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made. 1st Source has expressed its expectations, beliefs, and projections in good faith and 1st Source believes they have a reasonable basis. However, 1st Source makes no assurances that its expectations, beliefs, or projections will be achieved or accomplished. These forward-looking statements may not be realized due to a variety of factors, including, without limitation, the following: o Local, regional, national, and international economic conditions and the impact they may have on 1st Source and its clients and 1st Source's assessment of that impact. o Changes in the level of nonperforming assets and charge-offs. o Changes in estimates of future cash reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements. o The effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board. o Inflation, interest rate, securities market, and monetary fluctuations. o Political instability. o Acts of war or terrorism. o Substantial increases in the cost of fuel. o The timely development and acceptance of new products and services and perceived overall value of these products and services by others. o Changes in consumer spending, borrowings, and savings habits. o Changes in the financial performance and/or condition of 1st Source's borrowers. o Technological changes. o Acquisitions and integration of acquired businesses. o The ability to increase market share and control expenses. o Changes in the competitive environment among bank holding companies. o The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities, and insurance) with which 1st Source and its subsidiaries must comply. o The effect of changes in accounting policies and practices and auditing requirements, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board, and other accounting standard setters. o Changes in 1st Source's organization, compensation, and benefit plans. o The costs and effects of legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquires and the results of regulatory examinations or reviews. o Greater than expected costs or difficulties related to the integration of new products and lines of business. o 1st Source's success at managing the risks described in Item 1A. Risk Factors. CRITICAL ACCOUNTING POLICIES - ---------------------------- 1st Source's consolidated financial statements are prepared in accordance with U. S. generally accepted accounting principles and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates or judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates or judgments reflect management's view of the most appropriate manner in which to record and report 1st Source's overall financial performance. Because these estimates or judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experience. As such, changes in these estimates, judgments, and/or assumptions may have a significant impact on the financial statements. All accounting policies are important, and all policies described in Part II, Item 8, Financial Statements and Supplementary Data, Note A (Note A), should be reviewed for a greater understanding of how 1st Source's financial performance is recorded and reported. 1st Source has identified three policies as being critical because they require management to make particularly difficult, subjective, and/or complex estimates or judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the determination of the reserve for loan and lease losses, the valuation of mortgage servicing rights, and the valuation of securities. Management has used the best information available to make the estimations or judgments necessary to value the related assets and liabilities. Actual performance that differs from estimates or judgments and future changes in the key variables could change future valuations and impact net income. Management has reviewed the application of these policies with the Audit Committee of 1st Source's Board of Directors. A brief discussion of 1st Source's critical accounting policies appears below. RESERVE FOR LOAN AND LEASE LOSSES -- The reserve for loan and lease losses represents management's estimate of probable losses inherent in the loan and lease portfolio and the establishment of a reserve that is sufficient to absorb those losses. In determining an adequate reserve, management makes numerous judgments, assumptions, and estimates based on continuous review of the loan and lease portfolio, estimates of future customer performance, collateral values, 11 and disposition, as well as historical loss rates and expected cash flows. In assessing these factors, management benefits from a lengthy organizational history and experience with credit decisions and related outcomes. Nonetheless, if management's underlying assumptions prove to be inaccurate, the reserve for loan and lease losses would have to be adjusted. 1st Source's accounting policy related to the reserve is disclosed in Note A under the heading "Reserve for Loan and Lease Losses." MORTGAGE SERVICING RIGHTS VALUATION -- 1st Source recognizes as assets the rights to service mortgage loans for others, known as mortgage servicing rights whether the servicing rights are acquired through purchases or through originated loans. Mortgage servicing rights do not trade in an active open market with readily observable market prices. Although sales of mortgage servicing rights do occur, the precise terms and conditions may not be readily available. As such, the value of mortgage servicing assets are established and valued using discounted cash flow modeling techniques which require management to make estimates regarding estimated future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates, servicing costs, and other economic factors. The expected and actual rates of mortgage loan prepayments are the most significant factors driving the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced. In determining the fair value of the mortgage servicing assets, mortgage interest rates (which are used to determine prepayment rates), and discount rates are held constant over the estimated life of the portfolio. Expected mortgage loan prepayment rates are derived from a third-party model and adjusted to reflect 1st Source's actual prepayment experience. Mortgage servicing assets are carried at the lower of the initial capitalized amount, net of accumulated amortization or fair value. The values of these assets are sensitive to changes in the assumptions used and readily available market pricing does not exist. The valuation of mortgage servicing assets is discussed further in Note A under the heading "Mortgage Banking Activities." VALUATION OF SECURITIES -- 1st Source's available-for-sale security portfolio is reported at fair value. The fair value of a security is determined based on quoted market prices. If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments. Available-for-sale and held-to-maturity securities are reviewed quarterly for possible other-than-temporary impairment. The review includes an analysis of the facts and circumstances of each individual investment such as length of time the fair value has been below cost, the expectation for that security's performance, the credit worthiness of the issuer, and 1st Source's intent and ability to hold the security for a time necessary to recover the amortized cost. A decline in value that is considered to be other-than-temporary is recorded as investment securities and other investment losses in the Consolidated Statements of Income. The valuation of securities is discussed further in Note A under the heading "Securities." EARNINGS SUMMARY - ---------------- Net income in 2005 was $33.75 million, up from $24.97 million in 2004 and up from $19.15 million in 2003. Diluted net income per common share was $1.61 in 2005, $1.19 in 2004, and $0.91 in 2003. Return on average total assets was 1.00% in 2005 compared to 0.75% in 2004, and 0.59% in 2003. Return on average common shareholders' equity was 10.12% in 2005 versus 7.81% in 2004, and 6.12% in 2003. Net income in 2005 was favorably affected by a recovery in the provision for loan and lease losses, a reduction in loan and lease collection and repossession expense, and decreased professional fee expense. In addition, income from deposit fees increased and losses on investment securities decreased notably from 2004 and 2003. Equipment rental income decreased and depreciation on leased equipment decreased accordingly in 2005 from 2004. Net income included $0.61 million, $4.78 million, and $0 of other-than-temporary impairment on investment securities, for 2005, 2004, and 2003, respectively. Net income continued to be unfavorably affected by decreased net interest margins primarily due to the interest rate environment. Dividends paid on common stock in 2005 amounted to $0.49 per share, compared to $0.42 per share in 2004, and $0.37 per share in 2003. The level of earnings reinvested and dividend payouts are based on management's assessment of future growth opportunities and the level of capital necessary to support them. REPLACEMENT OF CORE AND ANCILLARY DATA PROCESSING SYSTEMS -- On December 1, 2005, 1st Source Bank, entered into a license and service agreement with Fiserv Solutions, Inc.(Fiserv), a subsidiary of Fiserv, Inc. The agreement was an integral part of the decision by 1st Source to replace the majority of its core and ancillary data processing systems. 1st Source expects the implementation of this project will increase the effectiveness and efficiency of its operations and facilitate future growth. 1st Source also expects that, over time, this investment in its core systems will be offset by elimination of current costs for ongoing support of the current technology platform. Under the agreement, 1st Source and its affiliates are licensing integrated core technology and ancillary systems from Fiserv. The core technology licensing includes a loan system, deposit system, general ledger system, and customer information file system. Fiserv is obligated to provide professional services for installation of the technology and training, and maintenance support services. The agreement provides an initial five year maintenance period to begin no later than March 2007, the target period for completion of the installation of the technology. The agreement provides for automatic renewal of the maintenance period, after the initial five year term, unless either party notifies the other of its intent not to renew. 1st Source is subject to termination fees for early termination of the maintenance period. 1st Source expects the cost will be approximately $6.0 million for the technology licenses, professional fees for installation and training, and hardware delivered under the Fiserv agreement. SECURITIZED LOAN PORTFOLIO PURCHASE -- In December 2003, the Bank purchased its securitized loan portfolio for $226.0 million. For several years, 1st Source originated and serviced loans sold to and owned by the 1st Source Master Trust. The loans were secured by business or personal use aircraft or by autos for the rental car industry, two of 1st Source's longstanding specialty finance product lines. The loans served as collateral for note certificates issued by the Master Trust and purchased by institutional investors. The portfolio purchased included $210.83 million in aircraft loans, $15.19 million in automobile rental loans, and $4.39 million of loan-related assets. Excess cash of $24.53 million in the Master Trust was used to repay 1st Source its retained interest in the Master Trust. The transaction did not have a material impact on the results of operations in 2003. 12 NET INTEREST INCOME -- Net interest income (the difference between income from earning assets and the interest cost of funding those assets) is 1st Source's primary source of earnings. Net interest income, on a fully taxable equivalent basis remained relatively stable in 2005 following a 4.56% decrease in 2004. Net interest margin (the ratio of net interest income to average earning assets) is affected by movements in interest rates and changes in the mix of earning assets and the liabilities that fund those assets. Net interest margin on a fully taxable equivalent basis was 3.21% in 2005 compared to 3.25% in 2004, and 3.56% in 2003. The Federal Reserve Board influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. The Federal funds rate has increased 325 basis points since June 2004. The continued rise in short-term interest rates has resulted in a flattened yield curve for the years ended 2005 and 2004. Compression of the net interest margin during 2005 and 2004 largely resulted from decreases in the net interest rate spread associated with increases in rates paid across deposit and other funding categories, continued mix shifts within the deposit base to higher cost time deposits, and the prolonged and significant flattening of the yield curve. Additionally, 1st Source's focus on loan portfolio credit quality coupled with increased competition for deposits across all markets were contributing factors leading to the decline in the net interest margin for 2005 and 2004. The average yield on earning assets in 2005 was 5.43%, compared to 4.94% in 2004, and 5.54% in 2003. Average earning assets in 2005 remained relatively stable, following a 4.71% increase in 2004. The effective rate on interest bearing liabilities was 2.71% in 2005 compared to 2.04% in 2004, and 2.38% for 2003. The following table provides an analysis of net interest income and illustrates the interest income earned and interest expense charged for each major component of interest earning assets and interest bearing liabilities. 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.
2005 2004 2003 Interest Interest Interest Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/ (Dollars in thousands) Balance Expense Rate Balance Expense Rate Balance Expense Rate - ------------------------------------------------------------------------------------------------------------------------------------ ASSETS - ------ Investment securities Taxable $ 515,992 $ 14,777 2.86% $ 590,786 $ 16,361 2.77% $ 535,233 $ 18,410 3.44% Tax-exempt 186,614 7,682 4.12 171,600 7,502 4.37 167,740 8,306 4.95 Mortgages held for sale 82,174 4,779 5.82 69,964 3,868 5.53 112,157 6,496 5.79 Net loans and leases 2,348,690 143,295 6.10 2,240,055 125,469 5.60 2,091,004 131,186 6.27 Other investments 18,765 666 3.55 49,585 952 1.92 75,488 916 1.21 - ---------------------------- ------------- ---------- --------- -------------- ---------- -------- ------------- ---------- -------- Total earning assets 3,152,235 171,199 5.43 3,121,990 154,152 4.94 2,981,622 165,314 5.54 Cash and due from banks 84,517 81,334 86,483 Reserve for loan and lease losses (61,072) (69,567) (63,123) Other assets 197,457 215,607 253,192 - ---------------------------- ------------- ---------- --------- -------------- ---------- -------- ------------- ---------- -------- Total assets $ 3,373,137 $ 3,349,364 $ 3,258,174 ==================================================================================================================================== LIABILITIES AND - --------------- SHAREHOLDERS' EQUITY -------------------- Interest bearing deposits $ 2,217,923 $ 56,341 2.54% $ 2,105,013 $ 41,698 1.98% $ 2,145,467 $ 49,153 2.29% Short-term borrowings 295,271 8,628 2.92 405,192 6,079 1.50 256,628 5,121 2.00 Subordinated notes 59,022 4,008 6.79 57,198 3,863 6.75 55,604 3,804 6.84 Long-term debt and mandatorily redeemable securities 18,270 1,127 6.17 22,921 1,109 4.84 20,132 992 4.93 - ----------------------------- ------------- ---------- --------- -------------- ---------- -------- ------------- ---------- ------- Total interest bearing liabilities 2,590,486 70,104 2.71 2,590,324 52,749 2.04 2,477,831 59,070 2.38 Noninterest bearing deposits 392,475 384,157 413,794 Other liabilities 56,553 55,146 53,756 Shareholders' equity 333,623 319,737 312,793 - ----------------------------- ------------- ---------- --------- -------------- ---------- -------- ------------- ---------- ------- Total liabilities and shareholders' equity $ 3,373,137 $ 3,349,364 $ 3,258,174 ==================================================================================================================================== Net interest income $101,095 $101,403 $106,244 ==================================================================================================================================== Net interest margin on a tax equivalent basis 3.21% 3.25% 3.56% ====================================================================================================================================
13 The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. The following table shows changes in tax equivalent interest earned and interest paid, resulting from changes in volume and changes in rates:
Increase (Decrease) due to (Dollars in thousands) Volume Rate Net - --------------------------------------------------------- ----------- ---------------- -------- 2005 compared to 2004 Interest earned on: Investment securities: Taxable $ (2,139) $ 555 $ (1,584) Tax-exempt 534 (354) 180 Mortgages held for sale 700 211 911 Net loans and leases 6,273 11,553 17,826 Other investments 781 (1,067) (286) - --------------------------------------------------------- ----------- ---------------- -------- Total earning assets $ 6,149 $ 10,898 $ 17,047 =============================================================================================== Interest paid on: Interest bearing deposits $ 2,323 $ 12,320 $ 14,643 Short-term borrowings (1,020) 3,569 2,549 Subordinated notes 122 23 145 Long-term debt and mandatorily redeemable securities (51) 69 18 - --------------------------------------------------------------------- ---------------- -------- Total interest bearing liabilities $ 1,374 $ 15,981 $ 17,355 =============================================================================================== Net interest income $ 4,775 $ (5,083) $ (308) =============================================================================================== 2004 compared to 2003 Interest earned on: Investment securities: Taxable $ 2,332 $ (4,381) $ (2,049) Tax-exempt 196 (1,000) (804) Mortgages held for sale (2,348) (280) (2,628) Net loans and leases 11,260 (16,977) (5,717) Other investments (51) 87 36 - --------------------------------------------------------------------- ---------------- -------- Total earning assets $ 11,389 $ (22,551) $(11,162) =============================================================================================== Interest paid on: Interest bearing deposits $ (914) $ (6,541) $ (7,455) Short-term borrowings 1,681 (723) 958 Subordinated notes 108 (49) 59 Long-term debt and mandatorily redeemable securities 135 (18) 117 - --------------------------------------------------------------------- ---------------- -------- Total interest bearing liabilities $ 1,010 $ (7,331) $ (6,321) =============================================================================================== Net interest income $ 10,379 $ (15,220) $ (4,841) ===============================================================================================
NONINTEREST INCOME -- Noninterest income for the most recent three years ended December 31 was as follows:
(Dollars in thousands) 2005 2004 2003 - --------------------------------------------------------------------- ----------------- ------------- Noninterest income: Trust fees $ 12,877 $ 12,361 $ 10,664 Service charges on deposit accounts 17,775 16,228 15,532 Mortgage banking 10,868 9,553 19,635 Securitization income - - 3,206 Insurance commissions 4,133 3,695 3,047 Equipment rental income 16,067 18,856 25,448 Other income 6,463 6,759 6,600 Investment securities and other investment gains (losses) 350 (4,719) (3,936) - --------------------------------------------------------------------- ----------------- ------------- Total noninterest income $ 68,533 $ 62,733 $ 80,196 =====================================================================================================
14 Noninterest income increased 9.25% in 2005 over 2004 mainly due to recoveries of mortgage servicing rights impairment, decreased charges for other-than-temporary impairment of securities, and gains on partnership investments. These increases were partially offset by decreases in equipment rental income. Noninterest income decreased 21.78% in 2004 from 2003 primarily due to decreased mortgage banking income, equipment rental income, securitization income, and increased investment securities losses. These decreases were partially offset by growth in trust and deposit fees and insurance commission income. During 2005, the Bank and Trustcorp together produced $826.63 million in new mortgages -- $139.06 million through the Bank; $214.05 million through Trustcorp; and $473.52 million purchased from wholesale production sources. Mortgage banking income increased 13.77% in 2005 over 2004, compared to a decrease of 51.35% in 2004 from 2003. The increase in 2005 was primarily the result of a recovery of impairment on mortgage servicing assets of $2.27 million versus impairment recoveries of $0.28 million, and impairment charges of $0.58 million during 2004 and 2003, respectively. During 2005, 1st Source determined that no direct write-down was necessary for previously recorded impairment on mortgage servicing assets. During 2004 and 2003, 1st Source determined that $0.70 million and $4.63 million, respectively, of previously recorded impairment was unrecoverable and was recorded as a direct write-down to the carrying value of the asset. Due to the December 2003 purchase of securitized loans by the Bank, there was no securitization income in 2004 or 2005. In the first half of 2003, 1st Source made a strategic decision to liquidate the Master Trust due to adequate capital and liquidity to hold the loans, otherwise eligible for securitization, on the balance sheet, and the desire to eliminate the expenses associated with the securitization. Servicing income was $3.50 million and losses on loan sales were $0.30 million in 2003. Trust fees (which includes investment management fees, estate administration fees, mutual fund annuity fees, and fiduciary fees) increased by 4.17% in 2005 from 2004 compared to an increase of 15.91% in 2004 over 2003. Trust fees are largely based on the size of client relationships and the market value and mix of assets under management. The market value of trust assets under management at December 31, 2005 and 2004, were $2.66 billion and $2.41 billion, respectively. At December 31, 2005, these trust assets were comprised of $1.32 billion of personal and agency trusts, $816.00 million of employee benefit plan assets, $333.67 million of estate administration assets, and $188.63 million of custody assets. A weaker stock and bond market slowed the growth of trust fees in 2005 from 2004 as compared to 2004 over 2003. Service charges on deposit accounts increased 9.53% in 2005 from 2004 compared to an increase of 4.48% in 2004 from 2003. The increases in service charges on deposit accounts in 2005, 2004, and 2003, were attributed primarily to increased debit card fees and consumer overdraft fees. Insurance commissions continued to grow and were up 11.85% in 2005 from 2004 compared to an increase of 21.27% in 2004 from 2003. The increases for 2005 and 2004 were mainly attributed to new business sales growth. Equipment rental income generated from operating leases declined by 14.79% during 2005 from 2004 compared to a decrease of 25.90% in 2004 from 2003. Revenues from operating leases for construction equipment, various trucks, and other equipment declined primarily due to portfolio maturities in 2005. Revenues for 2004 and 2003 were negatively affected as clients in these industries opted to take advantage of the tax benefits available for purchases of equipment versus equipment rental. Other income decreased 4.38% in 2005 from 2004 compared to an increase of 2.41% in 2004 from 2003. The decline in other income was primarily the result of lower standby letter of credit fee income which decreased by $0.17 million and miscellaneous fee income which decreased by $0.31 million in 2005. The increase in 2004 over 2003 was primarily the result of increased income on bank owned life insurance of $0.18 million. Investment securities and other investment gains totaled $0.35 million for the year ended 2005. Gains on venture capital investments were partially offset by other-than-temporary impairment of $0.61 million for 2005. In 2004, investment securities and other investment losses totaled $4.72 million, of this amount $4.58 million was comprised of other-than-temporary impairment charges on investments in Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) preferred stock. Investment securities and other investment losses in 2003 total $3.94 million, of this amount $2.99 million was impairment charges on the securitization retained asset. NONINTEREST EXPENSE -- Noninterest expense for the recent three years ended December 31 was as follows:
(Dollars in thousands) 2005 2004 2003 - ---------------------------------------------------------------------- ---------------- ------------- Noninterest expense: Salaries and employee benefits $ 69,767 $ 63,083 $ 69,457 Net occupancy expense 7,749 7,196 6,881 Furniture and equipment expense 11,418 10,290 10,363 Depreciation -- leased equipment 12,895 15,315 19,773 Professional fees 3,362 6,563 2,925 Supplies and communication 5,462 5,708 6,163 Business development and marketing expense 3,630 3,613 3,481 Intangible asset amortization 2,663 2,631 2,748 Loan and lease collection and repossession expense (1,094) 4,946 8,112 Other expense 7,587 7,746 9,001 - ---------------------------------------------------------------------- ---------------- ------------- Total noninterest expense $ 123,439 $ 127,091 $ 138,904 =====================================================================================================
1st Source experienced a decrease in noninterest expense of 2.87% in 2005 from 2004 compared to a decrease of 8.50% in 2004 from 2003 . The leading factors contributing to the decrease in noninterest expense in 2005 were reduced expenses for professional fees, decreased depreciation on leased equipment, and a decline in loan and lease collection and repossession expenses which were partially offset by an increase in salaries and employee benefits. Salaries and employee benefits increased 10.60% in 2005 from 2004, following a 9.18% decrease in 2004 from 2003. Salaries increased 2.88% in 2005 compared to a decrease of 9.61% in 2004. The increase in salaries in 2005 was primarily the result of merit-based and market-driven salary increases and increased commissions due to higher insurance revenues. The largest component of the 2004 decrease was the impact of the capitalization of an additional $3.21 million in salaries and benefits in connection with the deferral of loan origination costs. In addition, commission expense decreased $2.20 million in 2004 as mortgage originations slowed due to lower origination volume than that experienced in 2003. 15 Employee benefits increased 39.21% in 2005, following a 7.52% decrease in 2004. The increase in 2005 was primarily due to increased executive incentives and group insurance expense. In 2004, employee benefits decreased due to a reduction in pension and profit sharing expense and lower group insurance expense. Occupancy expense increased 7.68% in 2005 from 2004, compared to a 4.58% increase in 2004 from 2003. The increase in 2005 was primarily due to higher leasehold improvements and repair of premises expenses. Also, during the first quarter of 2005, 1st Source reviewed its lease accounting practices in light of the views expressed by the Office of the Chief Accountant of the SEC in a February 7, 2005 letter to the American Institute of Certified Public Accountants. As a result of its review, 1st Source recorded a one-time, net charge of $0.27 million to correct its accounting for straight-line rent and depreciation of leasehold improvements. During 2004, real estate property taxes increased as the Indiana state wide property reassessment was finalized. Furniture and equipment expense, including depreciation, increased in 2005 over 2004 by 10.96%, compared to a 0.70% decrease in 2004 from 2003. The leading causes for the increase in 2005 were increased third-party processing charges and desktop computer upgrades. The decrease in 2004 was due to reduced equipment depreciation and repair expense which were offset by increased software expense. The decrease in 2003 was the result of reduced equipment repair costs offset by increased computer processing charges. Depreciation on operating leases decreased 15.80% in 2005 from 2004, following a 22.55% decrease in 2004 from 2003. Depreciation on operating leases declined in conjunction with the decline in noninterest income from equipment owned under operating leases due to maturities in the operating lease portfolio during 2005 and clients who opted to take advantage of the tax benefits available for purchases of equipment versus equipment rental during 2004 and 2003. Professional fees decreased 48.77% in 2005 from 2004, compared to a 124.38% increase in 2004 from 2003. The decrease in 2005 was mainly due to the settlement, during the fourth quarter of 2004, of the lawsuit described in the 2003 Form 10-K Item 3, Legal Proceedings and a reduction in the associated legal fees. The increase in 2004 was primarily due to increased legal fees relating, in part, to defense of the lawsuit described in the 2003 Form 10-K Item 3, Legal Proceedings. Also, during 2004 professional fees increased due to the costs of implementing new internal control evaluation procedures in order to comply with the provisions of Section 404 of the Sarbanes-Oxley Act and fees incurred due to long-term projects involving operations improvements and system upgrades. Supplies and communications expense decreased 4.31% in 2005 from 2004, compared to a 7.38% decrease in 2004 from 2003. The decrease in 2005 was primarily due to lower charges for postage and freight and telephone service. The decrease in 2004 was due to lower charges for printing and supplies and reduced communication expense. Business development and marketing expense remained relatively flat for the year 2005 from 2004, compared to an increase of 3.79% in 2004 from 2003. During 2005, 2004, and 2003, 1st Source continued to engage in effective target advertising and marketing campaigns, while keeping expenses for these items under control. Intangible asset amortization increased 1.22% in 2005 from 2004 compared to a 4.26% decrease in 2004 from 2003. The increase in 2005 was due to amortization related to an insurance agency acquisition made during the year. The reduction in 2004 was due to lower amortization of intangibles related to insurance agency acquisitions. Loan and lease collection and repossession expenses decreased 122.12% or $6.04 million in 2005 from 2004, compared to a 39.03% or $3.17 million decrease in 2004 from 2003. In 2005 and 2004, valuation adjustments on repossessed assets continued to decrease along with a decrease in legal and collection expenses. Over the last three years, 1st Source took back 72 aircraft in repossession and all of these repossessed aircraft, except for one, had been disposed of as of December 31, 2005. The 2004 decreases were partially offset by valuation adjustments on equipment owned under operating leases. A decrease of 2.05% occurred in other expenses during 2005, compared to a 13.94% decrease in 2004 from 2003. Lower insurance cost was the primary factor for the decline for 2005. Other factors affecting other expenses were increases in forgery and miscellaneous losses, which were mostly offset by lower gains on sales of operating lease equipment in 2005. Additionally, 2004 decreases were offset by the write-off of capitalized debt issuance costs related to the redemption of the 1st Source Capital Trust I trust preferred securities. INCOME TAXES -- 1st Source recognized income tax expense in 2005 of $15.63 million, compared to $9.14 million in 2004, and $8.03 million in 2003. The effective tax rate in 2005 was 31.65% compared to 26.79% in 2004, and 29.54% in 2003. The effective tax rate increased in 2005 due to an increase in pre-tax income and a decrease in the dividend received deduction. For detailed analysis of 1st Source's income taxes see Part II, Item 8, Financial Statements and Supplementary Data -- Note N of the Notes to Consolidated Financial Statements. FINANCIAL CONDITION - ------------------- LOAN AND LEASE PORTFOLIO -- The following table shows 1st Source's loan and lease distribution at the end of each of the last five years as of December 31:
(Dollars in thousands) 2005 2004 2003 2002 2001 - --------------------------------------------------- ---------------- ---------------- ----------------- ------------- Commercial and agricultural loans $ 453,197 $ 425,018 $ 402,905 $ 428,367 $ 460,373 Auto, light truck and environmental 310,786 263,637 269,490 247,883 212,781 equipment Medium and heavy duty truck 302,137 267,834 221,562 197,312 131,233 Aircraft financing 459,645 444,481 489,155 323,802 514,573 Construction equipment financing 224,230 196,516 219,562 303,126 328,004 Loans secured by real estate 601,077 583,437 533,749 567,950 586,580 Consumer loans 112,359 99,245 94,577 111,012 128,305 - --------------------------------------------------- ----------------- ---------------- ----------------- ------------- Total loans and leases $ 2,463,431 $ 2,280,168 $ 2,231,000 $ 2,179,452 $ 2,361,849 ======================================================================================================================
At December 31, 2005, 16.0%, and 10.9% of total loans and leases were concentrated with borrowers in trucking and truck leasing and construction end users, respectively. 16 Average loans and leases, net of unearned discount, increased 4.85% and 7.13% in 2005 and 2004, respectively. Loans and leases, net of unearned discount, at December 31, 2005, were $2.46 billion and were 70.16% of total assets, compared to $2.28 billion and 63.98% of total assets at December 31, 2004. Commercial and agricultural lending, excluding those loans secured by real estate, increased 6.63% in 2005 over 2004. Commercial and agricultural lending outstandings were $453.20 million and $425.02 million at December 31, 2005 and December 31, 2004, respectively. This increase was mainly due to increased sales activity within the commercial loan and small business loan areas coupled with improved market conditions. Loans secured by real estate increased 3.02% during 2005 over 2004. Loans secured by real estate outstanding at December 31, 2005, were $601.08 million and $583.44 million at December 31, 2004. The primary focus of this lending area is commercial real estate ($386.30 million at December 31, 2005, the majority of which is owner occupied) and residential mortgage lending ($214.78 million at December 31, 2005) in the regional market area. This increase was mostly due to business clients' continued investment in real estate for expansion or relocation of their commercial facilities and 1st Source's ability to meet those funding needs. Auto, light truck, and environmental equipment financing increased 17.88% in 2005 over 2004. At December 31, 2005, auto, light truck, and environmental equipment financing had outstandings of $310.79 million and $263.64 million at December 31, 2004. The increase in this portfolio was primarily in the auto rental industry due to reduced competition in this market area, along with 1st Source's ability to provide personalized service to its clients in this business sector. Medium and heavy duty truck loans and leases experienced growth of $34.30 million, or an increase of 12.81%, in 2005. Medium and heavy duty truck financing at December 31, 2005 and 2004, had outstandings of $302.14 million and $267.83 million, respectively. Much of this increase can be attributed to improved overall market conditions, rigorous sales efforts, and the ability of the sales staff to continue to produce in the available market for medium and heavy duty trucks. Aircraft financing at year-end 2005 increased 3.41% from year-end 2004. Aircraft financing at December 31, 2005 and 2004, had outstandings of $459.65 million and $444.48 million, respectively. This increase was mainly due to growth in the corporate aircraft portfolio which was largely offset by intentional reduction of the operator business portfolio. Construction equipment financing increased 14.10% in 2005 over 2004. Construction equipment financing at December 31, 2005, had outstandings of $224.23 million, compared to outstandings of $196.52 million at December 31, 2004. The increase was mainly the result of an improving economy and greater funding availability at both the state and Federal levels for roads, bridges, and general transportation projects upon which 1st Source's client base relies for business. The continued strong housing market and improvements in the commercial building segment also contributed to the higher level of construction equipment loan and lease portfolio activity. Consumer loans increased 13.21% in 2005 over 2004. Consumer loans outstanding at December 31, 2005, were $112.36 million and $99.25 million at December 31, 2004. Successful marketing to new and established clients coupled with competitive rates on consumer loans was the main factor in the increase. The following table shows the maturities of loans and leases in the categories of commercial and agriculture, auto, light truck and environmental equipment, medium and heavy duty truck, aircraft and construction equipment outstanding as of December 31, 2005. The amounts due after one year are also classified according to the sensitivity to changes in interest rates.
(Dollars in thousands) 0 - 1 Year 1 - 5 Years Over 5 Years Total - ------------------------------------------------------- ----------- ---------------- ----------------- ------------- Commercial and agricultural loans $ 265,278 $ 167,257 $ 20,662 $ 453,197 Auto, light truck and environmental equipment 153,679 156,708 399 310,786 Medium and heavy duty truck 92,501 203,526 6,110 302,137 Aircraft financing 139,998 272,403 47,244 459,645 Construction equipment financing 68,658 154,254 1,318 224,230 - ------------------------------------------------------- ----------- ---------------- ----------------- ------------- Total $ 720,114 $ 954,148 $ 75,733 $ 1,749,995 =====================================================================================================================
Rate Sensitivity (Dollars in thousands) Fixed Rate Variable Rate Total - ------------------------------------------------------- ----------- ---------------- ----------------- ------------- 1 - 5 Years $ 650,254 $ 303,894 $ 954,148 Over 5 Years 12,853 62,880 75,733 - ------------------------------------------------------- ----------- ---------------- ----------------- ------------- Total $ 663,107 $ 366,774 $ 1,029,881 =====================================================================================================================
Most of the Bank's residential mortgages are sold into the secondary market and serviced by 1st Source's mortgage subsidiary, Trustcorp Mortgage Company (Trustcorp). Mortgage loans held for sale were $67.22 million at December 31, 2005 and were $55.71 million at December 31, 2004. CREDIT EXPERIENCE - ----------------- RESERVE FOR LOAN AND LEASE LOSSES -- 1st Source's reserve for loan and lease losses is provided for by direct charges to operations. Losses on loans and leases are charged against the reserve and likewise, recoveries during the period for prior losses are credited to the reserve. Management evaluates the adequacy of the reserve quarterly, reviewing all loans and leases over a fixed-dollar amount ($100,000) where the internal credit rating is at or below a predetermined classification, actual and anticipated loss experience, current economic events in specific industries, and other pertinent factors including general economic conditions. Determination of the reserve is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows or fair value of collateral on collateral-dependent impaired loans and leases, estimated losses on pools of homogeneous loans and leases based on historical loss experience, and consideration of economic trends, all of which may be susceptible to significant and unforeseen changes. Management of 1st Source reviews the status of the loan and lease portfolio to identify borrowers that might develop financial problems in order to aid borrowers in the handling of their accounts and to mitigate losses. See Part II, Item 8, Financial Statements and Supplementary Data -- Note A of the Notes to Consolidated Financial Statements for additional information on management's evaluation of the adequacy of the reserve for loan and lease losses. 17 The reserve for loan and lease losses at December 31, 2005 totaled $58.70 million and was 2.38% of loans and leases, compared to $63.67 million or 2.79% of loans and leases at December 31, 2004 and $70.05 million or 3.14% of loans and leases at December 31, 2003. It is management's opinion that the reserve for loan and lease losses was adequate to absorb losses inherent in the loan and lease portfolio as of December 31, 2005. The recovery of provision for loan and lease losses for 2005 was $5.86 million, compared to the provision for loan and lease losses of $0.23 million in 2004 and $17.36 million in 2003. The recovery of the provision was consistent with 1st Source's improved credit quality of the loan and lease portfolio. Net (recoveries)/charge-offs in 2005, 2004, and 2003, to aircraft dealers and operators were ($0.20) million, ($1.27) million and $5.25 million, respectively. The reserve for loan and lease losses increased $6.82 million in 2003 for reserves acquired in acquisitions. The following table summarizes 1st Source's loan and lease loss experience for each of the last five years ended December 31:
(Dollars in thousands) 2005 2004 2003 2002 2001 - --------------------------------------------------------------------------------------------------------------------------- Amounts of loans and leases outstanding at end of period $ 2,463,431 $ 2,280,168 $ 2,231,000 $ 2,179,452 $ 2,361,849 - --------------------------------------------------------------------------------------------------------------------------- Average amount of net loans and leases outstanding during period $ 2,348,690 $ 2,240,055 $ 2,091,004 $ 2,332,992 $ 2,347,746 - --------------------------------------------------------------------------------------------------------------------------- Balance of reserve for loan and lease losses at beginning of period $ 63,672 $ 70,045 $ 59,218 $ 57,624 $ 44,644 - --------------------------------------------------------------------------------------------------------------------------- Charge-offs: Commercial and agricultural loans 1,478 6,104 1,187 2,376 4,916 Auto, light truck and environmental equipment 630 2,408 2,789 6,380 753 Medium and heavy duty truck 15 352 69 771 - Aircraft financing 2,424 3,585 6,877 27,401 5,584 Construction equipment financing - 686 4,712 2,326 762 Loans secured by real estate 167 456 344 340 215 Consumer loans 858 1,090 1,560 2,127 2,102 - --------------------------------------------------------------------------------------------------------------------------- Total charge-offs 5,572 14,681 17,538 41,721 14,332 - --------------------------------------------------------------------------------------------------------------------------- Recoveries: Commercial and agricultural loans 1,308 1,312 519 1,311 328 Auto, light truck and environmental equipment 1,140 1,277 1,182 616 71 Medium and heavy duty truck 174 14 - - - Aircraft financing 2,255 4,460 1,698 759 92 Construction equipment financing 1,065 547 248 465 129 Loans secured by real estate 89 107 11 26 - Consumer loans 421 362 523 481 351 - --------------------------------------------------------------------------------------------------------------------------- Total recoveries 6,452 8,079 4,181 3,658 971 - --------------------------------------------------------------------------------------------------------------------------- Net (recoveries) charge-offs (880) 6,602 13,357 38,063 13,361 (Recoveries) provisions charged to operating expense (5,855) 229 17,361 39,657 25,745 Reserves acquired in acquisitions - - 6,823 - 596 - --------------------------------------------------------------------------------------------------------------------------- Balance at end of period $ 58,697 $ 63,672 $ 70,045 $ 59,218 $ 57,624 =========================================================================================================================== Ratio of net (recoveries) charge-offs to average net loans and leases outstanding (0.04)% 0.29 % 0.64 % 1.63 % 0.57 % ===========================================================================================================================
Net (recoveries) charge-offs as a percentage of average loans and leases by portfolio type follow:
2005 2004 2003 2002 2001 - ---------------------------------------------------------------------------------------------------------------------- Commercial and agricultural loans 0.04 % 1.14% 0.16% 0.23% 0.96% Auto, light truck and environmental equipment (0.17) 0.43 0.62 2.27 0.29 Medium and heavy duty truck (0.06) 0.14 0.03 0.47 - Aircraft financing 0.04 (0.19) 1.73 6.40 1.03 Construction equipment financing (0.51) 0.07 1.67 0.55 0.21 Loans secured by real estate 0.01 0.06 0.06 0.05 0.04 Consumer loans 0.41 0.77 1.04 1.39 1.37 - --------------------------------------------------------------------------------------------------------------------- Total net charge-offs to average portfolio loans and leases (0.04)% 0.29% 0.64% 1.63% 0.57% ======================================================================================================================
18 The reserve for loan and lease losses has been allocated according to the amount deemed necessary to provide for the possibility of losses being incurred within the categories of loans and leases set forth in the table below. The amount of such components of the reserve at December 31 and the ratio of such loan and lease categories to total outstanding loan and lease balances, are as follows (for purposes of this analysis, auto, light truck and environmental equipment and medium and heavy duty truck loans and leases have been consolidated into the category truck and automobile financing):
2005 2004 2003 2002 2001 Percent of Percent of Percent of Percent of Percent of Loans and Loans and Loans and Loans and Loans and Leases Leases Leases Leases Leases in Each in Each in Each in Each in Each Category Category Category Category Category to Total to Total to Total to Total to Total Reserve Loans and Reserve Loans and Reserve Loans and Reserve Loans and Reserve Loans and (Dollars in thousands) Amount Leases Amount Leases Amount Leases Amount Leases Amount Leases - ---------------------- -------------- --------- ---------- ---------- --------- ---------- --------- ---------- ---------- --------- Commercial and agricultural loans $ 15,472 18.40% $ 13,612 18.64% $ 9,589 18.06% $ 11,163 19.65% $ 14,247 19.49% Truck and automobile 13,008 24.88 12,633 23.31 13,966 22.01 11,006 20.43 9,924 14.57 financing Aircraft financing 19,583 18.66 26,475 19.49 31,733 21.93 21,603 14.86 19,987 21.79 Construction equipment 4,235 9.10 4,502 8.62 9,061 9.84 9,394 13.91 6,463 13.89 financing Loans secured by real estate 4,058 24.40 4,187 25.59 3,798 23.92 3,656 26.06 4,268 24.84 Consumer loans 2,341 4.56 2,263 4.35 1,898 4.24 2,396 5.09 2,735 5.42 - ---------------------------- --------- ---------- --------- ---------- --------- ---------- --------- ---------- --------- --------- Total $ 58,697 100.00% $ 63,672 100.00% $ 70,045 100.00% $ 59,218 100.00% $ 57,624 100.00% ====================================================================================================================================
NONPERFORMING ASSETS -- 1st Source's policy is to discontinue the accrual of interest on loans and leases where principal or interest is past due and remains unpaid for 90 days or more, except for mortgage loans, which are placed on nonaccrual at the time the loan is placed in foreclosure and consumer loans that are both well secured and in the process of collection. Nonperforming assets amounted to $22.04 million at December 31, 2005, compared to $33.21 million at December 31, 2004, and $36.83 million at December 31, 2003. Impaired loans and leases totaled $18.53 million, $47.22 million, and $60.04 million at December 31, 2005, 2004, and 2003, respectively. During 2005, interest income that would have been recorded on nonaccrual loans and leases under their original terms was $2.19 million, compared to $3.21 million in 2004. Interest income that was recorded on nonaccrual loans and leases was $0.81 million and $0.94 million in 2005 and 2004, respectively. Overall decreases in nonperforming assets for 2005 were realized across the entire loan and lease portfolio with the exception of loans secured by real estate which experienced a marginal increase.
Nonperforming assets at December 31 (Dollars in thousands) 2005 2004 2003 2002 2001 - ------------------------------------------------------------------------------------------------------------------------ Loans past due over 90 days $ 245 $ 481 $ 212 $ 154 $ 453 Nonaccrual loans and leases and restructured loans: Commercial and agricultural loans 3,701 6,928 2,795 4,819 6,580 Auto, light truck and environmental equipment 812 2,336 2,419 4,730 3,746 Medium and heavy duty truck 17 179 1,823 1,384 - Aircraft financing 7,641 10,132 12,900 12,281 16,365 Construction equipment financing 2,513 4,097 4,663 9,844 5,126 Loans secured by real estate 1,475 1,141 1,786 2,191 3,349 Consumer loans 393 440 699 415 659 - ------------------------------------------------------------------------------------------------------------------------ Total nonaccrual loans and leases and restructured loans 16,552 25,253 27,085 35,664 35,825 - ------------------------------------------------------------------------------------------------------------------------ Total nonperforming loans and leases 16,797 25,734 27,297 35,818 36,278 - ------------------------------------------------------------------------------------------------------------------------ Other real estate 960 1,307 3,010 4,362 3,137 Repossessions: Commercial and agricultural loans - - 34 - - Auto, light truck and environmental equipment 128 1,112 847 1,364 2,590 Medium and heavy duty truck - - - - - Aircraft financing 4,073 3,037 4,551 19,242 770 Construction equipment financing - 183 753 681 53 Consumer loans 83 50 78 56 96 - ------------------------------------------------------------------------------------------------------------------------ Total repossessions 4,284 4,382 6,263 21,343 3,509 - ------------------------------------------------------------------------------------------------------------------------ Operating leases - 1,785 257 2,594 369 - ------------------------------------------------------------------------------------------------------------------------ Total nonperforming assets $ 22,041 $ 33,208 $ 36,827 $ 64,117 $ 43,293 ======================================================================================================================== Nonperforming loans and leases to loans and leases, net of unearned discount 0.68% 1.13% 1.22% 1.64% 1.54% ======================================================================================================================== Nonperforming assets to loans and leases and operating leases, net of unearned discount 0.87% 1.42% 1.59% 2.79% 1.74% ========================================================================================================================
19 POTENTIAL PROBLEM LOANS AND LEASES -- At December 31, 2005, the Bank had a $3.32 million standby letter of credit outstanding which supported bond indebtedness of a customer. If this standby letter of credit is funded, due to the current financial condition of the customer, the Bank likely will foreclose on the real estate securing the customer's reimbursement obligation. This likely will result in an increase in other real estate for approximately the same amount as the funding. At December 31, 2005, management was not aware of any potential problem loans or leases that would have a material effect on loan and lease delinquency or loan and lease charge-offs. Loans and leases are subject to continual review and are given management's attention whenever a problem situation appears to be developing. INVESTMENT PORTFOLIO - -------------------- Securities at year-end 2005 decreased 19.30% from 2004, following a 4.01% increase from year-end 2003 to year-end 2004. Securities at December 31, 2005 were $637.88 million or 18.17% of total assets, compared to $790.40 million or 22.18% of total assets at December 31, 2004. The amortized cost of securities available-for-sale as of December 31 are summarized as follows:
(Dollars in thousands) 2005 2004 2003 - ---------------------------------------------------------------------------------------------------------------------------------- U.S. Treasury and government agencies, including agency mortgage-backed securities $ 415,793 $ 552,949 $ 504,748 States and political subdivisions 179,797 171,338 168,383 Other securities 42,288 66,117 86,814 - ---------------------------------------------------------------------------------------------------------------------------------- Total securities available-for-sale $ 637,878 $ 790,404 $ 759,945 ==================================================================================================================================
Yields on tax-exempt obligations are calculated on a fully tax equivalent basis assuming a 35% tax rate. The following table shows the maturities of securities available-for-sale at December 31, 2005, at the amortized costs and the weighted average yields of such securities:
(Dollars in thousands) Amount Yield - ---------------------------------------------------------------------------------------------------------------------------------- U.S. Treasury and government agencies, including agency mortgage-backed securities Under 1 year $ 217,350 3.14% 1 - 5 years 141,025 2.82 5 - 10 years 533 6.94 Over 10 years 56,885 4.67 - ---------------------------------------------------------------------------------------------------------------------------------- Total U.S. Treasury and government agencies, including agency mortgage-backed securities 415,793 3.25 - ---------------------------------------------------------------------------------------------------------------------------------- States and political subdivisions Under 1 year 34,345 4.03 1 - 5 years 115,691 4.05 5 - 10 years 26,261 5.03 Over 10 years 3,500 4.03 - ---------------------------------------------------------------------------------------------------------------------------------- Total states and political subdivisions 179,797 4.19 - ---------------------------------------------------------------------------------------------------------------------------------- Other securities Under 1 year 75 6.20 1 - 5 years 4,000 2.99 5 - 10 years 75 6.55 Over 10 years - - Marketable equity securities 38,138 4.56 - ---------------------------------------------------------------------------------------------------------------------------------- Total other securities 42,288 4.42 - ---------------------------------------------------------------------------------------------------------------------------------- Total securities available-for-sale $ 637,878 3.59% ==================================================================================================================================
20 DEPOSITS - -------- The average daily amounts of deposits and rates paid on such deposits are summarized as follows:
2005 2004 2003 (Dollars in thousands) Amount Rate Amount Rate Amount Rate - --------------------------------------------------------------------------------------------------------- Noninterest bearing demand deposits $ 392,475 -% $ 384,157 -% $ 413,794 -% Interest bearing demand deposits 784,366 1.78 707,168 0.88 645,131 0.79 Savings deposits 210,151 0.30 228,836 0.29 233,737 0.53 Other time deposits 1,223,406 3.41 1,169,009 2.98 1,266,599 3.38 - --------------------------------------------------------------------------------------------------------- Total $ 2,610,398 $ 2,489,170 $ 2,559,261 =========================================================================================================
The amount of certificates of deposit of $100,000 or more and other time deposits of $100,000 or more outstanding at December 31, 2005, by time remaining until maturity is as follows: (Dollars in thousands) - ----------------------------------------- Under 3 months $ 133,527 4 - 6 months 49,706 7 - 12 months 58,197 Over 12 months 149,497 - ----------------------------------------- Total $ 390,927 ========================================= SHORT-TERM BORROWINGS - --------------------- The following table shows the distribution of 1st Source's short-term borrowings and the weighted average interest rates thereon at the end of each of the last three years. Also provided are the maximum amount of borrowings and the average amount of borrowings, as well as weighted average interest rates for the last three years.
Federal Funds Purchased and Security Other Repurchase Commercial Short-Term Total (Dollars in thousands) Agreements Paper Borrowings Borrowings - ------------------------------------------------------------------ ------------- ------------- --------------- ------------ 2005 Balance at December 31, 2005 $ 230,756 $ 4,600 $ 42,113 $ 277,469 Maximum amount outstanding at any month-end 273,428 5,552 122,038 401,018 Average amount outstanding 214,199 2,054 79,018 295,271 Weighted average interest rate during the year 2.55% 3.36% 3.91% 2.92% Weighted average interest rate for outstanding amounts at December 31, 2005 3.86% 3.88% 2.76% 3.70% - ------------------------------------------------------------------ ------------- ------------- --------------- ------------ 2004 Balance at December 31, 2004 $ 216,751 $ 836 $ 82,075 $ 299,662 Maximum amount outstanding at any month-end 411,812 1,152 113,958 526,922 Average amount outstanding 295,172 815 109,205 405,192 Weighted average interest rate during the year 1.15% 1.23% 2.46% 1.50% Weighted average interest rate for outstanding amounts at December 31, 2004 2.09% 1.72% 2.09% 2.09% - ------------------------------------------------------------------ ------------- ------------- --------------- ------------ 2003 Balance at December 31, 2003 $ 276,040 $ 982 $ 113,832 $ 390,854 Maximum amount outstanding at any month-end 276,040 4,492 113,832 394,364 Average amount outstanding 209,098 2,442 45,088 256,628 Weighted average interest rate during the year 0.85% 1.06% 7.36% 2.00% Weighted average interest rate for outstanding amounts at December 31, 2003 0.85% 0.86% 1.42% 1.02% ===========================================================================================================================
21 LIQUIDITY - --------- CORE DEPOSITS -- 1st Source's major source of investable funds is provided by stable core deposits consisting of all interest bearing and noninterest bearing deposits, excluding brokered certificates of deposit and certain certificates of deposit of $100,000 and over. In 2005, average core deposits equaled 67.60% of average total assets, compared to 66.97% in 2004 and 70.83% in 2003. The effective cost rate of core deposits in 2005 was 1.96%, compared to 1.59% in 2004 and 1.81% in 2003. Average demand deposits (noninterest bearing core deposits) increased 2.17% in 2005 compared to a decrease of 7.16% in 2004. These represented 17.21% of total core deposits in 2005, compared to 17.13% in 2004, and 17.93% in 2003. PURCHASED FUNDS -- 1st Source's purchased funds are used to supplement core deposits and include certain certificates of deposit of $100,000 and over, brokered certificates of deposit, Federal funds, securities sold under agreements to repurchase, commercial paper, and other short-term borrowings. Purchased funds are raised from customers seeking short-term investments and are used to manage the Bank's interest rate sensitivity. During 2005, 1st Source's reliance on purchased funds decreased to 18.55% of average total assets from 19.45% in 2004. SHAREHOLDERS' EQUITY -- Average shareholders' equity equated to 9.89% of average total assets in 2005 compared to 9.55% in 2004. Shareholders' equity was 9.84% of total assets at year-end 2005, compared to 9.16% at year-end 2004. In accordance with Statements of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," 1st Source includes unrealized gain (loss) on available-for-sale securities, net of income taxes, as accumulated other comprehensive income (loss) which is a component of shareholders' equity. While regulatory capital adequacy ratios exclude unrealized gain (loss), it does impact 1st Source's equity as reported in the audited financial statements. The unrealized loss on available-for-sale securities, net of income taxes, was $3.24 million and $0.30 million at December 31, 2005 and 2004, respectively. LIQUIDITY RISK MANAGEMENT -- The Bank's liquidity is monitored and closely managed by the Asset/Liability Management Committee (ALCO), whose members are comprised of the Bank's senior management. Asset and liability management includes the management of interest rate sensitivity and the maintenance of an adequate liquidity position. The purpose of interest rate sensitivity management is to stabilize net interest income during periods of changing interest rates. Liquidity management is the process by which the Bank ensures that adequate liquid funds are available to meet financial commitments on a timely basis. Financial institutions must maintain liquidity to meet day-to-day requirements of depositors and borrowers, take advantage of market opportunities and provide a cushion against unforeseen needs. Liquidity of the Bank is derived primarily from core deposits, principal payments received on loans, the sale and maturity of investment securities, net cash provided by operating activities, and access to other funding sources. The most stable source of liability funded liquidity is deposit growth and retention of the core deposit base. The principal source of asset-funded liquidity is available-for-sale investment securities, cash and due from banks, Federal funds sold, securities purchased under agreements to resell, and loans and interest bearing deposits with other banks maturing within one year. Additionally, liquidity is provided by bank lines of credit, repurchase agreements, and the ability to borrow from the Federal Reserve Bank and Federal Home Loan Bank. INTEREST RATE RISK MANAGEMENT -- 1st Source's ALCO monitors and manages the relationship of earning assets to interest bearing liabilities and the responsiveness of asset yields, interest expense, and interest margins to changes in market interest rates. In the normal course of business, 1st Source faces ongoing interest rate risks and uncertainties. 1st Source occasionally utilizes interest rate swaps to partially manage the primary market exposures associated with the interest rate risk related to underlying assets, liabilities, and anticipated transactions. A hypothetical change in earnings was modeled by calculating an immediate 100 basis point (1.00%) change in interest rates across all maturities. This analysis presents the hypothetical change in earnings of those rate sensitive financial instruments and interest rate swaps held by 1st Source at December 31, 2005. The aggregate hypothetical increase in pre-tax earnings was estimated to be $2.00 million on an annualized basis on all rate-sensitive financial instruments, based on a hypothetical increase of a 100 basis point change in interest rates. The aggregate hypothetical decrease in pre-tax earnings was estimated to be $3.10 million on an annualized basis on all rate-sensitive financial instruments based on a hypothetical decrease of a 100 basis point change in interest rates. The earnings simulation model excludes the earnings dynamics related to how fee income and noninterest expense may be affected by changes in interest rates. Actual results may differ materially from those projected. The use of this methodology to quantify the market risk of the balance sheet should not be construed as an endorsement of its accuracy or the accuracy of the related assumptions. At December 31, 2005, the impact of these hypothetical fluctuations in interest rates on 1st Source's derivative holdings was not significant, and, as such, separate disclosure is not presented. Due to the nature of the mortgage banking business, 1st Source manages the earning assets and interest-bearing liabilities of Trustcorp on a separate basis. The predominant assets on Trustcorp's balance sheet are mortgage loans held for sale, which are funded by short-term borrowings (normally less than 30 days). These borrowings are managed on a daily basis. A portion of Trustcorp's other borrowings for working capital is funded by 1st Source. Trustcorp manages the interest rate risk related to loan commitments by entering into contracts for future delivery of loans. See Part II, Item 8, Financial Statements and Supplementary Data -- Note O of the Notes to Consolidated Financial Statements. OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS - ---------------------------------------------------------- In the ordinary course of operations, 1st Source enters into certain contractual obligations. Such obligations include the funding of operations through debt issuances as well as leases for premises and equipment. The following table summarizes 1st Source's significant fixed, determinable, and estimated contractual obligations, by payment date, at December 31, 2005, except for obligations associated with short-term borrowing arrangements. Payments for borrowings do not include interest. Further discussion of the nature of each obligation is included in the referenced note to the consolidated financial statements. 22 Contractual obligations payments by period.
Indeterminate (Dollars in thousands) Note 0 - 1 Year 1 - 3 Years 3 - 5 Years Over 5 Years maturity Total - ------------------------ -------------- -------------- --------------- --------------- --------------- ---------------- ------------ Deposits without stated maturity - $ 1,515,676 $ - $ - $ - $ - $1,515,676 Certificates of deposit - 631,668 516,483 67,186 14,574 - 1,229,911 Long-term debt and mandatorily redeemable securities J 265 15,538 226 110 7,098 23,237 Subordinated notes L - - - 59,022 - 59,022 Operating leases O 2,868 4,141 2,912 2,093 - 12,014 Purchase obligations - 25,532 3,898 1,534 50 - 31,014 - ------------------------------ -------- -------------- ---- ---------- ----- --------- ----- --------- ----- ---------- ------------ Total contractual obligations $ 2,176,009 $ 540,060 $ 71,858 $ 75,849 $ 7,098 $2,870,874 ====================================================================================================================================
1st Source routinely enters into contracts for services. These contracts may require payment for services to be provided in the future and may also contain penalty clauses for early termination of the contract. 1st Source made a diligent effort to account for such payments and penalties, where applicable. Additionally, where necessary, 1st Source has made reasonable estimates as to certain purchase obligations as of December 31, 2005. Management has used the best information available to make the estimations necessary to value the related purchase obligations. Management is not aware of any additional commitments or contingent liabilities which may have a material adverse impact on the liquidity or capital resources of 1st Source. 1st Source also enters into derivative contracts under which 1st Source is required to either receive cash from, or pay cash to, counterparties depending on changes in interest rates. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. The fair value of the contracts change daily as market interest rates change. Because the derivative liabilities recorded on the balance sheet at December 31, 2005 do not represent the amounts that may ultimately be paid under these contracts, these liabilities are not included in the table of contractual obligations presented above. Assets under management and assets under custody are held in fiduciary or custodial capacity for 1st Source's clients. These assets are not included in 1st Source's balance sheet, in accordance with U. S. generally accepted accounting principles. 1st Source is also party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit. Further discussion of these commitments is included in Part II, Item 8, Financial Statements and Supplementary Data -- Note O of the Notes to Consolidated Financial Statements. QUARTERLY RESULTS OF OPERATIONS - -------------------------------
Three Months Ended (Dollars in thousands, except per share amounts) March 31 June 30 September 30 December 31 - -------------------------------------------------------------- ---------------------- ---------- --------------- ------ 2005 Interest income $ 38,796 $ 40,843 $ 43,657 $ 45,236 Interest expense 15,192 16,641 18,358 19,913 Net interest income 23,604 24,202 25,299 25,323 (Recovery of) provision for loan and lease losses (421) (3,411) (1,304) (719) Investment securities and other investment gains (losses) 904 5 (559) - Income before income taxes 10,046 12,385 14,186 12,760 Net income 6,944 8,227 9,481 9,099 Diluted net income per common share 0.33 0.39 0.45 0.43 - -------------------------------------------------------------- ---------------------- ---------- --------------- ------ 2004 Interest income $ 38,125 $ 37,314 $ 37,220 $ 38,778 Interest expense 12,363 11,980 12,997 15,409 Net interest income 25,762 25,334 24,223 23,369 Provision for loan and lease losses 101 482 237 (591) Investment securities and other investment losses (252) (38) (3,744) (685) Income before income taxes 7,338 13,128 2,018 11,617 Net income 5,079 8,718 3,308 7,860 Diluted net income per common share 0.24 0.42 0.16 0.37 =======================================================================================================================
23 Net income was $9.10 million for the fourth quarter of 2005 compared to the $7.86 million of net income reported for the fourth quarter of 2004. Diluted net income per common share for the fourth quarter of 2005 amounted to $0.43, compared to $0.37 per common share reported in the fourth quarter of 2004. 1st Source's recovery of provision for loan and lease losses was $0.72 million in the fourth quarter of 2005 compared to a recovery of provision for loan and lease losses of $0.59 million in the fourth quarter of 2004. 1st Source's reserve for loan and lease losses as of December 31, 2005, was 2.38% of total loans and leases, compared to 2.79% as of December 31, 2004. Net recoveries were $0.87 million for the fourth quarter 2005, compared to net charge-offs of $3.93 million one year ago. The ratio of nonperforming assets to net loans and leases was 0.87% on December 31, 2005, compared to 1.42% on December 31, 2004. Noninterest income for the fourth quarter of 2005 was $17.57 million, down 2.84% from the fourth quarter of 2004. Lower recoveries of mortgage servicing rights impairment in the fourth quarter of 2005, as compared to the same quarter of 2004, was the predominate factor behind the decrease. Other income and deposit fee income increased marginally during the fourth quarter of 2005. Noninterest expense for the fourth quarter of 2005 was relatively flat at $30.86 million as compared to the $30.43 million reported for fourth quarter of 2004. Reductions in collection and repossession expense, a decline in professional fees, and lower depreciation expense on leased equipment were the significant factors behind the decrease. These decreases were partially offset by increases in salaries and employee benefits. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. For information regarding Quantitative and Qualitative Disclosures about Market Risk, see Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, Interest Rate Risk Management. 24 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. REPORTS OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - --------------------------------------------------------------------------- Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of 1st Source Corporation: We have audited management's assessment, included in the accompanying Report of Management, that 1st Source Corporation maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). 1st Source Corporation's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that 1st Source Corporation maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, 1st Source Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial condition of 1st Source Corporation as of December 31, 2005 and 2004, and the related consolidated statements of income, shareholders' equity and cash flow for each of the three years in the period ended December 31, 2005 and our report dated March 2, 2006 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP Chicago, Illinois March 2, 2006 25 Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of 1st Source Corporation: We have audited the accompanying consolidated statements of financial condition of 1st Source Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, shareholders' equity and cash flow for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of 1st Source Corporation and subsidiaries at December 31, 2005 and 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of 1st Source Corporation's internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 2, 2006 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP Chicago, Illinois March 2, 2006 26
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION - ----------------------------------------------- December 31 (Dollars in thousands) 2005 2004 - ------------------------------------------------------------------------------------------------------------------------------------ ASSETS - ------ Cash and due from banks $ 124,817 $ 78,255 Federal funds sold and interest bearing deposits with other banks 68,578 220,131 Investment securities, available-for-sale (amortized cost of $637,878 and $790,404 at December 31, 2005 and 2004, respectively) 632,625 789,923 Mortgages held for sale 67,224 55,711 Loans and leases, net of unearned discount: Commercial and agricultural loans 453,197 425,018 Auto, light truck and environmental equipment 310,786 263,637 Medium and heavy duty truck 302,137 267,834 Aircraft financing 459,645 444,481 Construction equipment financing 224,230 196,516 Loans secured by real estate 601,077 583,437 Consumer loans 112,359 99,245 - ------------------------------------------------------------------------------------------------ --------------------- ------------- Total loans and leases 2,463,431 2,280,168 Reserve for loan and lease losses (58,697) (63,672) - ------------------------------------------------------------------------------------------------ --------------------- ------------- Net loans and leases 2,404,734 2,216,496 Equipment owned under operating leases, net 58,250 47,257 Net premises and equipment 37,710 37,314 Accrued income and other assets 117,339 118,628 - ------------------------------------------------------------------------------------------------ --------------------- ------------- Total assets $ 3,511,277 $ 3,563,715 ==================================================================================================================================== LIABILITIES - ----------- Deposits: Noninterest bearing $ 393,494 $ 378,867 Interest bearing 2,352,093 2,428,136 - ------------------------------------------------------------------------------------------------ --------------------- ------------- Total deposits 2,745,587 2,807,003 - ------------------------------------------------------------------------------------------------ --------------------- ------------- Short-term borrowings: Federal funds purchased and securities sold under agreements to repurchase 230,756 216,751 Other short-term borrowings 46,713 82,911 - ------------------------------------------------------------------------------------------------ --------------------- ------------- Total short-term borrowings 277,469 299,662 - ------------------------------------------------------------------------------------------------ --------------------- ------------- Long-term debt and mandatorily redeemable securities 23,237 17,964 Subordinated notes 59,022 59,022 Accrued expenses and other liabilities 60,386 53,464 - ------------------------------------------------------------------------------------------------ --------------------- ------------- Total liabilities 3,165,701 3,237,115 ==================================================================================================================================== SHAREHOLDERS' EQUITY Preferred stock; no par value Authorized 10,000,000 shares; none issued or outstanding - - Common stock; no par value Authorized 40,000,000 shares; issued 21,617,073 shares in 2005 and 21,617,057 shares in 2004, less unearned shares (236,589 -- 2005 and 236,573 -- 2004) 7,578 7,578 Capital surplus 214,001 214,001 Retained earnings 139,601 115,830 Cost of common stock in treasury (711,299 shares -- 2005 and 651,257 shares -- 2004) (12,364) (10,512) Accumulated other comprehensive loss (3,240) (297) ==================================================================================================================================== Total shareholders' equity 345,576 326,600 ==================================================================================================================================== Total liabilities and shareholders' equity $ 3,511,277 $ 3,563,715 ====================================================================================================================================
The accompanying notes are a part of the consolidated financial statements. 27
CONSOLIDATED STATEMENTS OF INCOME - --------------------------------- Year Ended December 31 (Dollars in thousands, except per share data) 2005 2004 2003 - --------------------------------------------------------------------- -------------------------------- ----------------- ----------- Interest income: Loans and leases $ 147,814 $ 129,059 $ 137,382 Investment securities, taxable 14,777 16,361 18,410 Investment securities, tax-exempt 5,275 5,065 5,614 Other 666 952 916 - --------------------------------------------------------------------- -------------------------------- ----------------- ----------- Total interest income 168,532 151,437 162,322 - --------------------------------------------------------------------- -------------------------------- ----------------- ----------- Interest expense: Deposits 56,341 41,698 49,153 Short-term borrowings 8,628 6,079 5,121 Subordinated notes 4,008 3,863 3,804 Long-term debt and mandatorily redeemable securities 1,127 1,109 992 - --------------------------------------------------------------------- -------------------------------- ----------------- ----------- Total interest expense 70,104 52,749 59,070 - --------------------------------------------------------------------- -------------------------------- ----------------- ----------- Net interest income 98,428 98,688 103,252 (Recovery of) provision for loan and lease losses (5,855) 229 17,361 - ------------------------------------------------------------------------------- ------------------------ ---------------- ---------- Net interest income after (recovery of) provision for loan and lease losses 104,283 98,459 85,891 - ------------------------------------------------------------------------------- ------------------------ ---------------- ---------- Noninterest income: Trust fees 12,877 12,361 10,664 Service charges on deposit accounts 17,775 16,228 15,532 Mortgage banking income 10,868 9,553 19,635 Insurance commissions 4,133 3,695 3,047 Equipment rental income 16,067 18,856 25,448 Other income 6,463 6,759 9,806 Investment securities and other investment gains (losses) 350 (4,719) (3,936) - ------------------------------------------------------------------------------- ------------------------ ---------------- ---------- Total noninterest income 68,533 62,733 80,196 - -------------------------------------------------------------------- ---------------------------------- ---------------- ----------- Noninterest expense: Salaries and employee benefits 69,767 63,083 69,457 Net occupancy expense 7,749 7,196 6,881 Furniture and equipment expense 11,418 10,290 10,363 Depreciation -- leased equipment 12,895 15,315 19,773 Professional fees 3,362 6,563 2,925 Supplies and communications 5,462 5,708 6,163 Business development and marketing expense 3,630 3,613 3,481 Loan and lease collection and repossession expense (1,094) 4,946 8,112 Other expense 10,250 10,377 11,749 - -------------------------------------------------------------------- ---------------------------------- ---------------- ----------- Total noninterest expense 123,439 127,091 138,904 - -------------------------------------------------------------------- ---------------------------------- ---------------- ----------- Income before income taxes 49,377 34,101 27,183 Income taxes 15,626 9,136 8,029 - -------------------------------------------------------------------- ---------------------------------- ---------------- ----------- Net income $ 33,751 $ 24,965 $ 19,154 - -------------------------------------------------------------------- ---------------------------------- ---------------- ----------- Basic net income per common share $ 1.63 $ 1.21 $ 0.92 - -------------------------------------------------------------------- ---------------------------------- ---------------- ----------- Diluted net income per common share $ 1.61 $ 1.19 $ 0.91 ====================================================================================================================================
The accompanying notes are a part of the consolidated financial statements. 28
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY - ----------------------------------------------- Accumulated Cost of Other Common Comprehensive Common Capital Retained Stock Income (Loss), (Dollars in thousands, except per share data) Total Stock Surplus Earnings in Treasury Net - ---------------------------------------- ---------------- -------------- ------------- -------------- ------------- ---------------- Balance at January 1, 2003 $ 309,429 $ 7,579 $ 214,001 $ 90,897 $ (7,637) $ 4,589 - ------------------------------------------- --------------- ------------- -------------- ---- ---------- --- --------- ---------- Comprehensive income, net of tax: Net income 19,154 - - 19,154 - - Change in unrealized gains of available-for-sale securities, net of tax (2,234) - - - - (2,234) --------- Total comprehensive income 16,920 - - - - - Reclass of 399,241 mandatorily redeemable shares to liabilities (5,897) - - (955) (4,942) - Issuance of 205,973 common shares under stock based compensation plans, including related tax effects 2,598 (1) - (849) 3,448 - Cost of 39,459 shares of common stock acquired for treasury (646) - - - (646) - Cash dividends ($.370 per share) (7,713) - - (7,713) - - - ------------------------------------------- --------------- ------------- -------------- ---- ---------- --- --------- ---------- Balance at December 31, 2003 $ 314,691 $ 7,578 $ 214,001 $ 100,534 $ (9,777) $ 2,355 Comprehensive income, net of tax: Net income 24,965 - - 24,965 - - Change in unrealized gains of available-for-sale securities, net of tax (2,652) - - - - (2,652) --------- Total comprehensive income 22,313 - - - - - Issuance of 227,231 common shares under stock based compensation plans, including related tax effects 3,253 - - (970) 4,223 - Cost of 214,295 shares of common stock acquired for treasury (4,958) - - - (4,958) - Cash dividends ($.420 per share) (8,699) (8,699) - - - ----------------------------------------------- ---------------- ------------- ----------------- ---------------- --- ----------- Balance at December 31, 2004 $ 326,600 $ 7,578 $ 214,001 $ 115,830 $ (10,512) $ (297) Comprehensive income, net of tax: Net income 33,751 - - 33,751 - - Change in unrealized gains of available-for-sale securities, net of tax (2,943) - - - - (2,943) --------- Total comprehensive income 30,808 - - - - - Issuance of 51,433 common shares under stock based compensation plans, including related tax effects 528 - - 159 369 - Cost of 111,475 shares of common stock acquired for treasury (2,221) - - - (2,221) - Cash dividends ($.490 per share) (10,139) - - (10,139) - - - -------------------------------------------- -------------- ------------ --------------- --------------- ------------- ---------- Balance at December 31, 2005 $ 345,576 $ 7,578 $ 214,001 $ 139,601 $ (12,364) $(3,240) ====================================================================================================================================
The accompanying notes are a part of the consolidated financial statements. 29
CONSOLIDATED STATEMENTS OF CASH FLOW - ------------------------------------ Year Ended December 31 (Dollars in thousands) 2005 2004 2003 - ------------------------------------------------------------------------------ ---------- ----------- ---- --------------------- Operating activities: Net income $ 33,751 $ 24,965 $ 19,154 Adjustments to reconcile net income to net cash provided by operating activities: (Recovery of) provision for loan losses (5,855) 229 17,361 Depreciation of premises and equipment 5,002 4,813 5,090 Depreciation of equipment owned and leased to others 12,895 15,315 19,773 Amortization of investment security premiums and accretion of discounts, net 4,471 6,553 5,871 Amortization of mortgage servicing rights 6,782 7,384 8,007 Mortgage servicing asset impairment (recoveries) charges (2,271) (275) 581 Deferred income taxes (2,908) 5,346 (2,171) Realized investment securities (gains) losses (350) 4,719 3,936 Change in mortgages held for sale (11,513) 4,504 86,425 Change in trading account securities - - 13,347 Change in interest receivable (1,876) 1,036 1,245 Change in interest payable 3,265 490 (3,810) Change in other assets (1,347) (1,431) 6,727 Change in other liabilities 8,391 (8,871) 12,642 Other 827 233 1,839 - ------------------------------------------------------------------------------ ---------- ----------- ---- --------------------- Net cash from operating activities 49,264 65,010 196,017 - ------------------------------------------------------------------------------ ---------- ----------- ---- --------------------- Investing activities: Proceeds from sales and maturities of investment securities 344,466 233,245 351,747 Purchases of investment securities (196,061) (274,976) (481,565) Net change in short-term investments 151,552 (218,776) 80,526 Loans sold or participated to others 286 (557) 52,158 Net change in loans and leases (182,668) (35,908) (110,241) Net change in equipment owned under operating leases (23,887) 7,732 3,815 Purchases of premises and equipment (5,858) (3,736) (2,072) - ---------------------------------------------------------------------- ------------------------------ ------------- ------------ Net cash from (used in) investing activities 87,830 (292,976) (105,632) - ---------------------------------------------------------------------- ------------------------------ ------------- ------------ Financing activities: Net change in demand deposits, NOW accounts and savings accounts (132,699) 309,534 (39,210) Net change in certificates of deposits 71,284 10,254 (186,480) Net change in short-term borrowings (22,193) (110,497) 130,175 Proceeds from issuance of long-term debt 5,368 1,357 2,344 Proceeds from issuance of subordinated notes - 30,929 - Payments on subordinated notes - (28,351) - Payments on long-term debt (274) (6,224) (2,484) Net proceeds from issuance of treasury stock 528 3,253 2,598 Acquisition of treasury stock (2,221) (4,958) (646) Cash dividends (10,325) (8,863) (7,789) - -------------------------------------------------------------------------- -------------------------- ------------- ------------ Net cash (used in) from financing activities (90,532) 196,434 (101,492) - -------------------------------------------------------------------------- -------------------------- ------------- ------------ Net change in cash and cash equivalents 46,562 (31,532) (11,107) - -------------------------------------------------------------------------- -------------------------- ------------- ------------ Cash and cash equivalents, beginning of year 78,255 109,787 120,894 - --------------------------------------------------------------- ------------------------------------- ------------- ------------ Cash and cash equivalents, end of year $ 124,817 $ 78,255 $ 109,787 - --------------------------------------------------------------- ------------------------------------- ------------- ------------ Supplemental Information: Cash paid for: Interest $ 66,839 $ 52,259 $ 62,880 Income taxes 12,002 6,216 2,655 ================================================================================================================================
The accompanying notes are a part of the consolidated financial statements. 30 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------ Note A -- Accounting Policies The principal line of business of 1st Source and subsidiaries is banking and closely related activities. The following is a summary of significant accounting policies followed in the preparation of the consolidated financial statements. PRINCIPLES OF CONSOLIDATION -- The financial statements consolidate 1st Source and its subsidiaries (principally the Bank and Trustcorp). All significant intercompany balances and transactions have been eliminated. For purposes of the parent company only financial information presented in Note S, investments in subsidiaries are carried at 1st Source's equity in the underlying net assets. USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS -- Financial statements prepared in accordance with U. S. generally accepted accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates. CASH FLOW -- For purposes of the consolidated and parent company only statements of cash flows, 1st Source considers cash and due from banks as cash and cash equivalents. SECURITIES -- Securities that 1st Source has the ability and positive intent to hold to maturity are classified as investment securities held-to-maturity. Held-to-maturity investment securities, when present, are carried at amortized cost. 1st Source currently holds no securities classified as held-to-maturity. Securities that may be sold in response to, or in anticipation of, changes in interest rates and resulting prepayment risk, or for other factors, are classified as available-for-sale and are carried at fair value. Unrealized gains and losses on these securities are reported net of applicable taxes, as a separate component of accumulated other comprehensive income (loss) in shareholders' equity. The fair value is determined based on quoted market prices. If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments. Available-for-sale and held-to-maturity securities are reviewed quarterly for possible other-than-temporary impairment. The review includes an analysis of the facts and circumstances of each individual investment such as length of time the fair value has been below cost, the expectation for that security's performance, the credit worthiness of the issuer, and 1st Source's intent and ability to hold the security for a time necessary to recover the amortized cost. A decline in value that is determined to be other-than-temporary is recorded as a loss in the Consolidated Statements of Income. Debt and equity securities that are purchased and held principally for the purpose of selling them in the near term are classified as trading account securities and are carried at fair value with unrealized gains and losses reported in earnings. Realized gains and losses on the sales of all securities are reported in earnings and computed using the specific identification cost basis. LOANS AND LEASES -- Loans are stated at the principal amount outstanding, net of unamortized deferred loan origination fees and costs and net of unearned income. Interest income is accrued as earned based on unpaid principal balances. Origination fees and direct loan and lease origination costs are deferred and the net amount amortized to interest income over the estimated life of the related loan or lease. Loan commitment fees are deferred and amortized into other income over the commitment period. At December 31, 2005 and 2004, net deferred loan and lease costs were $5.66 million and $4.61 million, respectively. Direct financing leases are carried at the aggregate of lease payments plus estimated residual value of the leased property, less unearned income. Interest income of direct financing leases is recognized over the term of the lease to achieve a constant periodic rate of return on the outstanding investment. The accrual of interest on loans and leases is discontinued when a loan or lease becomes contractually delinquent for 90 days, except for residential mortgage loans and consumer loans that are well secured and in the process of collection. Residential mortgage loans are placed in nonaccrual at the time the loan is placed in foreclosure. When interest accruals are discontinued, interest credited to income in the current year is reversed and interest accrued in the prior year is charged to the reserve for loan and lease losses. However, in some cases, management may elect to continue the accrual of interest when the net realizable value of collateral is sufficient to cover the principal and accrued interest. When a loan or lease is classified as nonaccrual and the future collectibility of the recorded loan or lease balance is doubtful, collections on interest and principal are applied as a reduction to principal outstanding. A loan or lease is considered impaired, based on current information and events, if it is probable that 1st Source will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or lease agreement. Interest on impaired loans and leases, which are not classified as nonaccrual, is recognized on the accrual basis. 1st Source, through its subsidiary Trustcorp, sells mortgage loans to the Government National Mortgage Association (GNMA) in the normal course of business and retains the servicing rights. The GNMA programs under which the loans are sold allow 1st Source to repurchase individual delinquent loans that meet certain criteria from the securitized loan pool. At 1st Source's option, and without GNMA's prior authorization, 1st Source may repurchase a delinquent loan for an amount equal to 100% of the remaining principal balance on the loan. Under Statements of Financial Accounting Standards (SFAS) No. 140, once 1st Source has the unconditional ability to repurchase a delinquent loan, 1st Source is deemed to have regained effective control over the loan and is required to recognize the loan on its balance sheet and record an offsetting liability, regardless of 1st Source's intent to repurchase the loan. At December 31, 2005 and 2004, residential real estate portfolio loans included $18.09 million and $19.31 million, respectively, of loans available for repurchase under the GNMA optional repurchase programs with the offsetting liability recorded within other borrowed funds. 31 MORTGAGE BANKING ACTIVITIES -- Loans held for sale are primarily composed of performing one-to-four family residential mortgage loans originated for resale and carried at the lower of cost or fair value as determined on an aggregate basis. Fair value is determined using available secondary market prices for loans with similar coupons, maturities, and credit quality. 1st Source recognizes the rights to service mortgage loans for others as separate assets, whether the servicing rights are acquired through a separate purchase or through the sale of originated loans with servicing rights retained. 1st Source allocates a portion of the total cost of a mortgage loan to servicing rights based on the relative fair value. The fair value of the servicing rights is based on market prices, when available, or is determined by estimating the present value of future net servicing income, taking into consideration market loan prepayment speeds and discount rates. These assets are amortized as reductions of mortgage servicing fee income over the estimated servicing period in proportion to the estimated servicing income to be received. Gains and losses on the sale of mortgage servicing rights are recognized as noninterest income in the period in which such rights are sold. Mortgage servicing assets are evaluated for impairment in accordance with SFAS No. 140. For purposes of impairment measurement, mortgage servicing assets are stratified based on the predominant risk characteristics of the underlying servicing, principally by loan type and interest rate. The fair value of each tranche of the servicing portfolio is estimated by calculating the present value of estimated future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates, servicing costs, and other economic factors. If temporary impairment exists within a tranche, a valuation allowance is established through a charge to income equal to the amount by which the carrying value exceeds the fair value. If it is later determined all or a portion of the temporary impairment no longer exists for a particular tranche, the valuation allowance is reduced through a recovery of income. Mortgage servicing assets are also reviewed for other-than-temporary impairment. Other-than-temporary impairment exists when recoverability of a recorded valuation allowance is determined to be remote considering historical and projected interest rates and loan pay-off activity. When this situation occurs, the unrecoverable portion of the valuation allowance is applied as a direct write-down to the carrying value of the mortgage servicing asset. Unlike a valuation allowance, a direct write-down permanently reduces the carrying value of the mortgage servicing asset and the valuation allowance, precluding subsequent recoveries. As part of mortgage banking operations, 1st Source enters into commitments to purchase or originate loans whereby the interest rate on these loans is determined prior to funding ("rate lock commitments"). Similar to loans held for sale, the fair value of rate lock commitments is subject to change primarily due to changes in interest rates. Under 1st Source's risk management policy, these fair values are hedged primarily by selling forward contracts on agency securities. The rate lock commitments on mortgage loans intended to be sold and the related hedging instruments are recorded at fair value with changes in fair value recorded in current earnings. The fair value of rate lock commitments is determined using current secondary market prices for underlying loans with similar coupons, maturity and credit quality, subject to the anticipated loan funding probability, or fallout factor. The benefit of servicing rights inherent in the loans underlying the rate lock commitments is not recognized until these loans are funded and sold. RESERVE FOR LOAN AND LEASE LOSSES -- The reserve for loan and lease losses is maintained at a level believed to be adequate by management to absorb probable losses inherent in the loan and lease portfolio. The determination of the reserve requires significant judgment reflecting management's best estimate of probable loan and lease losses related to specifically identified loans and leases as well as probable losses in the remainder of the various loan and lease portfolios. The methodology for assessing the appropriateness of the reserve consists of several key elements, which include: specific reserves for identified special attention loans and leases (classified loans and leases and internal watch list credits), percentage allocations for special attention loans and leases without specific reserves, formula reserves for each business lending division portfolio including a higher percentage reserve allocation for special attention loans and leases without a specific reserve and reserves for pooled homogenous loans and leases. Management's evaluation is based upon a continuing review of these portfolios, estimates of future customer performance, collateral values and disposition and forecasts of future economic and geopolitical events, all of which are subject to judgment and will change. Specific reserves are established for certain business and specialty finance credits based on a regular analysis of special attention loans and leases. This analysis is performed by the Credit Policy Committee, the Loan Review Department, Credit Administration and the Loan Workout Departments. The specific reserves are based on an analysis of underlying collateral values, cash flow considerations and, if applicable, guarantor capacity. The formula reserves determined for each business lending division portfolio are calculated quarterly by applying loss factors to outstanding loans and leases and certain unfunded commitments based upon a review of historical loss experience and qualitative factors, which include but are not limited to, economic trends, current market risk assessment by industry, recent loss experience in particular segments of the portfolios, movement in equipment values collateralizing specialized industry portfolios, concentrations of credit, delinquencies, trends in volume, experience and depth of relationship managers and division management, and the effects of changes in lending policies and practices, including changes in quality of the loan and lease origination, servicing and risk management processes. Special attention loans and leases without specific reserves receive a higher percentage allocation ratio than credits not considered special attention. Pooled loans and leases are smaller credits and are homogenous in nature, such as consumer credits and residential mortgages. Pooled loan and lease loss reserves are based on historical net charge-offs, adjusted for delinquencies, the effects of lending practices and programs and current economic conditions, and projected trends in the geographic markets which 1st Source serves. A comprehensive analysis of the reserve is performed by management on a quarterly basis. Although management determines the amount of each element of the reserve separately and relies on this process as an important credit management tool, the entire reserve is available for the entire loan and lease portfolio. The actual amount of losses incurred can vary significantly from the estimated amounts both positively and negatively. Management's methodology includes several factors intended to minimize the difference between estimated and actual losses. These factors allow management to adjust its estimate of losses based on the most recent information available. 32 Loans and leases, which are deemed uncollectible, are charged off and deducted from the reserve, while recoveries of amounts previously charged off are credited to the reserve. A provision for loan and lease losses is charged to operations based on management's periodic evaluation of the factors previously mentioned, as well as other pertinent factors. EQUIPMENT OWNED UNDER OPERATING LEASES -- 1st Source finances various types of construction equipment, medium and heavy duty trucks, and automobiles under leases classified as operating leases. Revenue consists of the contractual lease payments and is recognized on a straight-line basis over the lease term. Lease terms range from three to seven years. Leased assets are being depreciated on a straight-line method over the lease term to the estimate of the equipment's fair market value at lease termination, also commonly referred to as "residual" value. These residual values are reviewed periodically to ensure the recorded amount does not exceed the fair market value at the lease termination. OTHER REAL ESTATE -- Other real estate acquired through partial or total satisfaction of nonperforming loans is included in other assets and recorded at the estimated fair value less anticipated selling costs based upon the property's appraised value at the date of transfer, with any difference between the fair value of the property and the carrying value of the loan charged to the reserve for loan losses. Subsequent changes in value are reported as adjustments to the carrying amount and are recorded in noninterest expense on the income statement. Gains or losses not previously recognized resulting from the sale of other real estate are recognized on the date of sale. As of December 31, 2005 and 2004, other real estate had carrying values of $0.96 million and $1.88 million, respectively. REPOSSESSED ASSETS -- Repossessed assets consist of specialty finance equipment, including aircraft, construction equipment, and vehicles acquired through foreclosure or in lieu of foreclosure. Repossessed assets are included in other assets at the lower of cost or fair value of the equipment or vehicle. 1st Source estimates fair value based on the best estimate of an orderly liquidation value. Valuation resources typically include vehicle and equipment dealers, valuation guides, and other third parties, including appraisers. At the time of foreclosure, the recorded amount of the loan or lease is written down, if necessary, to the fair value of the equipment or vehicle by a charge to the reserve for loan and lease losses. Subsequent write-downs are included in noninterest expense. Gains or losses not previously recognized resulting from the sale of repossessed assets are recognized on the date of sale. Repossessed assets totaled $4.28 million and $4.38 million, as of December 31, 2005 and 2004, respectively. PREMISES AND EQUIPMENT -- Premises and equipment are stated at cost, less accumulated depreciation and amortization. The provision for depreciation is computed by the straight-line method, primarily with useful lives of 5, 7, 15 and 31.5 years. Maintenance and repairs are charged to expense as incurred, while improvements, which extend the useful life, are capitalized and depreciated over the estimated remaining life. Long-lived depreciable assets are evaluated periodically for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. Impairment exists when the expected undiscounted future cash flows of a long-lived asset are less than its carrying value. In that event, 1st Source recognizes a loss in the amount of the difference between the carrying amount and the estimated fair value of the asset based on a quoted market price, if applicable, or a discounted cash flow analysis. Impairment losses are recorded in other noninterest expense in the income statement. GOODWILL AND INTANGIBLES -- Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset, or liability. Goodwill is reviewed at least annually for impairment. Intangible assets that have finite lives continue to be amortized over their estimated useful lives and also continue to be subject to impairment testing. All of 1st Source's other intangible assets have finite lives and are amortized on a straight-line basis over varying periods not exceeding seven years. 1st Source performed the required annual impairment test of goodwill during the first quarter of 2005 and determined that no impairment exists. VENTURE CAPITAL INVESTMENT -- Venture capital investments in partnerships are carried at estimated fair value with changes in fair value recognized in investment securities and other investment (losses) gains. The fair values of publicly traded investments in these partnerships are determined using quoted market prices. For other investments in these partnerships, fair value is determined by the General Partner. All valuations are approved by the Valuation Committee of the Advisory Board of the Partnership. Venture capital investments in partnerships are included in other assets on the balance sheet. The balances as of December 31, 2005 and 2004 were $4.75 million and $2.74 million, respectively. SHORT-TERM BORROWINGS -- 1st Source's short-term borrowings consist of Federal funds purchased, securities sold under agreement to repurchase, commercial paper, U.S. Treasury demand notes, Federal Home Loan Bank notes, and borrowings from non-affiliated banks. Federal funds purchased, securities sold under agreements to repurchase, and other short-term borrowings mature within one to 365 days of the transaction date. Commercial paper matures within seven to 270 days. Other short-term borrowings on the balance sheet includes 1st Source's liability related to mortgage loans available for repurchase under GNMA optional repurchase programs. Securities purchased under agreements to resell and securities sold under agreements to repurchase are treated as collateralized financing transactions and are recorded at the amounts at which the securities were acquired or sold plus accrued interest. The fair value of collateral either received from or provided to a third party is continually monitored and additional collateral obtained or requested to be returned to 1st Source as deemed appropriate. TRUST FEES -- Trust fees are recognized on the accrual basis. INCOME TAXES -- 1st Source and its subsidiaries file a consolidated Federal income tax return. The provision for incomes taxes is based upon income in the financial statements, rather than amounts reported on 1st Source's income tax return. 33 Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date. NET INCOME PER COMMON SHARE -- Net income per common share is computed in accordance with SFAS No. 128, "Earnings per Share." Basic earnings per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding, which were as follows (in thousands): 2005, 20,686; 2004, 20,709; and 2003, 20,859. Diluted earnings per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding, plus the dilutive effect of outstanding stock options. The weighted-average number of common shares, increased for the dilutive effect of stock options, used in the computation of diluted earnings per share were as follows (in thousands): 2005, 20,957; 2004, 20,985; and 2003, 21,150. At December 31, 2005, the company had six stock-based employee compensation plans, which are described more fully in Note K. These include two stock option plans, a stock option agreement, the Employee Stock Purchase Plan, the Executive Incentive Plan, and the Restricted Stock Award Plan. 1st Source accounts for those plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. Stock-based employee compensation cost under the Executive Incentive Plan and the Restricted Stock Award Plan is reflected in net income. No stock-based employee compensation cost for the stock option plans, the stock option agreement, or the Employee Stock Purchase Plan is reflected in net income. All options granted under the stock option plans and the stock option agreement had an exercise price equal to the market value of the underlying common stock on the date of grant. Options granted under the Employee Stock Purchase Plan had an exercise price based on the market value of the underlying common stock on the date of grant as described more fully in Note K. The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation.
Year Ended December 31 (Dollars in thousands, except per share data) 2005 2004 2003 - -------------------------------------------------------------------------------- -------------------- ----------------- ------------ Net income, as reported $ 33,751 $ 24,965 $ 19,154 Add: Stock-based employee compensation expense included in reported net income, net of related tax effects 2,875 1,392 1,360 Deduct: Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (2,998) (1,586) (1,593) - -------------------------------------------------------------------------------- -------------------- ----------------- ------------ Pro forma net income $ 33,628 $ 24,771 $ 18,921 - -------------------------------------------------------------------------------- -------------------- ----------------- ------------ Earnings per share: Basic -- as reported $ 1.63 $ 1.21 $ 0.92 Basic -- pro forma $ 1.63 $ 1.20 $ 0.91 - -------------------------------------------------------------------------------- -------------------- ----------------- ------------ Diluted -- as reported $ 1.61 $ 1.19 $ 0.91 Diluted -- pro forma $ 1.61 $ 1.18 $ 0.90 ====================================================================================================================================
SEGMENT INFORMATION -- It is management's opinion that 1st Source has two principal business segments, namely: commercial banking (conducted through its wholly-owned subsidiary, 1st Source Bank) and mortgage banking (conducted through its wholly-owned subsidiary, Trustcorp). While 1st Source's chief decision makers monitor the revenue streams of various products and services, the identifiable segments' operations are managed and financial performance is evaluated on a company-wide basis. Accordingly, all of 1st Source's financial service operations are considered by management to be aggregated in one reportable operating segment. DERIVATIVE FINANCIAL INSTRUMENTS -- 1st Source occasionally enters into derivative financial instruments as part of its interest rate risk management strategies. These derivative financial instruments consist primarily of interest rate swaps. Under the guidance of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended, all derivative instruments are recorded on the balance sheet, as either an asset or liability, at their fair value. The accounting for the gain or loss resulting from the change in fair value depends on the intended use of the derivative. For a derivative used to hedge changes in fair value of a recognized asset or liability, or an unrecognized firm commitment, the gain or loss on the derivative will be recognized in earnings together with the offsetting loss or gain on the hedged item. This results in an earnings impact only to the extent that the hedge is ineffective in achieving offsetting changes in fair value. If it is determined that the derivative instrument is not highly effective as a hedge, hedge accounting is discontinued and the adjustment to fair value of the derivative instrument is recorded in earnings. For a derivative used to hedge changes in cash flows associated with forecasted transactions, the gain or loss on the effective portion of the derivative will be deferred, and reported as accumulated other comprehensive income, a component of shareholders' equity, until such time the hedged transaction affects earnings. For derivative instruments not accounted for as hedges, changes in fair value are recognized in noninterest income/expense. Deferred gains and losses from derivatives that are terminated are amortized over the shorter of the original remaining term of the derivative or the remaining life of the underlying asset or liability. 34 Note B -- Recent Accounting Pronouncements MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT: In November 2005, the Financial Accounting Standards Board (FASB) issued Staff Position (FSP) SFAS No. 115-1 and 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." The FSP addresses the determination of when an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss. The FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The FSP amends SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and SFAS No. 124, "Accounting for Certain Investments Held by Not-for-Profit Organizations," and APB Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock." The FSP nullifies certain requirements of EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments," and supercedes Emerging Issues Task Force (EITF) Abstracts, Topic D-44, "Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value." The FSP is required to be applied to reporting periods beginning after December 15, 2005. The issuance of this FSP is not expected to have a material impact on the financial condition, the results of operations, or liquidity of 1st Source. ACCOUNTING CHANGES AND ERROR CORRECTIONS: In May 2005, the FASB issued SFAS No. 154, "Accounting for Changes and Error Corrections," which changes the accounting for and reporting of a change in accounting principle. This statement also applies to all voluntary changes in accounting principle and changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. This statement requires retrospective application to prior period financial statements of changes in accounting principle, unless it is impractical to determine either the period - specific or cumulative effects of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The adoption of this standard is not expected to have a material effect on the financial condition, the results of operations or liquidity of 1st Source. EXCHANGES OF NONMONETARY ASSETS: In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets," an amendment to APB Opinion No. 29, "Accounting for Nonmonetary Transactions." This statement amends the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged and more broadly provides for exceptions regarding exchanges of nonmonetary assets that do not have commercial substance. This Statement is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of this standard is not expected to have a material effect on the financial condition, the results of operations or liquidity of 1st Source. ACCOUNTING FOR STOCK-BASED COMPENSATION: On December 16, 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment," which is a revision of SFAS No. 123 "Accounting for Stock-Based Compensation." SFAS No. 123(R) supersedes Accounting Principles Board (APB) Opinion No. 25 "Accounting for Stock Issued to Employees," and amends SFAS No. 95, "Statement of Cash Flows." Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS No. 123(R) must be adopted no later than January 1, 2006. Early adoption is permitted in periods in which financial statements have not yet been issued. 1st Source will adopt SFAS No. 123(R) on January 1, 2006. SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods: 1. A "modified prospective" method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123(R) for all share-based payments granted after the effective date, and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date. 2. A "modified retrospective" method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS No. 123 for purposes of pro forma disclosures either (a) all prior periods presented, or (b) prior interim periods of the year of adoption. 1st Source will utilize the modified prospective method upon adoption of SFAS No. 123(R). As permitted by SFAS No. 123, 1st Source currently accounts for share-based payments to employees using APB Opinion No. 25's intrinsic value method. Under the terms of the Executive Incentive Plan and Restricted Stock Award Plan, 1st Source recognizes the entire share-based compensation cost in net income at the grant date. 1st Source recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS No. 123(R)'s fair value method could have a significant impact on 1st Source's results of operations, although 1st Source expects the adoption will have minimal impact on 1st Source's overall financial position. 1st Source is still calculating the impact of adoption of SFAS No. 123(R), including the result of recognizing share-based compensation cost for the awards granted under the Executive Incentive Plan and Restricted Stock Award Plan over the "requisite service period" as defined in SFAS No. 123(R) and estimating forfeitures. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While 1st Source cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were $0, $1.09 million, and $0 in 2005, 2004, and 2003, respectively. 35 ACCOUNTING FOR CERTAIN LOANS AND DEBT SECURITIES ACQUIRED IN A TRANSFER: In December 2003, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 03-3, "Accounting for Certain Loans and Debt Securities Acquired in a Transfer (formerly known as Discounts Related to Credit Quality)." This SOP addresses accounting differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. This SOP prohibits "carrying over" or creation of valuation allowances in the initial accounting of all loans acquired in a transfer that are within the scope of this SOP. The prohibition of the valuation allowance carryover applies to the purchase of an individual loan, a pool of loans, a group of loans, and loans acquired in a purchase business combination. The provisions of SOP 03-3 are effective for loans acquired in fiscal years beginning after December 15, 2004. 1st Source has not acquired any loans subsequent to the effective date of SOP 03-3; therefore, implementation of this statement did not have a material impact on 1st Source's results of operations, financial position, or liquidity. RECLASSIFICATIONS -- Certain amounts in the prior period consolidated financial statements have been reclassified to conform with the current year presentation. These reclassifications had no effect on total assets, shareholders' equity or net income as previously reported. Note C -- Investment Securities Investment securities available-for-sale were as follows:
Amortized Gross Gross (Dollars in thousands) Cost Unrealized Gains Unrealized Losses Fair Value - --------------------------------------------------------- -------------------------- ----- ---------- ----------------- ------------ December 31, 2005 U.S. Treasury and government agencies securities $ 357,754 $ - $ (5,543) $ 352,211 States and political subdivisions 179,797 80 (2,144) 177,733 Mortgage-backed securities 58,039 162 (849) 57,352 Other securities 42,288 3,307 (266) 45,329 - ---------------------------------------------------------- -------------------------- ---------------- ----------------- ----------- Total investment securities $ 637,878 $ 3,549 $ (8,802) $ 632,625 - ---------------------------------------------------------- -------------------------- ---------------- ----------------- ----------- December 31, 2004 U.S. Treasury and government agencies securities $ 498,507 $ 70 $ (4,424) $ 494,153 States and political subdivisions 171,338 1,496 (318) 172,516 Mortgage-backed securities 54,442 412 (353) 54,501 Other securities 66,117 2,821 (185) 68,753 - ---------------------------------------------------------- -------------------------- ---------------- ----------------- ----------- Total investment securities $ 790,404 $ 4,799 $ (5,280) $ 789,923 ====================================================================================================================================
The contractual maturities of investments in securities available-for-sale at December 31, 2005, 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. Amortized (Dollars in thousands) Cost Fair Value - -------------------------------------------------------- ------------ Due in one year or less $ 251,770 $ 250,282 Due after one year through five years 260,095 254,009 Due after five years through ten years 26,336 26,121 Due after ten years 3,500 3,500 Mortgage-backed securities 58,039 57,352 Equity securities 38,138 41,361 - -------------------------------------------------------- ------------ Total securities $ 637,878 $ 632,625 ===================================================================== 36 At December 31, 2005, the mortgage-backed securities held by 1st Source consisted primarily of FNMA and FHLMC pass-through certificates which are guaranteed by those respective agencies of the United States government. At December 31, 2005, other securities held by 1st Source consisted primarily of FNMA and FHLMC preferred securities and FHLB securities. Gross losses of $0.64 million, $4.62 million, and $3.03 million and gross gains of $0.17 million, $0.15 million and $0.01 million were recognized on investment securities available-for-sale, in 2005, 2004, and 2003, respectively. The gross losses in 2005 and 2004 include $0.61 million and $4.58 million, respectively, in other-than-temporary impairment on preferred stock issued by the FNMA and the FHLMC. The gross loss in 2003 includes $2.99 million of impairment charges on the securitization retained interest. Realized and unrealized gains and (losses) on trading securities were $0, ($0.04) million, and $0.60 million in 2005, 2004 and 2003, respectively. There were no trading securities outstanding at December 31, 2005 or 2004. The following tables summarize 1st Source's gross unrealized losses and fair value by investment category and age:
Less than 12 Months 12 months or Longer Total ------------------- ------------------- ----- Fair Unrealized Fair Unrealized Fair Unrealized (Dollars in thousands) Value Losses Value Losses Value Losses - ----------------------------------------------- ------------ -------------- --------------- -------------- -------------- ---------- December 31, 2005 U.S. Treasury and government agencies securities $ 76,363 $ (153) $ 255,799 $ (5,390) $ 332,162 $ (5,543) States and political subdivisions 99,320 (1,105) 48,301 (1,039) 147,621 (2,144) Mortgage-backed securities 22,175 (344) 15,766 (505) 37,941 (849) Other securities 3,409 (84) 3,369 (182) 6,778 (266) - ----------------------------------------------- ------------ -------------- --------------- -------------- -------------- ---------- Total temporarily impaired securities $ 201,267 $ (1,686) $ 323,235 $ (7,116) $ 524,502 $ (8,802) - ------------------------------------------------ ------------ -------------- --------------- -------------- -------------- --------- December 31, 2004 U.S. Treasury and government agencies securities $ 443,597 $ (3,419) $ 40,487 $ (1,005) $ 484,084 $ (4,424) States and political subdivisions 51,784 (301) 1,136 (17) 52,920 (318) Mortgage-backed securities 10,937 (68) 19,798 (285) 30,735 (353) Other securities 5,827 (44) 3,409 (141) 9,236 (185) - ------------------------------------------------ ------------ -------------- --------------- -------------- -------------- --------- Total temporarily impaired securities $ 512,145 $ (3,832) $ 64,830 $ (1,448) $ 576,975 $ (5,280) ====================================================================================================================================
At December 31, 2005, 1st Source did not believe any individual unrealized loss represented other-than-temporary impairment. The unrealized losses were primarily attributable to changes in interest rates. 1st Source had both the intent and the ability to hold these securities for a time necessary to recover the amortized cost. At December 31, 2005 and 2004, investment securities with carrying values of $318.51 million and $285.06 million, respectively, were pledged as collateral to secure government deposits, security repurchase agreements, and for other purposes. Note D -- Loans and Lease Financings Total loans and leases outstanding were recorded net of unearned income and deferred loan fees and costs at December 31, 2005 and 2004, and totaled $2.46 billion and $2.28 billion, respectively. The loan and lease portfolio includes direct financing leases, which are included in auto, light truck and environmental equipment, medium and heavy duty truck, aircraft financing, and construction equipment financing on the consolidated balance sheet. A summary of the gross investment in lease financing and the components of the investment in lease financing at December 31, 2005 and 2004, follows: (Dollars in thousands) 2005 2004 - -------------------------------------------------------------- -------------- Direct finance leases $ 155,737 $ 188,244 - --------------------------------------------------------------- ------------- Rentals receivable 99,276 130,930 Estimated residual value of leased assets 56,461 57,314 - --------------------------------------------------------------- ------------- Gross investment in lease financing 155,737 188,244 Unearned income (12,826) (17,219) - --------------------------------------------------------------- ------------- Net investment in lease financing $ 142,911 $ 171,025 ============================================================================= 37 At December 31, 2005, the minimum future lease payments receivable for each of the years 2006 through 2010 were $36.77 million, $26.49 million, $17.86 million, $10.91 million, and $5.42 million, respectively. 1st Source and its subsidiaries have extended, and expect to extend in the future, loans to officers, directors, and principal holders of equity securities of 1st Source and its subsidiaries and to their associates. In the opinion of management, these loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other parties and are consistent with sound banking practices and within applicable regulatory and lending limitations. The aggregate dollar amounts of these loans were $17.48 million and $23.44 million at December 31, 2005 and 2004, respectively. During 2005, $17.31 million of new loans were made and repayments and other reductions totaled $23.27 million. Note E -- Reserve for Loan and Lease Losses Changes in the reserve for loan and lease losses for each of the three years ended December 31 are shown below.
(Dollars in thousands) 2005 2004 2003 - --------------------------------------------------------------- -------------- ------------ Balance, beginning of year $ 63,672 $ 70,045 $ 59,218 (Recovery of) provision for loan and lease losses (5,855) 229 17,361 Charge-offs (5,572) (14,681) (17,538) Recoveries 6,452 8,079 4,181 Reserves acquired in acquisitions - - 6,823 - --------------------------------------------------------------- -------------- ------------ Balance, end of year $ 58,697 $ 63,672 $ 70,045 ===========================================================================================
At December 31, 2005 and 2004, nonaccrual and restructured loans and leases, substantially all of which are collateralized, were $16.55 million and $25.25 million, respectively. Interest income for the years ended December 31, 2005, 2004, and 2003, would have increased by approximately $1.38 million, $2.27 million, and $2.64 million, respectively, if these loans and leases had earned interest at their full contract rate. As of December 31, 2005 and 2004, impaired loans and leases totaled $18.53 million and $47.22 million, respectively, of which $3.10 million and $22.30 million had corresponding specific reserves for loan and lease losses totaling $3.03 million and $10.43 million, respectively. The remaining balances of impaired loans and leases had no specific reserves for loan and lease losses associated with them. As of December 31, 2005, a total of $12.62 million of the impaired loans and leases were nonaccrual loans and leases. For 2005, 2004, and 2003 the average recorded investment in impaired loans and leases was $29.39 million, $53.21 million and $60.36 million, respectively, and interest income recognized on impaired loans and leases totaled $1.04 million, $2.65 million, and $2.63 million, respectively. Note F -- Operating Leases 1st Source finances various types of construction equipment, medium and heavy duty trucks, automobiles, and miscellaneous production equipment under leases principally classified as operating leases. These operating leases are reported at cost, net of accumulated depreciation. These operating lease arrangements require the lessee to make a fixed monthly rental payment over a specified lease term, typically from three to seven years. These operating lease assets are recorded net of accumulated depreciation in the consolidated balance sheet. Rental income is earned by 1st Source on the operating lease assets and reported as noninterest income. These operating lease assets are depreciated over the term of the lease to the estimated fair value of the asset at the end of the lease. The depreciation of these operating lease assets is reported as a component of noninterest expense. At the end of the lease, the operating lease asset is either purchased by the lessee or returned to 1st Source. Operating lease equipment at December 31, 2005 and 2004, was $58.25 million and $47.26 million, respectively, net of accumulated depreciation of $29.79 million and $35.37 million, respectively. Depreciable lives for operating lease equipment generally range from three to seven years. The minimum future lease rental payments due from clients on operating lease equipment at December 31, 2005, totaled $44.23 million, of which $14.35 million is due in 2006, $10.13 million in 2007, $8.11 million in 2008, $6.43 million in 2009, $3.66 million in 2010, $1.06 million in 2011, and $0.49 million in 2012. Depreciation expense related to operating lease equipment for the year ended December 31, 2005 was $12.90 million. Note G -- Premises and Equipment Premises and equipment as of December 31 consisted of the following: (Dollars in thousands) 2005 2004 - -------------------------------------------------------- ------------ Land $ 6,884 $ 6,719 Buildings and improvements 42,616 40,905 Furniture and equipment 33,205 32,476 - -------------------------------------------------------- ------------ Total premises and equipment 82,705 80,100 Accumulated depreciation and amortization (44,995) (42,786) - -------------------------------------------------------- ------------ Net premises and equipment $ 37,710 $ 37,314 ===================================================================== Depreciation and amortization of properties and equipment totaled $5.00 million in 2005, $4.81 million in 2004, and $5.09 million in 2003. 38 Note H -- Mortgage Servicing Assets The unpaid principal balance of residential mortgage loans serviced for third parties was $1.54 billion at December 31, 2005, compared to $1.91 billion at December 31, 2004, and $2.06 billion at December 31, 2003. Changes in the carrying value of mortgage servicing assets and the associated valuation allowance follow:
Year Ended December 31 (Dollars in thousands) 2005 2004 - ------------------------------------------------------------------------------------ --------------------------------- ------------- Mortgage servicing assets: Balance at beginning of period $ 23,715 $ 27,601 Additions 10,012 9,985 Amortization (6,782) (7,384) Application of valuation allowance to directly write-down servicing assets - (700) Sales (7,552) (5,787) - ------------------------------------------------------------------------------------- --------------------------------- ------------ Carrying value before valuation allowance at end of period 19,393 23,715 - ------------------------------------------------------------------------------------- --------------------------------- ------------ Valuation allowance: Balance at beginning of period (2,301) (3,276) Impairment recoveries 2,271 275 Application of valuation allowance to directly write-down servicing assets - 700 - ------------------------------------------------------------------------------------- --------------------------------- ------------ Balance at end of period $ (30) $ (2,301) - ------------------------------------------------------------------------------------- --------------------------------- ------------ Net carrying value of mortgage servicing assets at end of period $ 19,363 $ 21,414 - ------------------------------------------------------------------------------------- --------------------------------- ------------ Fair value of mortgage servicing assets at end of period $ 23,967 $ 23,521 ====================================================================================================================================
Mortgage servicing assets are evaluated for impairment and a valuation allowance is established through a charge to income when the carrying value of the mortgage servicing assets exceeds the fair value and the impairment is determined to be temporary. Other-than-temporary impairment is recognized when the recoverability of a recorded valuation allowance is determined to be remote taking into consideration historical and projected interest rates and loan pay-off activity. When this situation occurs, the unrecoverable portion of the valuation allowance is applied as a direct write-down to the carrying value of the mortgage servicing asset. Unlike a valuation allowance, a direct write-down permanently reduces the carrying value of the mortgage servicing asset and the valuation allowance, precluding subsequent recoveries. During 2005, management determined that it was not necessary to permanently write-down any previously established valuation allowance. At December 31, 2005, the fair value of mortgage servicing assets exceeded the carrying value reported in the consolidated balance sheet by $4.60 million. This difference represents increases in the fair value of certain mortgage servicing assets accounted for under SFAS No. 140 that could not be recorded above cost basis. The key economic assumptions used to estimate the value of mortgage servicing rights follow: Year Ended December 31 (Dollars in thousands) 2005 2004 - ---------------------------------------------------------------------- Expected weighted-average life (in years) 3.01 3.10 Weighted-average constant prepayment rate (CPR) 12.66 % 20.16 % Weighted-average discount rate 8.71 % 8.68 % ====================================================================== Funds held in trust at 1st Source for the payment of principal, interest, taxes and insurance premiums applicable to mortgage loans being serviced for others, were approximately $21.04 million and $37.96 million at December 31, 2005 and December 31, 2004, respectively. Note I -- Intangible Assets and Goodwill At December 31, 2005, intangible assets consisted of goodwill of $18.85 million and other intangible assets of $2.53 million, net of accumulated amortization of $10.43 million. At December 31, 2004, intangible assets consisted of goodwill of $18.85 million and other intangible assets of $4.74 million, net of accumulated amortization of $7.77 million. Intangible asset amortization was $2.66 million, $2.63 million, and $2.75 million for 2005, 2004, and 2003, respectively. Amortization on other intangible assets is expected to total $1.91 million, $0.21 million, $0.11 million, and $0.11 million in 2006, 2007, 2008, and 2009, respectively. A summary of core deposit intangible and other intangible assets follows: Year Ended December 31 (Dollars in thousands) 2005 2004 - -------------------------------------------------------- -------------- Core deposit intangibles: Gross carrying amount $ 5,762 $ 5,307 Less: accumulated amortization (4,260) (3,244) - -------------------------------------------------------- -------------- Net carrying amount $ 1,502 $ 2,063 - -------------------------------------------------------- -------------- Other intangibles: Gross carrying amount $ 7,201 $ 7,201 Less: accumulated amortization (6,174) (4,527) - -------------------------------------------------------- -------------- Net carrying amount $ 1,027 $ 2,674 ======================================================================= 39 Note J -- Long-Term Debt and Mandatorily Redeemable Securities Details of long-term debt and mandatorily redeemable securities as of December 31, 2005 and 2004, are as follows:
(Dollars in thousands) 2005 2004 - --------------------------------------------------------------- ---------------- ------------ Term loan $ 10,000 $ 10,000 Federal Home Loan Bank borrowings (4.79%-6.98%) 5,989 1,008 Mandatorily redeemable securities 6,273 6,093 Other long-term debt 975 863 - --------------------------------------------------------------- ---------------- ------------ Total long-term debt and mandatorily redeemable securities $ 23,237 $ 17,964 =============================================================================================
Annual maturities of long-term debt outstanding at December 31, 2005, for the next five years beginning in 2006, are as follows (in thousands): $265; $10,304; $5,234; $226; and $110. At December 31, 2005, the $10.00 million term loan bore a fixed interest rate of 4.76%. Interest is payable quarterly with principal due at the October 31, 2007, maturity. The Term Loan Agreement contains, among other provisions, certain covenants relating to existence and mergers, capital structure, and financial requirements. At December 31, 2005, the Federal Home Loan Bank borrowings represented a source of funding for certain residential mortgage activities and consisted of five fixed rate notes with maturities ranging from 2006 to 2022. These notes were collateralized by $9.58 million of certain real estate loans and $5.00 million of investment securities. Mandatorily redeemable securities as of December 31, 2005, of $6.27 million reflected the "book value" shares under the 1st Source Executive Incentive Plan. See "Executive Incentive Plan" section of Note K for additional information on this plan. Dividends paid on these shares and increases in book value per share are recorded as other interest expense. Total interest expense recorded for 2005 and 2004 was $0.54 million and $0.38 million, respectively. Note K -- Common Stock 1st Source has adopted SFAS No. 123 on a disclosure basis only. The disclosure requirements include reporting the pro forma effect on net income and net income per share of compensation expense attributable to the fair value of stock options and other stock-based compensation which have been issued to employees under the Stock Option Plans and the Employee Stock Purchase Plan. 1st Source is following APB No. 25 in accounting for these plans. In addition, the Executive Incentive Plan (including annual and special long-term awards) and the Restricted Stock Award Plan are also accounted for under the provisions of APB No. 25. Compensation cost charged against income for these plans was $4.66 million, $2.26 million, and $2.19 million for the years ended December 31, 2005, 2004, and 2003, respectively. STOCK OPTION PLANS -- 1st Source's incentive stock option plans include the 1992 Stock Option Plan (the "1992 Plan") and the 2001 Stock Option Plan (the "2001 Plan"). As of December 31, 2005, an aggregate 2,445,291 shares of common stock were reserved for issuance under the above plans. Under the 2001 Plan, the exercise price of each option equals the market price of 1st Source stock on the date of grant, and an option's term is ten years, except for reload options, which are given the remaining term of the original grant. Options under the 2001 Plan vest in one to eight years from date of grant. Options are granted on a discretionary basis by the Executive Compensation and Human Resources Committee (the "Committee") of the 1st Source Board of Directors. The fair value of each option on the date of grant was estimated using the Black-Scholes option pricing model. The following weighted-average assumptions were used in the option pricing model for options granted in 2003 (no options were granted in 2004 or 2005): a risk-free interest rate of 3.39%; an expected dividend yield of 2.32%; an expected volatility factor of 37.02%; and an expected option life of 6.39 years. The weighted-average grant date fair value of options granted in 2003 was $4.94. 40 The following table is a summary of the activity with respect to 1st Source's stock option plans for the years ended December 31, 2003, 2004 and 2005: Number of Weighted-Average Shares Exercise Price - ------------------------------------------------------------- ------------------ Options outstanding, January 1, 2003 828,082 $ 20.33 - ------------------------------------------------------------- ------------------ Options granted 20,000 13.24 Options exercised (71,528) 8.71 Options forfeited (4,235) 19.24 - ------------------------------------------------------------- ------------------ Options outstanding, December 31, 2003 772,319 21.23 - --------------------------------------------------------------- ---------------- Options granted - - Options exercised (207,753) 8.39 Options forfeited (3,027) 24.00 - --------------------------------------------------------------- ---------------- Options outstanding, December 31, 2004 561,539 25.97 - --------------------------------------------------------------- ---------------- Options granted - - Options exercised (27,019) 12.44 Options forfeited (6,481) 29.93 - --------------------------------------------------------------- ---------------- Options outstanding, December 31, 2005 528,039 26.61 - --------------------------------------------------------------- ---------------- Options exercisable, December 31, 2005 504,706 $ 27.07 ================================================================================ The following table summarizes information about stock options outstanding at December 31, 2005:
Options Outstanding Options Exercisable ----------------- ---------------------- ---------------------- ------------- ---------------- Weighted-Average Number of Remaining Contractual Weighted-Average Number of Weighted-Average Range of Exercise Prices Shares Life (Years) Exercise Price Shares Exercise Price - ----------------------------- ----------------- ---------------------- ---------------------- ------------- ---------------- $ 12.44 to $ 19.99 109,938 3.09 $ 14.48 94,938 $ 14.68 $ 20.00 to $ 29.99 65,793 4.59 22.74 57,460 22.71 $ 30.00 to $ 31.99 352,308 2.55 31.12 352,308 31.12 ============================================================================================================================
EMPLOYEE STOCK PURCHASE PLAN -- 1st Source also has an employee stock purchase plan for substantially all employees with at least two years of service on the effective date of an offering under the plan. Eligible employees may elect to purchase any dollar amount of stock, so long as such amount does not exceed 25% of their base rate of pay and the aggregate stock accrual rate for all offerings does not exceed $25,000 in any calendar year. The purchase price for shares offered is the lower of the closing market bid price for the offering date or the average market bid price for the five business days preceding the offering date. The purchase price and discount to the actual market closing price for the 2005, 2004, and 2003 offerings were $21.84 (2.02%), $22.38 (3.69%), and $16.47 (4.96%), respectively. Payment for the stock is made through payroll deductions over the offering period, and employees may discontinue the deductions at any time and exercise the option or take the funds out of the program. The most recent offering began June 1, 2005 and runs through May 31, 2007, with $302,253 in stock value to be purchased at $21.84 per share. The fair value of the employees' purchase rights for the 2005, 2004, and 2003 offerings was estimated using the Black-Scholes model. The following assumptions were used in the model in each of the last three years: a risk-free interest rate of 3.40% for 2005; 2.52% for 2004; and 1.38% for 2003; an expected dividend yield of 2.17% for 2005; 1.66% for 2004; and 2.72% for 2003; an expected volatility factor of 27.49% for 2005; 44.20% for 2004; and 49.56% for 2003; and an expected life of 2.00 years for 2005, 2004, and 2003. The fair value for shares offered in 2005, 2004, and 2003 was $3.44, $5.81, and $4.61, respectively. Pro forma net income and diluted net income per common share, reported as if compensation expense had been recognized under the fair value provisions of SFAS No. 123 for the stock option and employee stock purchase plans, are as follows: 2005 2004 2003 - ------------------------------------------------------------------------ --- Net income (dollars in thousands): As reported $ 33,751 $ 24,965 $ 19,154 Proforma 33,628 24,771 18,921 - ------------------------------------------------------------------------ --- Diluted net income per common share: As reported $ 1.61 $ 1.19 $ 0.91 Proforma $ 1.61 $ 1.18 $ 0.90 ============================================================================ 41 EXECUTIVE INCENTIVE PLAN -- 1st Source's Executive Incentive Plan is also administered by the Committee. Awards under the plan include "book value" shares of common stock. These shares are awarded annually based on weighted performance criteria and vest over a period of five years. The plan shares may only be sold to 1st Source and such sale is mandatory in the event of death, retirement, disability, or termination of employment. Grants under the plan for 2005, 2004, and 2003 are summarized as follows: 2005 2004 2003 - ---------------------------------------------------------------------------- Number of shares 65,418 31,973 13,776 Weighted-average grant-date fair value $15.76 $15.19 $14.77 ============================================================================ SPECIAL LONG-TERM INCENTIVE AWARD -- During February 2001 and February 1996, 1st Source granted special long-term incentive awards, including 1st Source common stock, to participants in the Executive Incentive Plan. Shares granted under the plan vest over a period of ten years. The first 10% was vested at the time of the grants. Subsequent vesting requires (i) the participant to remain an employee of 1st Source and (ii) that 1st Source be profitable on an annual basis, based on the determination of the Committee. RESTRICTED STOCK AWARD PLAN -- 1st Source also has a restricted stock award plan for key employees. Awards under the plan are made to employees recommended by the Chief Executive Officer and approved by the Committee. Shares granted under the plan vest over a five to ten-year period and vesting is based upon meeting certain criteria, including continued employment by 1st Source. Grants under the plan for 2005, 2004, and 2003 are summarized below: 2005 2004 2003 - ---------------------------------------------------------------------------- Number of shares 10,918 2,000 15,158 Weighted-average grant-date fair value $22.24 $20.84 $19.37 ============================================================================ Note L --Subordinated Notes As of December 31, 2005, 1st Source sponsored three trusts, 1st Source Capital Trust II, III and IV (Capital Trusts) of which 100% of the common equity is owned by 1st Source. The Capital Trusts were formed for the purpose of issuing corporation-obligated mandatorily redeemable capital securities (the capital securities) to third-party investors and investing the proceeds from the sale of the capital securities solely in junior subordinated debt securities of 1st Source (the subordinated notes). The subordinated notes held by each Capital Trust are the sole assets of that Capital Trust. Distributions on the capital securities issued by Capital Trust II, III and IV are payable quarterly at a rate per annum equal to the interest rate being earned by the Capital Trust on the subordinated notes held by that Capital Trust. The capital securities are subject to mandatory redemption, in whole or in part, upon repayment of the subordinated notes. 1st Source has entered into agreements which, taken collectively, fully and unconditionally guarantee the capital securities subject to the terms of each of the guarantees. The capital securities held by the Capital Trusts qualify as Tier 1 capital for 1st Source under Federal Reserve Board guidelines. On March 1, 2005, the Federal Reserve issued rules that retain Tier 1 capital treatment for trust preferred securities but with stricter limits. Under the final rules, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements will retain its current limit of 25% of Tier 1 capital elements, net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions. These new rules have no impact on 1st Source's Tier 1 capital. The subordinated notes are summarized as follows, at December 31, 2005: Amount of Interest Maturity (Dollars in thousands) Subordinated Notes Rate Date - -------------------------------------------------------------------------------- March 1997 issuance-floating rate $ 17,784 6.26% 03/31/27 November 2002 issuance-floating rate 10,310 6.95% 11/15/32 September 2004 issuance-fixed rate 30,928 7.66% 12/15/34 - -------------------------------------------------------------------------------- Total $ 59,022 ================================================================================ The March 1997 floating rate issuance interest rate is equal to the sum of the three-month Treasury adjusted to a constant maturity, plus 2.25%. The November 2002 issuance interest rate is fixed at 6.95% until November 15, 2007, at which time it will become floating at an interest rate equal to LIBOR, plus 3.35%. 42 Note M -- Employee Benefit Plans 1st Source maintains the 1st Source Profit Sharing Plan which includes a defined contribution profit sharing and savings plan and a defined contribution money purchase pension plan covering the majority of its employees. The defined contribution profit sharing and savings plan allows eligible employees to make contributions by salary reduction pursuant to Section 401(k) of the Internal Revenue Code. 1st Source is required under the plan to match 100% of participant contributions up to 4% of compensation and one-half of any additional participant contributions up to 6% of compensation, provided that 1st Source is profitable for the respective plan year. 1st Source may also make discretionary contributions to the plan, depending on its profitability. Contribution expense for this plan for the years ended December 31, 2005, 2004, and 2003, amounted to $2.21 million, $1.65 million, and $1.99 million, respectively. Contributions to the defined contribution money purchase pension plan are based on 2% of participants' eligible compensation. For the years ended December 31, 2005, 2004, and 2003, total pension expense for this plan amounted to $0.86 million, $0.72 million, and $0.87 million, respectively. Trustcorp contributes to a defined contribution plan for all of its employees who meet the general eligibility requirements of the plan. Contribution expense for this plan for the years ended December 31, 2005, 2004, and 2003, amounted to $0.14 million, $0.13 million, and $0.16 million, respectively. In addition to the 1st Source Profit Sharing Plan, 1st Source provides certain health care and life insurance benefits for substantially all of its retired employees. All of 1st Source's full-time employees become eligible for these retiree benefits upon reaching age 55 with 20 years of credited service. The medical plan pays a stated percentage of eligible medical expenses reduced for any deductibles and payments made by government programs and other group coverage. The lifetime maximum benefit payable under the medical plan is $15,000 and life insurance is $3,000. 1st Source's net periodic postretirement benefit cost recognized in the consolidated financial statements for the years ended December 31, 2005, 2004, and 2003 amounted to $0.33 million, $0.10 million, and ($0.34) million, respectively. 1st Source's accrued postretirement benefit cost was not material at December 31, 2005, 2004 and 2003. Note N -- Income Taxes Income tax expense was comprised of the following: Year Ended December 31 (Dollars in thousands) 2005 2004 2003 - -------------------------------------------------------------------------------- Current: Federal $ 16,625 $ 2,920 $ 9,226 State 1,909 870 2,315 - -------------------------------------------------------------------------------- Total current 18,534 3,790 11,541 - -------------------------------------------------------------------------------- Deferred: Federal (2,644) 4,610 (2,697) State (264) 736 (815) - -------------------------------------------------------------------------------- Total deferred (2,908) 5,346 (3,512) - -------------------------------------------------------------------------------- Total provision $ 15,626 $ 9,136 $ 8,029 ================================================================================ The reasons for the difference between income tax expense and the amount computed by applying the statutory federal income tax rate (35%) to income before income taxes are as follows:
2005 2004 2003 Percent of Percent of Percent of Pretax Pretax Pretax Year Ended December 31 (Dollars in thousands) Amount Income Amount Income Amount Income - ---------------------------------------------------- ------------------ ------ ----- ------------- ------------------------ -------- Statutory federal income tax $ 17,282 35.0% $ 11,935 35.0% $ 9,514 35.0% (Decrease) increase in income taxes resulting from: Tax-exempt interest income (1,749) (3.5) (1,782) (5.2) (1,969) (7.3) State taxes, net of federal income tax benefit 1,069 2.2 1,044 3.1 975 3.6 Dividends received deduction (188) (0.4) (1,607) (4.7) (48) (0.2) Other (788) (1.6) (454) (1.4) (443) (1.6) - ---------------------------------------------------- ------------------ ------ ----- ------------- ------------------------ -------- Total $ 15,626 31.7% $ 9,136 26.8% $ 8,029 29.5% ====================================================================================================================================
The tax expense (benefit) applicable to securities gains and losses for the years 2005, 2004 and 2003 was $134,000, $(1,808,000) and $(1,508,000), respectively. 43 Deferred tax assets and liabilities as of December 31, 2005 and 2004 consisted of the following:
Year Ended December 31 (Dollars in thousands) 2005 2004 - ----------------------------------------------------------------------------------------- ----------- Deferred tax assets: Reserve for loan and lease losses $ 23,060 $ 26,396 Accruals for employee benefits 5,120 3,680 Net unrealized losses on securities available-for-sale 2,013 184 Securities valuation reserve 1,150 (134) Alternative minimum tax - 2,567 Other 1,010 1,637 - ----------------------------------------------------------------------------------------- ----------- Total deferred tax assets 32,353 34,330 - ----------------------------------------------------------------------------------------- ----------- Deferred tax liabilities: Differing depreciable bases in premises and leased equipment 34,433 40,141 Mortgage servicing 7,534 8,278 Differing bases in assets related to acquisitions 959 1,734 Other 2,732 2,219 - ----------------------------------------------------------------------------------------- ----------- Total deferred tax liabilities 45,658 52,372 - ----------------------------------------------------------------------------------------- ----------- Net deferred tax liability $ 13,305 $ 18,042 =====================================================================================================
Note 0 -- Contingent Liabilities, Commitments, and Financial Instruments with Off-Balance-Sheet Risk CONTINGENT LIABILITIES --1st Source and its subsidiaries are defendants in various legal proceedings arising in the normal course of business. In the opinion of management, based upon present information including the advice of legal counsel, the ultimate resolution of these proceedings will not have a material effect on 1st Source's consolidated financial position or results of operation. COMMITMENTS -- 1st Source and its subsidiaries are obligated under operating leases for certain office premises and equipment. In 1982, 1st Source sold the headquarters building and entered into a leaseback agreement with the purchaser. At December 31, 2005, the remaining term of the lease was six years with options to renew for up to 15 additional years. Approximately 30% of the facility is subleased to other tenants. Future minimum rental commitments for all noncancellable operating leases total approximately, $2.87 million in 2006, $2.25 million in 2007, $1.89 million in 2008, $1.63 million in 2009, $1.28 million in 2010, and $2.09 million, thereafter. As of December 31, 2005, future minimum rentals to be received under noncancellable subleases totaled $3.43 million. Rental expense of office premises and equipment and related sublease income were as follows: Year Ended December 31 (Dollars in thousands) 2005 2004 2003 - --------------------------------------------------------------------------- Gross rental expense $ 3,574 $ 3,075 $ 3,216 Sublease rental income (1,809) (1,558) (1,502) - --------------------------------------------------------------------------- Net rental expense $ 1,765 $ 1,517 $ 1,714 =========================================================================== FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK --To meet the financing needs of its customers, 1st Source and its subsidiaries are parties to financial instruments with off-balance-sheet risk in the normal course of business. These off-balance-sheet financial instruments include commitments to originate, purchase and sell loans, and standby letters of credit. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. 1st Source's exposure to credit loss in the event of nonperformance by the other party to the financial instruments for loan commitments and standby letters of credit is represented by the dollar amount of those instruments. 1st Source uses the same credit policies and collateral requirements in making commitments and conditional obligations as it does for on-balance-sheet instruments. Loan commitments have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Trustcorp and the Bank grant mortgage loan commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan commitments is managed by entering into contracts for future deliveries of loans. Letters of credit are conditional commitments issued by 1st Source to guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit are essentially the same as those involved in extending loan commitments to customers. 44 As of December 31, 2005 and 2004, 1st Source and its subsidiaries had commitments outstanding to originate and purchase mortgage loans aggregating $130.73 million and $106.61 million, respectively. Outstanding commitments to sell loans aggregated $98.39 million at December 31, 2005, and $83.82 million at December 31, 2004. Standby letters of credit totaled $76.43 million and $90.67 million at December 31, 2005 and 2004, respectively. Standby letters of credit have terms ranging from six months to one year. Note P -- Derivative Financial Instruments 1st Source has certain interest rate derivative positions that are not designated as hedging instruments. These derivative positions relate to transactions in which 1st Source enters 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, 1st Source agrees to pay interest to the client on a notional amount at a variable interest rate and receive interest from the client on a same notional amount at a fixed interest rate. At the same time, 1st Source agrees 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 1st Source's client to effectively convert a variable rate loan to a fixed rate. Because 1st Source acts as an intermediary for its client, changes in the fair value of the underlying derivative contracts offset each other and do not impact 1st Source's results of operations. At December 31, 2005, the notional amount of non-hedging interest rate swaps was $5.61 million. Note Q -- Regulatory Matters 1st Source is subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements can result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a material effect on 1st Source's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, 1st Source must meet specific capital guidelines that involve quantitative measures of 1st Source's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. 1st Source's capital amounts and classification are subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require 1st Source to maintain minimum amounts and ratios of total capital and Tier I capital to risk-weighted assets and of Tier I capital to average assets. Management believes that 1st Source meets all capital adequacy requirements to which it is subject. As of December 31, 2005, the most recent notification from the Federal bank regulators categorized the Bank, the largest of 1st Source's subsidiaries, as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as "well capitalized" 1st Source must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table below. There are no conditions or events since that notification that management believes will have changed the institution's category. As discussed in Note L, the capital securities held by the Capital Trusts qualify as Tier 1 capital for 1st Source under Federal Reserve Board guidelines. The actual capital amounts and ratios of 1st Source and its largest subsidiary, the Bank, as of December 31, 2005, are presented in the table below:
To Be Well Capitalized Under Minimum Capital Prompt Corrective Actual Adequacy Action Provisions (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio - ------------------------------------------------------------------------------------------------------------------------- Total Capital (to Risk-Weighted Assets): Consolidated $ 421,771 14.90% $ 226,521 8.00% $ 283,151 10.00% 1st Source Bank 397,061 14.29% 222,211 8.00% 277,763 10.00% Tier I Capital (to Risk-Weighted Assets): Consolidated 384,685 13.59% 113,261 4.00% 169,891 6.00% 1st Source Bank 361,760 13.02% 111,105 4.00% 166,658 6.00% Tier I Capital (to Average Assets): Consolidated 384,685 11.42% 134,725 4.00% 168,406 5.00% 1st Source Bank 361,760 11.02% 131,327 4.00% 164,159 5.00% =========================================================================================================================
The Bank is required to maintain noninterest bearing cash balances with the Federal Reserve Bank. The average balance of these deposits for the years ended December 31, 2005 and 2004, were approximately $8.45 million and $4.81 million, respectively. Dividends that may be paid by a subsidiary bank to the parent company are subject to certain legal and regulatory limitations and also may be affected by capital needs, as well as other factors. Without regulatory approval, the Bank can pay dividends in 2006 of $56.97 million, plus an additional amount equal to its net profits for 2006, as defined by statute, up to the date of any such dividend declaration. 1st Source's mortgage subsidiary, Trustcorp, is required to maintain minimum net worth capital requirements established by various governmental agencies. Trustcorp's net worth requirements are governed by the Department of Housing and Urban Development and GNMA. As of December 31, 2005, Trustcorp met its minimum net worth capital requirements. 45 Note R -- Fair Values of Financial Instruments The fair values of 1st Source's financial instruments as of December 31, 2005 and 2004 are summarized in the table below.
2005 2004 Carrying or Carrying or (Dollars in thousands) Contract Value Fair Value Contract Value Fair Value - ------------------------------------------------------------- ------------------------ -------------------------------- ------------ Assets: Cash and due from banks $ 124,817 $ 124,817 $ 78,255 $ 78,255 Federal funds sold and interest bearing deposits with other banks 68,578 68,578 220,131 220,131 Investment securities, available-for-sale 632,625 632,625 789,923 789,923 Mortgages held for sale 67,224 67,448 55,711 55,821 Loans and leases, net of reserve for loan and lease losses 2,404,734 2,380,891 2,216,496 2,221,357 Interest rate swaps 65 65 - - - ------------------------------------------------------------- ------------------------ -------------------------------- ------------ Liabilities: Deposits $ 2,745,587 $ 2,750,212 $ 2,807,003 $ 2,816,693 Short-term borrowings 277,469 277,469 299,662 299,662 Long-term debt and mandatorily redeemable securities 23,237 23,065 17,964 18,033 Subordinated notes 59,022 58,619 59,022 59,767 Interest rate swaps 65 65 652 652 Off-balance-sheet instruments * - (431) - (593) ====================================================================================================================================
* Represents estimated cash outflows required to currently settle the obligations at current market rates. The following methods and assumptions were used by 1st Source in estimating the fair value of its financial instruments: CASH AND CASH EQUIVALENTS -- The carrying values reported in the consolidated statements of financial condition for cash and due from banks, Federal funds sold and interest bearing deposits with other banks approximate fair values for these assets. INVESTMENT SECURITIES -- Fair values for securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are estimated based on quoted market prices of comparable investments. LOANS AND LEASES -- For variable rate loans and leases that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for certain real estate loans (e.g., one-to-four single family residential mortgage loans) are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. The fair values of all other loans and leases are estimated using discounted cash flow analyses which use interest rates currently being offered for loans and leases with similar terms to borrowers of similar credit quality. DEPOSITS -- The fair values for all deposits other than time deposits are equal to the amounts payable on demand (the carrying value). Fair values of variable rate time deposits are equal to their carrying values. Fair values for fixed rate time deposits are estimated using discounted cash flow analyses using interest rates currently being offered for deposits with similar remaining maturities. SHORT-TERM BORROWINGS -- The carrying values of Federal funds purchased, securities sold under repurchase agreements, and other short-term borrowings, including 1st Source's liability related to mortgage loans available for repurchase under GNMA optional repurchase programs, approximate their fair values. LONG-TERM DEBT AND MANDATORILY REDEEMABLE SECURITIES -- The fair values of 1st Source's long-term debt are estimated using discounted cash flow analyses, based on 1st Source's current estimated incremental borrowing rates for similar types of borrowing arrangements. The carrying values of mandatorily redeemable securities are based on approximate fair values. SUBORDINATED NOTES -- Fair values are based on quoted market prices, where available. If quoted market prices are not available, fair values are estimated based on calculated market prices of comparable securities. INTEREST RATE SWAPS -- The carrying values of interest rate swaps are based on approximate fair values. GUARANTEES AND LOAN COMMITMENTS -- Contract and fair values for certain of 1st Source's off-balance-sheet financial instruments (guarantees and loan commitments) are estimated based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing. OFF-BALANCE-SHEET INSTRUMENTS -- Fair values for off-balance-sheet instruments are based on the net amount necessary to currently settle the transaction. LIMITATIONS -- Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments. Because no market exists for a significant portion of 1st Source's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other such factors. These estimates do not reflect any premium or discount that could result from offering for sale at one time 1st Source's entire holdings of a particular financial instrument. These estimates are subjective in nature and require considerable judgment to interpret market data. Accordingly, the estimates presented herein are not necessarily indicative of the amounts 1st Source could 46 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 mortgage banking operation, premises and equipment, other assets, and liabilities not defined as financial instruments, are not included in the above disclosures. In addition, for investment and mortgage-backed securities, the income tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in many of the estimates. Also, the fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market. Note S -- 1st Source Corporation (Parent Company Only) Financial Information
STATEMENTS OF FINANCIAL CONDITION December 31 (Dollars in thousands) 2005 2004 - ----------------------------------------------------------------------------- ------------------------------------------------------ ASSETS - ------ Cash $ 1 $ 2 Short-term investments with bank subsidiary 11,562 5,233 Investment securities, available-for-sale (amortized cost of $12,893 and $17,740 at December 31, 2005 and 2004, respectively) 15,282 20,037 Investments in: Bank subsidiaries 376,538 355,421 Non-bank subsidiaries 9,544 8,134 Loan receivables: Non-bank subsidiaries 6,000 7,000 Premises and equipment, net 2,143 2,330 Other assets 8,074 5,952 - ----------------------------------------------------------------------------- ------------------------------------------ ----------- Total assets $ 429,144 $ 404,109 ==================================================================================================================================== LIABILITIES AND SHAREHOLDERS' EQUITY - ------------------------------------ Commercial paper borrowings $ 4,800 $ 836 Other liabilities 3,033 1,385 Long-term debt and mandatorily redeemable securities 75,735 75,288 - ----------------------------------------------------------------------------- ------------------------------------------ ----------- Total liabilities 83,568 77,509 Shareholders' equity 345,576 326,600 - ------------------------------------------------------------------------ ----------------------------------------------- ----------- Total liabilities and shareholders' equity $ 429,144 $ 404,109 ====================================================================================================================================
47 STATEMENTS OF INCOME Year Ended December 31 (Dollars in thousands) 2005 2004 2003 - ------------------------ ---------------------------------------------------------- ------------------- ----------- ----------- Income: Dividends from bank and non-bank subsidiaries $ 11,552 $ 9,749 $ 8,715 Rental income from subsidiaries 2,472 829 2,668 Other 3,286 2,721 1,306 - ----------------------------------------------------------------------------------- ------------------- ----------- ----------- Total income 17,310 13,299 12,689 - ----------------------------------------------------------------------------------- ------------------- ----------- ----------- Expenses: Interest on long-term debt and mandatorily redeemable securities 5,040 4,869 4,725 Interest on commercial paper and other short-term borrowings 73 10 26 Rent expense 1,059 1,059 1,059 Other 2,352 2,705 1,998 - ----------------------------------------------------------------------------------- ------------------- ----------- ----------- Total expenses 8,524 8,643 7,808 - ----------------------------------------------------------------------------------- ------------------- ----------- ----------- Income before income tax benefit and equity in undistributed income of subsidiaries 8,786 4,656 4,881 Income tax benefit 897 2,269 1,386 - ----------------------------------------------------------------------------------- ------------------- ----------- ----------- Income before equity in undistributed income of subsidiaries 9,683 6,925 6,267 Equity in undistributed income of subsidiaries: Bank subsidiaries 24,057 19,832 13,285 Non-bank subsidiaries 11 (1,792) (398) - ----------------------------------------------------------------------------------- ------------------- ----------- ----------- Net income $ 33,751 $ 24,965 $ 19,154 ===============================================================================================================================
STATEMENTS OF CASH FLOWS Year Ended December 31 (Dollars in thousands) 2005 2004 2003 - ------------------------ ---------------------------------------------------------- ------------------- ----------- ----------- Operating activities: Net income $ 33,751 $ 24,965 $ 19,154 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed income of subsidiaries (24,068) (18,040) (12,887) Depreciation of premises and equipment 305 283 338 Realized and unrealized investment securities (gains)losses (72) 851 1,092 Other (218) 523 (820) - ------------------------------------------------ ---------------------------------- ------------------- ----------- ----------- Net cash from operating activities 9,698 8,582 6,877 - ------------------------------------------------ ---------------------------------- ------------------- ----------- ----------- Investing activities: Proceeds from sales and maturities of investment securities 15,356 6,645 1,895 Purchases of investment securities (10,361) - (313) Net change in premises and equipment (118) (264) (262) (Increase) decrease in short-term investments with bank subsidiary (6,329) (2,080) 1,926 Decrease (increase) in loans made to subsidiaries, net 1,000 (285) (1,715) Capital contributions to subsidiaries (1,460) - - Return of capital from subsidiaries - 500 - - ----------------------------------------------------------------------------------- ------------------- ----------- ----------- Net cash (used in) from investing activities (1,912) 4,516 1,531 - ----------------------------------------------------------------------------------- ------------------- ----------- ----------- Financing activities: Net increase (decrease) in commercial paper and other short-term borrowings 3,964 (146) (2,456) Proceeds from issuance of subordinated notes - 30,929 - Payments on subordinated notes - (28,351) - Proceeds from issuance of long-term debt 311 18 47 Payments on long-term debt (44) (5,048) (94) Net proceeds from issuance of treasury stock 528 3,253 2,598 Acquisition of treasury stock (2,221) (4,958) (646) Cash dividends (10,325) (8,863) (7,789) - ----------------------------------------------------------------------------------- ------------------- ----------- ----------- Net cash used in financing activities (7,787) (13,166) (8,340) - ----------------------------------------------------------------------------------- ------------------- ----------- ----------- Net change in cash and cash equivalents (1) (68) 68 Cash and cash equivalents, beginning of year 2 70 2 Cash and cash equivalents, end of year $ 1 $ 2 $ 70 ===============================================================================================================================
48 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None ITEM 9A. CONTROLS AND PROCEDURES. MANAGEMENT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING - -------------------------------------------------------------- Management of 1st Source Corporation ("1st Source") is responsible for establishing and maintaining adequate internal control over financial reporting. 1st Source's internal control over financial reporting includes policies and procedures pertaining to 1st Source's ability to record, process, and report reliable information. Actions are taken to correct any deficiencies as they are identified through internal and external audits, regular examinations by bank regulatory agencies, 1st Source's formal risk management process, and other means. 1st Source's internal control system is designed to provide reasonable assurance to 1st Source's management and Board of Directors regarding the preparation and fair presentation of 1st Source's published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Further, because of changes in conditions, the effectiveness of internal control may vary over time. 1st Source's management assessed the effectiveness of internal control over financial reporting as of December 31, 2005. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control -- Integrated Framework. Based on management's assessment, we believe that, as of December 31, 2005, 1st Source's internal control over financial reporting is effective based on those criteria. Ernst & Young LLP, independent registered public accounting firm, has issued an attestation report on management's assessment of 1st Source's internal control over financial reporting. This report appears on page 25. /s/ CHRISTOPHER J. MURPHY III /s/ LARRY E. LENTYCH - ----------------------------- -------------------- Christopher J. Murphy III, Larry E. Lentych, Chief Executive Officer Chief Financial Officer South Bend, Indiana ITEM 9B. OTHER INFORMATION. None 49 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information under the caption "Proposal Number 1: Election of Directors," "Board Committees and other Corporate Governance Matters," and "Section 16(a) Beneficial Ownership Reporting Compliance" of the 2006 Proxy Statement is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION. The information under the caption "Remuneration of Executive Officers" of the 2006 Proxy Statement is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information under the caption "Voting Securities and Principal Holders Thereof" and "Proposal Number 1: Election of Directors" of the 2006 Proxy Statement is incorporated herein by reference.
Equity Compensation Plan Information: (a) (b) (c) Number of Securities Remaining Available for Future Issuance Number of Securities to be Weighted-average Under Equity Issued upon Exercise of Exercise Price of Compensation Plans Outstanding Options, Outstanding Options, [excluding securities Warrants and Rights Warrants and Rights reflected in column (a)] - --------------------------------------------- ----------------------------- ---------------------------- ------------------- ----- Equity compensation plans approved by shareholders 1992 stock option plan 445,291 $ 27.97 - 2001 stock option plan 82,748 19.32 1,917,252 1997 employee stock purchase plan 22,863 22.08 165,847 1982 executive incentive plan - - 100,000 (1)(2) 1982 restricted stock award plan - - 172,362 (1) - --------------------------------------------- ----------------------------- ---------------------------- ------------------- ----- Total plans approved by shareholders 550,902 $ 26.43 2,355,461 - --------------------------------------------- ----------------------------- ---------------------------- ------------------- ----- Equity compensation plans not approved by shareholders - - - - --------------------------------------------- -------------------------------- ----------------------------- -------------------- Total equity compensation plans 550,902 $ 26.43 2,355,461 ==================================================================================================================================
(1)Amount is to be awarded by grants administered by the Executive Compensation Committee of the 1st Source Board of Directors. (2)Amount includes market value stock only. Book value shares used for annual awards may only be sold to 1st Source. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information under the caption "Proposal Number 1: Election of Directors" of the 2006 Proxy Statement is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES. The information under the caption "Relationship with Independent Registered Public Accounting Firm" of the 2006 Proxy Statement is incorporated herein by reference. 50 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES. (a) Financial Statements and Schedules: The following Financial Statements and Supplementary Data are filed as part of this annual report: Reports of Independent Registered Public Accounting Firm Consolidated statements of financial condition -- December 31, 2005 and 2004 Consolidated statements of income -- Years ended December 31, 2005, 2004, and 2003 Consolidated statements of shareholders' equity -- Years ended December 31, 2005, 2004, and 2003 Consolidated statements of cash flows -- Years ended December 31, 2005, 2004, and 2003 Notes to consolidated financial statements -- December 31, 2005, 2004, and 2003 Financial statement schedules required by Article 9 of Regulation S-X are not required under the related instructions, or are inapplicable and, therefore, have been omitted. (b) Exhibits (numbered in accordance with Item 601 of Regulation S-K): 3(a) Articles of Incorporation of Registrant, as amended April 30, 1996, and filed as exhibit to Form 10-K, dated December 31, 1996, and incorporated herein by reference. 3(b) By-Laws of Registrant, as amended January 29, 2004, filed as exhibit to Form 10-K, dated December 31, 2003, and incorporated herein by reference. 4(a) Form of Common Stock Certificates of Registrant filed as exhibit to Registration Statement 2-40481 and incorporated herein by reference. 4(c)(1) Form of Floating Rate Cumulative Trust Preferred Securities Indenture, dated March 21, 1997, filed as exhibit to Form 10-K, dated December 31, 1997, and incorporated herein by reference. 4(c)(2) Form of Floating Rate Cumulative Trust Preferred Securities Trust Agreement, dated March 21, 1997, filed as exhibit to Form 10-K, dated December 31, 1997, and incorporated herein by reference. 4(c)(3) Form of Floating Rate Cumulative Trust Preferred Securities Guarantee Agreement, dated March 21, 1997, filed as exhibit to Form 10-K, dated December 31, 1997, and incorporated herein by reference. 4(d) Agreement to Furnish Long-term Debt Instruments, dated February 11, 2003, filed as an exhibit to Form 10-K, dated December 31, 2002, and incorporated herein by reference. 10(a)(1) Employment Agreement of Christopher J. Murphy III, dated April 16, 1998, filed as exhibit to Form 10-K, dated December 31, 1998, and incorporated herein by reference. 10(a)(2) Employment Agreement of Wellington D. Jones III, dated April 16, 1998, filed as exhibit to Form 10-K, dated December 31, 1998, and incorporated herein by reference. 10(a)(4) Employment Agreement of Larry E. Lentych, dated April 16, 1998, filed as exhibit to Form 10-K, dated December 31, 1998, and incorporated herein by reference. 10(a)(5) Employment Agreement of Richard Q. Stifel, dated April 16, 1998, filed as exhibit to Form 10-K, dated December 31, 1998, and incorporated herein by reference. 10(a)(6) Employment Agreement of John B. Griffith, dated March 31, 2001, filed as exhibit to Form 10-K, dated December 31, 2002, and incorporated herein by reference. 10(b) 1st Source Corporation Employee Stock Purchase Plan dated April 17, 1997, filed as exhibit to Form 10-K, dated December 31, 1997, and incorporated herein by reference. 10(c) 1st Source Corporation 1982 Executive Incentive Plan, amended January 17, 2003, and filed as exhibit to Form 10-K, dated December 31, 2003, and incorporated herein by reference. 10(d) 1st Source Corporation 1982 Restricted Stock Award Plan, amended January 17, 2003, and filed as exhibit to Form 10-K, dated December 31, 2003, and incorporated herein by reference. 10(e) 1st Source Corporation 2001 Stock Option Plan, filed as an exhibit to 1st Source Corporation Proxy Statement dated March 7, 2001, and incorporated herein by reference. 10(g)(1) 1st Source Corporation 1992 Stock Option Plan, dated April 23, 1992, as amended December 11, 1997, filed as exhibit to Form 10-K, dated December 31, 1997, and incorporated herein by reference. 10(g)(2) An amendment to 1st Source Corporation 1992 Stock Option Plan, dated July 18, 2000, and filed as exhibit to Form 10-K, dated December 31, 2000, and incorporated herein by reference. 51 10(h) 1st Source Corporation 1998 Performance Compensation Plan, dated February 19, 1998, filed as exhibit to Form 10-K, dated December 31, 1998, and incorporated herein by reference. 10(i) Consulting Agreement of Ernestine M. Raclin, dated April 14, 1998, filed as exhibit to Form 10-K, dated December 31, 1998, and incorporated herein by reference. 10(j) Contract with Fiserv Solutions, Inc., dated November 23, 2005, filed as exhibit to Form 10-K, dated, December 31, 2005, and incorporated Inc. dated herein by reference. 21 Subsidiaries of Registrant (unless otherwise indicated, each subsidiary does business under its own name): Name Jurisdiction ---- ------------ 1st Source Bank Indiana SFG Equipment Leasing, Inc. * Indiana 1st Source Insurance, Inc. * Indiana 1st Source Specialty Finance, Inc. * Indiana FBT Capital Corporation (Inactive) Indiana 1st Source Leasing, Inc. Indiana 1st Source Capital Corporation * Indiana Trustcorp Mortgage Company Indiana 1st Source Capital Trust II Delaware 1st Source Capital Trust III Delaware 1st Source Capital Trust IV Delaware Michigan Transportation Finance Corporation * Michigan 1st Source Intermediate Holding, LLC Delaware 1st Source Funding, LLC Delaware 1st Source Corporation Investment Advisors, Inc. * Indiana SFG Commercial Aircraft Leasing, Inc. * Indiana SFG Equipment Leasing Corporation I* Indiana *Wholly-owned subsidiaries of 1st Source Bank 23 Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm. 31.1 Certification of Christopher J. Murphy III, Chief Executive Officer (Rule 13a-14(a)). 31.2 Certification of Larry E. Lentych, Chief Financial Officer (Rule 13a-14(a)). 32.1 Certification of Christopher J. Murphy III, Chief Executive Officer. 32.2 Certification of Larry E. Lentych, Chief Financial Officer. (c) Financial Statement Schedules -- None. 52 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. 1st SOURCE CORPORATION By /s/ CHRISTOPHER J. MURPHY III ------------------------------------------------------- Christopher J. Murphy III, Chairman of the Board, President and Chief Executive Officer Date: March 3, 2006 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /s/ CHRISTOPHER J. MURPHY III - ------------------------------- Chairman of the Board, March 3, 2006 Christopher J. Murphy III President and Chief Executive Officer /s/ WELLINGTON D. JONES III Executive Vice President March 3, 2006 - ------------------------------- and Director Wellington D. Jones III /s/ LARRY E. LENTYCH Treasurer, March 3, 2006 - ------------------------------- Chief Financial Officer Larry E. Lentych and Principal Accounting Officer /s/ JOHN B. GRIFFITH Secretary March 3, 2006 - ------------------------------- and General Counsel John B. Griffith /s/ DAVID C. BOWERS Director March 3, 2006 - ------------------------------- David C. Bowers /s/ DANIEL B. FITZPATRICK Director March 3, 2006 - ------------------------------- Daniel B. Fitzpatrick /s/ TERRY L. GERBER Director March 3, 2006 - ------------------------------- Terry L. Gerber /s/ LAWRENCE E. HILER Director March 3, 2006 - ------------------------------- Lawrence E. Hiler /s/ WILLIAM P. JOHNSON Director March 3, 2006 - ------------------------------- William P. Johnson /s/ CRAIG A. KAPSON Director March 3, 2006 - ------------------------------- Craig A. Kapson /s/ REX MARTIN Director March 3, 2006 - ------------------------------- Rex Martin /s/ DANE A. MILLER Director March 3, 2006 - ------------------------------- Dane A. Miller /s/ TIMOTHY K. OZARK Director March 3, 2006 - ------------------------------- Timothy K. Ozark /s/ JOHN T. PHAIR Director March 3, 2006 - ------------------------------- John T. Phair /s/ MARK D. SCHWABERO Director March 3, 2006 - ------------------------------- Mark D. Schwabero /s/ TOBY S. WILT Director March 3, 2006 - ------------------------------- Toby S. Wilt EX-23.1 2 consent23.txt CONSENT OF E & Y Exhibit 23 Consent of Independent Registered Public Accounting Firm We consent to the incorporation by reference in the Registration Statements listed below of 1st Source Corporation of our reports dated March 2, 2006, with respect to the consolidated financial statements of 1st Source Corporation and subsidiaries, 1st Source Corporation management's assessment of the effectiveness of internal control over financial reporting, and the effectiveness of internal control over financial reporting of 1st Source Corporation, included in this Annual Report (Form 10-K) for the year ended December 31, 2005. Registration Statement No. 333-101712 on Form S-8 dated December 6, 2002 Registration Statement No. 333-101711 on Form S-8 dated December 6, 2002 Registration Statement No. 333-101710 on Form S-8 dated December 6, 2002 Registration Statement No. 333-101709 on Form S-8 dated December 6, 2002 Registration Statement No. 333-64314 on Form S-8 dated July 2, 2001 Registration Statement No. 333-64306 on Form S-8 dated July 2, 2001 Registration Statement No. 333-64304 on Form S-8 dated July 2, 2001 Registration Statement No. 333-26243 dated April 30, 1997 Registration Statement No. 33-81852 dated July 22, 1994 Registration Statement No. 33-8840 dated September 16, 1986 /s/ Ernst & Young LLP Chicago, Illinois March 2, 2006 EX-31.1 3 ceo31_1.txt CERTIFICATION CEO EXHIBIT 31.1 CERTIFICATIONS I, Christopher J. Murphy III, Chief Executive Officer, certify that: 1. I have reviewed this annual report on Form 10-K of 1st Source Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's Board of Directors: a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 3, 2006 By /s/ CHRISTOPHER J. MURPHY III - -------------------------------------------------- Christopher J. Murphy III, Chief Executive Officer EX-31.2 4 cfo31_2.txt CERTIFICATION CFO EXHIBIT 31.2 CERTIFICATIONS I, Larry E. Lentych, Chief Financial Officer, certify that: 1. I have reviewed this annual report on Form 10-K of 1st Source Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's Board of Directors: a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 3, 2006 By /s/ LARRY E. LENTYCH - ----------------------------------------- Larry E. Lentych, Chief Financial Officer EX-32.1 5 ceo32_1.txt CERTIFICATION CEO EXHIBIT 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of 1st Source Corporation (1st Source) on Form 10-K for the fiscal year ended December 31, 2005, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Christopher J. Murphy III, Chief Executive Officer of 1st Source, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge: (1) The Report fully complies with the requirements of sections 13(a) or 15(d) of the Securities and Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of 1st Source. Date: March 3, 2006 By /s/ CHRISTOPHER J. MURPHY III - -------------------------------------------------- Christopher J. Murphy III, Chief Executive Officer EX-32.2 6 cfo32_2.txt CERTIFICATION CFO EXHIBIT 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of 1st Source Corporation (1st Source) on Form 10-K for the fiscal year ended December 31, 2005, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Larry E. Lentych, Chief Financial Officer of 1st Source, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge: (1) The Report fully complies with the requirements of sections 13(a) or 15(d) of the Securities and Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of 1st Source. Date: March 3, 2006 By /s/ LARRY E. LENTYCH - ----------------------------------------- Larry E. Lentych, Chief Financial Officer EX-10 7 fiserv.txt CONTRACT WITH FISERV SOLUTIONS, INC. Exhibit 10 (j) LICENSE AND SERVICE AGREEMENT This License and Service Agreement ('Agreement') numbered 3810225 is entered into as of November 23, 2005 ('Effective Date') by and between Fiserv Solutions, Inc., a Wisconsin corporation with offices located at 600 Colonial Center Parkway, Lake Mary, Florida 32746 ("Fiserv") and 1st Source Bank, a State chartered bank organized under the laws of Indiana, with offices located at 100 North Michigan, South Bend, Indiana 46601 ("Client'). WITNESSETH: WHEREAS, Fiserv is the licensor of Software (as defined below), and WHEREAS, Client wishes to install and Use (as defined below) Software in Client's premises. NOW, THEREFORE, the parties agree as follows: 1. DEFINITIONS The following definitions are used in this Agreement: 1.1 'Basic Maintenance Services' means maintenance services described in Section 5 below. Basic Maintenance Services are available only with respect to the current and last prior Software release made generally available to all Fiserv clients licensed to use the applicable Software. 1.2 `Business Requirements List' means Client's detailed operational and business requirements as relates to the functioning of the Software. 1.3 `CBS Core Application' means the Software listed in License section of Exhibit M-1 under the heading "Core Application." 1.4 `Change Request' means changes to scope or pricing for a professional service deliverable as specified on Fiserv's then current Change Request form. 1.5 'Client Confidential Information' means any confidential plans, procedures, products, policies, research, development, trade secrets, business affairs, customer lists, information, and other proprietary material of Client that is marked with a restrictive legend, or if not so marked with such legend or if disclosed orally, is identified as confidential at the time of disclosure (and written confirmation thereof is promptly provided to Fiserv); (B) any information and data concerning the business and financial records of Client's customers prepared by or for Fiserv, or used in any way by Fiserv in connection with the provision of Services (whether or not any such information is marked with a restrictive legend; and (C) any information and data received from Client that Fiserv reasonably ought to know is confidential (whether or not any such information is marked with a restrictive legend). 1.6 'Computer System' means the manufacturer-supplied equipment and software identified on each Exhibit 1n. Client shall have sole responsibility to own or lease, unpack, plan, install, test, and maintain the equipment according to any and all applicable building or electrical codes, regulations or requirements, as well as the manufacturer and Fiserv recommendations. 1.7 'Documentation' means the Software documentation specified on each Exhibit 1n. 1.8 `Effective Date' means the date identified as such in this Agreement as the date upon which this Agreement shall commence. 1.9 'Enhancements' means modifications made to Software that add program features or functions not originally within the Software and that are provided upon payment of additional License Fees. Fiserv reserves the right to determine which changes are upgrades or separately priced enhancements. 1.10 'Equipment' means the computer hardware identified on each Exhibit 2n. 1.11 'Exhibit 1n' and 'Exhibit 2n' means each sequentially lettered Exhibit for Software and Equipment, respectively, to be provided by Fiserv to Client under this Agreement; e.g. Exhibit 1A, 1B, 1C, Exhibit 2A, 2B, 2C. 1.12 `Functional Specifications' means the description of the detailed functionality changes to Software developed by Fiserv that are based on the Business Requirements List approved by Client. 1.13 `License" means rights to Use the Software, as set forth in Section 2.1, at the Location on the designated Computer System (i) to process the designated number of accounts; or (ii) by the maximum number of users, or other fee determinant specified in each Exhibit 1n. 1.14 'Location' means the premises identified on each Exhibit 1n. 1.15 'Maintenance Fee' means the annual fee specified in each Exhibit 1n for Basic Maintenance Services. 1.16 `Modifications' means changes or interfaces made by Fiserv to the Software at Client's request, that are provided pursuant to Section 4 below and for which Special Maintenance Fees will apply. 1.17 'Non-conformity' means a failure of Software to perform in substantial accordance with the functions described in the Documentation. 1.18 'Operational Support' means optional Fiserv services available, at Client request, to support Client's Software operation. Operational Support shall only be available if Client is receiving Basic Maintenance Services. 1.19 `PRDA' means a Project Requirements Definition Authorization or similar work authorization signed by Client. 1.20 'Professional Service Fees' means fees specified in each Exhibit 1n for professional services provided by Fiserv related to the Software. 1.21 `Services' means Professional Services, Basic Maintenance Services, and Special Maintenance Services. 1.22 'Software' means the standard, unmodified computer programs in object code (or in the case of the CBS Core Application as specified in Exhibit 1A, standard, unmodified computer programs provided in source code), together with one set of Documentation as specified in each Exhibit 1n. Software does not include separate, independent, and stand-alone modules or subsystems that Client has developed and maintained without Fiserv's assistance. 1.23 'Software System' means the Software and Third Party Software. 1.24 'Special Maintenance Services' means any other maintenance services as specified on each Exhibit 1n. , PRDA or similar work authorization. 1.25 'Special Maintenance Fees' means the annual fee specified in each Exhibit 1n, PRDA or similar work authorization for Special Maintenance Services. 1.26 'Specification Non-conformity' means a failure of the modified Software to operate in accordance with the Functional Specifications. 1.27 'Taxes' means all sales, use, excise, value added, and other taxes and duties however designated levied by any taxing authority. Taxes shall not include any levies by any taxing authority based on Fiserv's net income. 1.28 'Third Party' means any party other than Fiserv, and its employees, agents, and subcontractors, and Client. 1.29 'Third Party Software' means software provided by Fiserv that is owned or licensed by Third Parties, where applicable, as identified on Exhibit 1n. 1.30 'Total License Fee' means the total License fee specified on each Exhibit 1n for Software. 1.31 'Upgrades' means changes made to maintain compatibility with new system software releases or to improve previously existing features and operations within Software. This primarily includes Software program fixes. 1.32 'Use' means copying or loading any portion of Software from storage units or media into any equipment for the processing of data by Software, or the operation of any procedure or machine instruction utilizing any portion of either the computer program or instructional material supplied with Software. Use is limited to the type of operations described in the Documentation solely to process Client's and its Affiliates' work, provided that Client notifies Fiserv in writing prior to beginning processing the work of any Affiliate and Client provides Fiserv with an accounting of the change in the number of accounts, users, workstations, asset size, or other fee determinant within 30 days following the start of such processing. As used herein, "Affiliate" means an entity that owns more than 50% of Client; an entity that is more than 50% owned by the same entity that owns more than 50% of Client; an entity of which Client owns more than 50% ("Subsidiary"); or an entity that is more than 50% owned by a Subsidiary. Use specifically excludes any service bureau or time-share services to Third Parties without Fiserv's prior written consent and payment by Client of additional fees in accordance with mutually agreed terms. 2. LICENSE 2.1 Fiserv agrees to furnish Software to Client and does hereby grant to Client a personal, non-exclusive, nontransferable (except as explicitly provided elsewhere in this Agreement) License. 2.2 Client may change the Location in the event Client transfers its data processing to a new location within the same country. Client will provide Fiserv with 15 days advance notice of any proposed transfer of operations. Assistance by Fiserv related to the transfer shall be chargeable at Fiserv's then current professional service rates. Client shall reimburse Fiserv for any out-of-pocket expenses incurred in the course of providing such assistance. 2.3 Fiserv prohibits the copying of any portions of the Software System except that Client may copy reasonable quantities of any standard end user documentation; and may copy machine language code, in whole or in part, in reasonable quantities, in printed or electronic form, for use by Client at the Location for archive, back-up, or emergency restart purposes, or to replace copy made on defective media. The original, and any copies of Software, or any part thereof, shall remain Fiserv's property. 2.4 Client shall maintain any such copies and the original at the Location and one Client archive site (`Archive Site) in the same country. Client may transport or transmit a copy of Software from the Location or the Archive Site to another location in the same country as the Location for back-up use when required by Computer System malfunction or disaster recovery purposes, provided that the copy or original is destroyed or returned to the Location or Archive Site when the malfunction is corrected. Client shall reproduce and include Fiserv's copyright and other proprietary notices on all copies, in whole or in part, in any form, of the Software System made as specified herein. 2.5 Client shall not decompile, disassemble, or otherwise reverse engineer the Software System. 2.6 Third Party Software is provided to Client under the following supplemental terms: (i) Use of Third Party Software shall be restricted to use as part of the Software System. (ii) Fiserv and Third Party Software owners shall not be liable for any damages, whether direct, indirect, incidental, or consequential arising from the use of the Third Party Software. (iii) Publication of benchmark tests of Third Party Software is permitted only by a writing signed by an authorized officer of Fiserv and the Third Party Software owner. (iv) Third Party Software owners are hereby designated as third party beneficiaries of this Agreement as it relates to their software. To the extent allowed by a Supplier (as defined in Exhibit 2n) Fiserv shall pass-through to Client any warranty a Supplier has granted to Fiserv with respect to materials purchased pursuant to Exhibit 2n, subject to the terms and conditions set forth in this Agreement, including Exhibit 2n. (v) Third Party Software is not specifically developed, or licensed for use in any nuclear, aviation, mass transit, or medical application or in any inherently dangerous applications. Third Party Software owners and Fiserv shall not be liable for any claims or damages arising from such use if Client uses the Software System for such applications. 2.7 Fiserv grants Client the right to Use any Software modifications furnished or authorized by Fiserv pursuant to this Agreement. 3. LICENSE FEES Client agrees to pay the license fees in accordance with the schedule set forth in each Exhibit 1n. 4. PROFESSIONAL SERVICES TERMS 4.1 Fiserv agrees to provide access to Fiserv personnel for the provision of professional services outlined in each Exhibit 1n (`Professional Services'). All such services shall be provided in accordance with the terms and conditions set forth below. Client may request Fiserv to provide additions and changes to such services. Any such additions or changes shall be provided only after the execution of a mutually agreed upon Change Request. 4.2 Operational Support. Unless specified otherwise in Exhibit 1n, if requested by Client, Fiserv agrees to provide Operational Support at the rates and terms to be mutually agreed upon in writing at the time of Client's request. 4.3 Business Requirements List. All professional services work to be performed by Fiserv shall be based upon a Business Requirements List. Client shall provide Fiserv with a Business Requirements List for each Modification or other information requested by Fiserv for the performance of its obligations under this Agreement. Fiserv shall review and suggest revisions to such Business Requirements List on a timely basis. 4.4 Modifications listed in Exhibit 1n and estimates of costs and completion dates for professional services, if any, are referenced solely for the purpose of allowing Client to plan its budgets and are based upon the then available information. Fiserv shall not be obligated to perform any work until the Business Requirements List has been accepted by Fiserv and agreed to by Client in writing, as evidenced by a signed PRDA. 4.5 Client agrees to pay Fiserv at mutually agreed upon rates (to be defined in a PRDA) for services rendered in connection with Fiserv's review and revisions to the Business Requirements List. 4.6 In the event Fiserv provides Modifications or other professional services, such services shall be based on specifications created by Fiserv and approved by Client (`Scope of Services'), as provided below. (i) In the case of Modifications, Scope of Services shall consist of developing the Functional Specifications created by Fiserv based on the Business Requirements List. All other professional services shall be based on the Scope of Services mutually agreed to for the project. (ii) Fiserv shall not be obligated to perform any work until the Scope of Services is approved in writing by Client, which approval shall not be unreasonably withheld or unduly delayed. (iii) Modifications, changes, enhancements, conversions, upgrades, or additions to the agreed upon Scope of Services shall be added only after the execution of a mutually agreed upon Change Request. In the event the parties agree to add any such items, the Scope of Services and the applicable Project Plan shall automatically be modified to the extent necessary to allow for the inclusion of the items. 4.7 Project Plan. When warranted by the size and complexity of the project, Fiserv shall develop a project plan for the professional services to be provided by Fiserv ("Project Plan'). Each such mutually agreed upon Project Plan shall contain a listing of the nature and timing of tasks for the project, some of which are to be performed by Fiserv and some by Client. Changes to the Project Plan shall be made only after the execution of a mutually agreed upon Change Request. 4.8 In the event that Fiserv is to provide installation, conversion, or training services to Client for the Software, the fees therefor shall be as specified on each Exhibit 1n. The nature and timing of any installation, conversion and training shall be as specified in the Project Plan and mutually agreed upon by the parties. 4.9 If Client is unable to provide access to required facilities or personnel or is unable to meet its tasks assigned on a Project Plan in a timely manner, Fiserv will endeavor to reschedule tasks to minimize non-productive time. If such non-productive time is expected to be significant, Fiserv will endeavor to reassign its personnel to other suitable work. All non-productive time which may be chargeable to Client by Fiserv shall be identified in the mutually agreed upon Change Request. 4.10 Delivery. Unless otherwise mutually agreed, upon delivery of each Modification, Client shall have up to 30 days to perform user testing. Client acknowledges Modifications can only be adequately tested in Client's system environment and Client agrees to reimburse Fiserv for all assistance during Client's user testing phase. Client shall thoroughly test the Modification in Client's system environment and promptly report on Fiserv's then current service request form any Specification Non-conformity disclosed by such user testing or Use to Fiserv with reasonable particularity, including applicable supporting documentation such as screen prints, user documentation, diagrams, etc. to allow Fiserv to properly analyze the issue. Fiserv shall correct any Specification Nonconformities disclosed by such testing or Use without further charge to Client within 14 days of Client's notice or a mutually agreed upon time. 4.11 Acceptance. Unless specified otherwise in the applicable PRDA, Modifications shall be deemed to have been accepted by Client 30 days following delivery or by the live operation and Use of the Modification for a period of 10 days, whichever occurs first. 4.12 Client agrees that it is responsible for providing Fiserv remote electronic access to Client's environments for the provision of professional services. Fiserv agrees to comply with Client's access and security requirements while performing such professional services, provided that (i) Client provides Fiserv with all such requirements in writing not less than 30 days prior to Fiserv's personnel arrival onsite, (ii) all such requirements are reasonable in nature and do not conflict with Fiserv policies and practices, and (iii) Client shall reimburse Fiserv for any costs incurred by Fiserv in complying with such Client's requirements. 5. MAINTENANCE SERVICES TERMS 5.1 Fiserv provides the following as part of Basic Maintenance Services to Client: (i) Telephone support 24 hours per day, 7 days per week for reporting of a Non-conformity that causes the Software to be inoperable. (ii) Up to 10 hours per month for telephone support during normal business hours for reasonable operator support. Non-conformity support is not included within this limitation. For telephone support in excess of 10 hours per month or for support provided outside of normal business hours unrelated to a Non-conformity (`Extended Use'), Fiserv agrees to notify Client of such Extended Use. In such event, Fiserv and Client will decide on a mutually agreeable corrective action plan. Fiserv reserves the right to invoice Client and Client agrees to pay for Extended Use at Fiserv's then current Professional Service rates, in the event Client fails to successfully implement the corrective action evidenced by a cessation of such Extended Use. (iii) Services to correct or resolve a Non-conformity, provided that such Non-conformity is capable of reconstruction and is due to a defect in the Software, are provided during Fiserv's normal business hours. (iv) Fiserv may utilize remote diagnostic software and dial-up telephone lines made available by Client in providing these services. Client shall cooperate and assist Fiserv to expedite resolution of all Non-conformities. (v) Software program fixes to correct Non-conformities for the current and last prior Software release made generally available to all Fiserv client's using the applicable Software will be provided within a reasonable period of time upon notice by Client. Client agrees to provide Fiserv with reasonable assistance and information in connection therewith. (vi) Software Upgrades. 5.2 Client agrees to properly document all Nonconformities using Fiserv's then current service request form, and provide adequate supporting documentation. Fiserv will utilize such documentation to evaluate, prioritize, and resolve Client support issues. Accurate and complete documentation by Client is a prerequisite of all support issues. Failure to provide adequate supporting documentation may result in delayed resolution of a Non-conformity. 5.3 Should Fiserv's review of the Non-conformity indicate, in Fiserv's reasonable opinion, that the reported problem is not a Software defect but is due to other problems including, but not limited to, input not in accordance with specifications, Client's abuse or misuse of the Software System, or by a modification or addition to the Software System not performed by Fiserv, or by Client's failure to properly maintain the Computer System or to install the required system software release as instructed by Fiserv, then: (i) Client agrees to reimburse Fiserv for the related costs of work performed by Fiserv in investigating the problem at Fiserv's then current professional service rates, and (ii) Fiserv, at Client's request, shall advise Client whether Fiserv can correct or assist in resolving such problem, and the terms under which Fiserv shall undertake the same. Upon written acceptance by Client, Fiserv shall correct or assist in resolving the problem in accordance with such terms. 5.4 Special Maintenance Fees for Special Maintenance Services, if selected by Client, shall be designated on each Exhibit 1n, the PRDA or similar work authorization. 5.5 Services in addition to those defined in or requested under this Agreement may be made available on a time-and-materials basis at Fiserv's then current professional services rates and as mutually agreed pursuant to Section 4 of this Agreement. Such additional services may include, without limitation, (i) On-site support. (ii) Installation of Upgrades. (iii) Training for Upgrades. (iv) Retrofit and integration services. 5.6 Unless explicitly stated otherwise in an Exhibit 1n, the initial Maintenance Fee, specified in each Exhibit 1n, is subject to annual increases on the anniversary date of the Maintenance Start Date. Annual increases shall be limited to the lesser of 7.5% or the change in the U.S. Department of Labor, Consumer Price Index (CPI) for the Urban Wage Earners and Clerical Workers, All Cities, (1982 = 100) for the 12 month period preceding the anniversary date. Maintenance Fees shall also be subject to increase following delivery of , modifications or additions to the Software or changes in the numbers of accounts processed, user seats, or other fee determinant. Fiserv may also increase Maintenance Fees in the event that Fiserv implements major system enhancements to comply with changes in law, government regulation, or industry practices. 5.7 Client agrees to train current and future employed staff members on the technical and user operations of the Software. 5.8 Client shall obtain and maintain at its own expense such data processing and communications equipment and supplies as may be necessary or appropriate to facilitate the proper use of the Software System. 5.9 Network-related problems are not covered under Basic Maintenance Service. In the event Fiserv does provide such service, Client agrees to pay Fiserv's then current professional service rates. 6. TERM 6.1 The term of this Agreement and the licenses granted hereunder shall begin on the Effective Date and continue in perpetuity unless terminated earlier as provided herein. 6.2 The provision of Basic Maintenance Services by Fiserv shall begin on the earlier of (i) the first day of the CBS Live Conversion or (ii) March 15, 2007, ("Maintenance Start Date"), and shall continue for a period of 5 years ("Initial Term"). For purposes of the foregoing, the "CBS Live Conversion" shall be the date the first live account is processed on any "CBS Core Application Subsystem" listed in the Software License section of Exhibit 1A. The provision of maintenance services by Fiserv shall renew for a successive 3-year term (`Initial Renewal Term"), and thereafter, for successive 1-year terms (`"Subsequent Renewal Term"),(collectively, "Renewal Term"), at Fiserv's then current fees for all modules then licensed unless either party provides 180 days prior written notice to the other party prior to the expiry of the Initial Term or then current Renewal Term. 7. EQUIPMENT TERMS 7.1 Client agrees to purchase, and Fiserv agrees to sell, Equipment described in each Exhibit 2n. Client understands that Fiserv is acting as an independent sales organization representing each manufacturer or supplier identified in each Exhibit 2n. 7.2 Client also understands and agrees that Fiserv's ability to obtain Equipment may be subject to availability and delays due to causes beyond Fiserv's control. Fiserv shall promptly place any orders submitted under this Agreement with each manufacturer or supplier and shall, at Client's direction, request expedited delivery whenever available. 7.3 Client shall be responsible for appropriate property insurance for all equipment, whether Client-owned or Fiserv-owned, within Client's premises. 7.4 On Client's behalf, Fiserv shall arrange for Equipment delivery to the site or sites (collectively, "Installation Site") designated by Client on each Exhibit 2n on or about the date ("Delivery Date") requested by Client. In the absence of shipping instructions, Fiserv shall select a common carrier on Client's behalf. 7.5 Fiserv shall arrange for Equipment installation in consideration of the Installation Fees listed on each Exhibit 2n. Client shall not perform any installation activities without Fiserv's written consent. Client shall provide Fiserv or its designee access to the Equipment and Installation Site until installation is completed. Fiserv agrees to comply with Client's access and security requirements while performing Services on Client site, provided that (i) Client provides Fiserv with all such requirements in writing not less than 30 days prior to Fiserv's personnel arrival onsite, (ii) all such requirements are reasonable in nature and do not conflict with Fiserv policies and practices, and (iii) Client shall reimburse Fiserv for any costs incurred by Fiserv in complying with such Client's requirements. If a suitable installation environment is not provided by Client, then Fiserv shall be required to perform only as many normal installation procedures as it deems to be practicable within the available facilities. Equipment installation will take place during normal Fiserv business hours, Monday through Friday, exclusive of Fiserv holidays, unless otherwise agreed by Fiserv. 7.6 Client shall provide a suitable installation environment for Equipment as specified by Fiserv or its agents and any and all other specifications provided to Client by the manufacturer, supplier, or Fiserv. Client shall also be responsible for furnishing all labor required for unpacking and placing each item of Equipment in the desired location for installation. Client shall be responsible for physical planning including, but not limited to, floor planning, cable requirements, and safety requirements in accordance with the installation manual and any and all applicable building, electrical, or other codes, regulations, and requirements. All such physical planning shall be completed on or before the Delivery Date. 7.7 All prices shown on each Exhibit 2n are F.O.B. at manufacturer's or supplier's plant. All transportation, rigging, drayage, insurance, and other costs of Equipment delivery to the Installation Site shall be itemized on an invoice submitted to Client and shall be paid by Client. Risk of loss shall pass to Client upon shipment. 7.8 Title to Equipment shall remain with Fiserv until all payments for Equipment are made by Client and, until such time, Client agrees that it shall not sell, transfer, pledge, or otherwise dispose of Equipment without Fiserv's prior written consent. 7.9 Client agrees Fiserv retains a security interest in all Equipment and the proceeds thereof until the purchase price due Fiserv are paid in full. Client shall execute any instruments or documents Fiserv deems appropriate to protect the security interest and, in any event, this Agreement shall constitute a financing agreement within the meaning of Article 9 of the Uniform Commercial Code and a copy of this Agreement may be filed at any time after signature by Fiserv as a financing statement for that purpose. In the event of default in payment or other breach by Client, Fiserv shall have all rights and remedies of a secured creditor upon default as provided by applicable law. 7.10 Equipment shall be deemed accepted when it passes Fiserv's, the manufacturer's, or supplier's standard post-installation test procedures at the Installation Site. 7.11 Fiserv warrants that Client will acquire good and clear title to Equipment free and clear of all liens and encumbrances. Fiserv hereby assigns to Client all applicable Equipment warranties the manufacturer or supplier has granted to Fiserv. Client hereby agrees to all of the terms and conditions applicable to those warranties and acknowledges that: (i) none of the manufacturer, supplier, or Fiserv warrants that Equipment use will be uninterrupted or error free; and (ii) manufacturer's or supplier's warranties, and the assignment of such warranties by Fiserv to Client, shall not impose any liability on Fiserv due to the services or assistance provided to Client by Fiserv with respect thereto. 7.12 Unless the parties agree otherwise, Fiserv shall not be responsible for the provision of any Equipment maintenance or repairs or of any Equipment parts or replacements. 8. PAYMENT 8.1 Fiserv shall invoice, and Client shall pay, any Taxes related to products and services provided by Fiserv to Client, however designated, that are levied by any taxing authority on the products and services provided by Fiserv. Fiserv shall remit such Taxes to the appropriate taxing authorities. 8.2 Each payment to be paid to Fiserv hereunder is due 30 days following receipt of the invoice from Fiserv and shall be paid by Client as specified on each Exhibit 1n. 8.3 In the event the whole or any part of any invoice remains unpaid after payment is due, Client shall pay a late charge of 1.5% per month; except that Client may withhold any portion of an invoiced amount that is disputed in good faith and without assessment of late charges, provided that (i) Client gives Fiserv written notice and explanation of such good faith dispute within 15 days after receipt of the invoice, (ii) Client promptly commences and diligently pursues efforts to resolve the dispute with Fiserv in a timely manner, and (iii) Client pays Fees due on resolved disputes within 15 days after resolution is reached. Subject to the provision in the preceding sentence, Client agrees that it shall neither make nor assert any right of deduction or set-off from fees or other charges on invoices submitted by Fiserv. 8.4 Except as otherwise expressly provided herein, Client agrees to pay the reasonable travel and living expenses of any employees of Fiserv and its authorized contractors who render services at either the Location or any other Client site in connection with the activities described in this Agreement. All expenses shall be itemized on invoices submitted by Fiserv. 9. PERFORMANCE 9.1 Client shall give Fiserv reasonable access to the Location, Software, and Computer System to enable Fiserv to provide Services and shall make available information, facilities, personnel, and services reasonably required by Fiserv for the performance of its obligations hereunder. Fiserv agrees to comply with Client's access and security requirements while performing Services on Client site, provided that (i) Client provides Fiserv with all such requirements in writing not less than 30 days prior to Fiserv's personnel arrival onsite, (ii) all such requirements are reasonable in nature and do not conflict with Fiserv policies and practices, and (iii) Client shall reimburse Fiserv for any costs incurred by Fiserv in complying with such Client's requirements. 9.2 The Software shall be deemed accepted when it passes the Fiserv test procedures at the installation site. 9.3 Work in determining the nature of any problem or in making Software corrections, amendments, or additions may be carried out at Fiserv's site or the Location, at Fiserv's reasonable discretion. 9.4 Client agrees to maintain the Computer System, Software, and Third Party Software in accordance with Fiserv's then current specified minimum configuration during the term hereof, or contract with Fiserv to so provide. 9.5 Client shall be responsible for ensuring that its systems are Year 2000 compliant and capable of passing and/or accepting date formats from and/or to the Software. 10. WARRANTIES 10.1 Fiserv warrants that the Software will perform in accordance with its functional specifications when operated in the specified operating environment as described in the Documentation. During the period beginning from the delivery (i.e., shipment) of Software to the Maintenance Start Date, Fiserv will provide replacements or corrections to any portion of the Software that does not so perform where such failure is material, provided Fiserv is notified in writing. This warranty shall not apply if the problem is caused by unauthorized modification to the Software System, use of the Software in combination with non-Fiserv provided software, or by incorrect Use. Client acknowledges that the warranties given by Fiserv are conditional upon the procurement and maintenance by Client of the Computer System in accordance with the then current specified configuration. 10.2 Fiserv's sole obligation under the warranty stated in the foregoing paragraph shall be to repair or replace defective or Non-conforming portions of the Software at its own expense and within a reasonable time. 10.3 Fiserv warrants that it has the right to license the Use of the Software. 10.4 Fiserv warrants that the Software is Year 2000 compliant. 10.5 Fiserv warrants that the Services described in this Agreement shall be performed in a workmanlike manner and in accordance with standards applicable to the financial software services industry. 10.6 THE WARRANTIES STATED ABOVE ARE LIMITED WARRANTIES AND ARE THE ONLY WARRANTIES MADE BY FISERV. FISERV DOES NOT MAKE, AND CLIENT HEREBY EXPRESSLY WAIVES, ALL OTHER WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE. 11. INDEMNITY 11.1 Fiserv shall indemnify Client and hold it harmless against any claim or action that alleges Use of the Software infringes a patent, copyright, or other proprietary right of a Third Party enforceable in the Location. Client agrees to notify Fiserv promptly in writing of any such claim and grants Fiserv sole right to control the defense and disposition of such claim. 11.2 If, as a result of such claim, Fiserv or Client is permanently enjoined from using a portion of the Software by a final, non-appealable decree, Fiserv, at its sole option and expense, may (i) procure for Client the right to continue to use the affected portion of the Software or (ii) provide a replacement or modification for the affected portion of Software so as to settle such claim. If such Software modification is not reasonably practical in Fiserv's sole opinion, Fiserv may discontinue and terminate the affected portion of this License upon written notice to Client and shall refund to Client on a pro rata basis, based on a 60 month amortization schedule, the Total License Fee paid to Fiserv for the affected portion of the Software. In making this determination, Fiserv will give due consideration to all factors, including financial expense. 11.3 The foregoing states Fiserv's entire liability for the infringement of any copyrights, patents, or other proprietary rights by the Software or any part thereof, and Client hereby expressly waives any other liabilities on the part of Fiserv arising therefrom. 11.4 Fiserv shall have no liability for any claim based upon (i) Use of any part of Software in combination with materials, software, or equipment not provided by Fiserv; or (ii) modifications made by Client or any Third Party. 12. LIMITATION OF LIABILITY OF THE PARTIES 12.1 Each party shall indemnify and hold the other harmless against any (i) loss of or any damage to any tangible property or (ii) injury to or death of any person; caused by the negligence of, breach of statutory duty by, or willful misconduct of the indemnifying party's employees, agents, or sub-contractors. 12.2 FISERV SHALL HAVE NO LIABILITY WITH RESPECT TO ITS OBLIGATIONS UNDER THIS AGREEMENT OR OTHERWISE FOR LOSS OF GOODWILL, OR FOR SPECIAL, INDIRECT, CONSEQUENTIAL, OR INCIDENTAL DAMAGES, WHETHER IN TORT OR IN CONTRACT, EVEN IF ADVISED OF THE POSSIBILITY OF SUCH DAMAGES. FISERV'S AGGREGATE LIABILITY FOR ANY AND ALL CLAIMS OR OBLIGATIONS RELATING TO THIS AGREEMENT FOR ANY REASON AND UPON ANY CAUSE OF ACTION WHATSOEVER SHALL BE LIMITED TO THE TOTAL LICENSE FEE PAID BY CLIENT TO FISERV FOR THE APPLICABLE SOFTWARE RESULTING IN SUCH LIABILITY AS OF THE DATE ON WHICH SUCH CAUSE OF ACTION ACCRUED. NOTWITHSTANDING THE FOREGOING, FISERV'S AGGREGATE LIABILITY FOR A DEFAULT RELATING TO THIRD PARTY EQUIPMENT OR THIRD PARTY SOFTWARE PROVIDED BY FISERV SHALL BE LIMITED TO THE AMOUNT PAID BY CLIENT TO FISERV FOR THE THIRD PARTY EQUIPMENT OR THIRD PARTY SOFTWARE. 13. TITLE 13.1 Nothing in this Agreement shall convey to Client any title to or any rights in the Software including but not limited to all proprietary rights or ownership of any modifications or derivations thereof. Client's sole right in relation to the Software or any modifications is to Use the same for the duration of this Agreement under the terms and conditions contained herein. Client shall have a period of exclusive use of those Modifications funded solely by Client, provided that such exclusive use (i) shall be expressly stated in the mutually agreed upon PRDA or similar work authorization; (ii) shall only apply to the South Bend, Indiana market; and (iii) shall expire upon the earlier of (a) 3 years following delivery of the applicable Modification; or (b) the date in which the Modification is incorporated into the Software and made generally available to other Fiserv clients. In the event of the latter, Fiserv shall discontinue billing client Special Maintenance Fees related to the Modification upon release of the Software version containing such modification. 13.2 Software and all Software modifications, enhancements, derivations or upgrades, and all patents, copyrights, or other proprietary rights related thereto are Fiserv's sole and exclusive property, whether made by Fiserv, Client, or any of their employees or agents. Client shall execute documents reasonably required by Fiserv to perfect such rights. 13.3 All information, reports, studies, object or source code, flow charts, diagrams, and other tangible or intangible material of any nature whatsoever produced by or as a result of any of the (i) services performed hereunder by Fiserv or jointly with Client, or (ii) related to any products provided hereunder by Fiserv, shall be the sole and exclusive property of Fiserv or its corporate parent. Client shall be entitled to Use all such work product produced by Fiserv in accordance with the terms and conditions hereof. For purposes of clarity, the foregoing does not include Client's customer data, which shall remain the property of Client. 14. NON-DISCLOSURE 14.1 Fiserv has granted Client the limited right to use the Software as provided herein. Client acknowledges that (i) the Software, including all specifications, work product, translations and other materials developed by Fiserv; and (ii) the terms and conditions of this Agreement contain Fiserv's highly confidential, unique, secret, and valuable information. Client agrees that it shall not sell, transfer, publish, disclose, display or otherwise make available to any Third Party the Software, any materials relating to or forming a part of the Software or any other Fiserv proprietary information without Fiserv's prior written consent. Client agrees to secure and protect the Software and proprietary information and to take appropriate action by written agreement with its employees who are permitted access to such materials to satisfy its obligations hereunder. Client further agrees to use its best efforts to assist Fiserv in identifying and preventing any use or disclosure of any portion of the Software or proprietary information. As a precondition to Client's request to Fiserv for consent to disclose the Software, in whole or in part, to a Third Party, Client shall obtain from such party an executed Exhibit 3 which shall not be modified without Fiserv's prior written consent. All Client obligations and undertakings relating to confidentiality and nondisclosure shall survive the termination of this Agreement for any reason. 14.2 Fiserv shall protect any Client Confidential Information from disclosure with the same degree of care afforded by Fiserv to its own confidential information. Not withstanding anything to the contrary herein, Fiserv specifically agrees that it will not use any non-public personal information about Client's customers in any manner prohibited by Title V of the Gramm-Leach-Bliley Act. All Fiserv obligations and undertakings relating to Client Confidential Information shall survive the termination of this Agreement for whatever reason. 14.3 Client shall permit Fiserv's authorized representatives at all reasonable times during Client's normal hours of operation to audit Client's Use at the Location to determine that the provisions of this Agreement are being faithfully performed. For that purpose, Fiserv shall be entitled to enter into any of Client's premises and Client hereby irrevocably grants authority to Fiserv and authorized representative to enter such premises for such purpose. Any such audit shall be conducted in such a manner as to minimize the disruption to Client's business and/or Software Use. Where reasonably practicable, Client shall permit Fiserv to perform audits, not more than twice yearly, through the use of automated monitoring systems, system generated reports, or other auditing methods. 14.4 Client shall promptly notify Fiserv if Client becomes aware of any breach of confidence relating to Software or other Fiserv proprietary information and give Fiserv all reasonable assistance in connection with Fiserv's investigation of same. 15. TERMINATION 15.1 The termination of this Agreement shall automatically, and without further action by Fiserv, terminate and extinguish the license, and all rights in and to Software shall automatically revert irrevocably to Fiserv. Fiserv shall have the right to take immediate possession of Software and all copies thereof wherever located without further notice or demand. 15.2 Client may terminate the Agreement in the event of a material default by Fiserv not cured within a reasonable cure period (with the minimum being 90 days if no other cure period is stated) after notice to Fiserv specifying the nature of the default with reasonable particularity. 15.3 If Client violates any of the Non-Disclosure, Non-Assignment, or License to Use provisions of this Agreement and fails to remedy any such breach within 5 days of notice thereof from Fiserv, Fiserv may terminate this Agreement without further notice. 15.4 If Client violates or fails to perform any of the terms or conditions other than those specifically expressed in Sub-section 15.3 and fails to remedy any such breach within 90 days of notice thereof from Fiserv, or if Client shall become insolvent or ceases to do business, then Fiserv may give notice declaring this Agreement is terminated at the expiration of such notice period. 15.5 Exercise of either party's right of termination shall not prejudice legal rights or remedies either party may have against the other in respect of any breach of the terms of this Agreement. 15.6 Client's failure to pay on a timely basis is cause for termination of this Agreement and the licenses granted hereunder. 15.7 Convenience: Early Termination. Client may terminate this Agreement during the Initial Term or any Renewal Term by paying a termination fee based on the remaining unused term for Services. The amount of such termination fee shall be determined by multiplying the average of Client's monthly invoices for Services received by Client pursuant to the Agreement during the 6 month period preceding the effective date of termination (or if no monthly invoice has been received, the sum of the billing for Services received or to be received hereunder calculated as a monthly amount (for example, annual maintenance will be divided by 12 to calculate the implied monthly amount)) by the applicable termination percentage (as defined below) times the remaining number of months in the term for Services. Client understands and agrees that Fiserv losses incurred as a result of early termination of the Agreement would be difficult or impossible to calculate as of the effective date of termination since they will vary based on, among other things, the number of clients using the Fiserv Services on the date the Agreement terminates. Accordingly, the amount set forth in the first sentence of this subsection represents Client's agreement to pay and Fiserv's agreement to accept as liquidated damages (and not as a penalty) such amount for any such Client termination. For purposes of clarity, without limiting to the foregoing, Client shall pay Fiserv for all Services performed through the date of termination pursuant to the terms of this Agreement. ------------------------------------- ------------------------------------- If Termination occurs during the year Then, the applicable Termination % specified in the Initial Term: shall be ------------------------------------- ------------------------------------- Year 1 70% ------------------------------------- ------------------------------------- Year 2 70% ------------------------------------- ------------------------------------- Year 3 80% ------------------------------------- ------------------------------------- Year 4 90% ------------------------------------- ------------------------------------- Year 5 100% ------------------------------------- ------------------------------------- -------------------------------------- ------------------------------------ If Termination occurs during the year Then, the applicable Termination % specified in the Initial Renewal Term: shall be -------------------------------------- ------------------------------------ Year 1 80% -------------------------------------- ------------------------------------ Year 2 90% -------------------------------------- ------------------------------------ Year 3 100% -------------------------------------- ------------------------------------ -------------------------------------- ----------------------------------- If Termination occurs during the year Then, the applicable Termination % specified in any Subsequent shall be Renewal Term: -------------------------------------- ------------------------------------ Year 1 100% -------------------------------------- ------------------------------------ 16. NON-ASSIGNMENT 16.1 In the event of the sale of 50% or more of Client's common stock, or the sale of all or substantially all of Client's assets, or in the event of any merger in which Client is not the surviving organization, (a "Change of Control"), Client may transfer this Agreement with Fiserv's prior written consent, which shall not be unreasonably withheld, provided that (1) if the Software System will be used in a different or expanded manner after the Change of Control, both parties mutually agree upon terms, conditions, and fees for transfer and such use; or (2) if the Software System will be used in the same manner as used prior to the Change of Control, then the surviving entity may continue to use the Software System under the terms, conditions and fees specified in this Agreement and the Exhibits providing Client is covered by the Basic Maintenance Services as defined herein. . 16.2 If the organization acquiring Client's common stock, assets, or surviving a merger is an organization deriving more than 5% of its gross revenues from providing service bureau, time share, computer software consulting services, computer software licensing, or computer hardware sales, Fiserv shall be under no obligation to consent to such transfer. 16.3 Except as expressly provided above, neither party may assign or transfer its rights, duties, or obligations under this Agreement to any person or entity, in whole or in part, without the other party's prior written consent, which consent shall not be unreasonably withheld or delayed, except that Fiserv may assign this Agreement to an affiliate without the consent of Client. 17. ENTIRE AGREEMENT 17.1 This Agreement, including its Exhibits 1 - 3, which are hereby expressly incorporated herein, constitutes the complete and exclusive statement of the agreement between the parties as to the subject matter hereof and supersedes all previous agreements with respect thereto. This Agreement may not be amended or modified except by a written instrument executed by both parties. 17.2 Each party hereby acknowledges that it has not entered into this Agreement in reliance upon any representation made by the other party but not embodied herein. 18. NOTICES 18.1 Any written notice required or permitted to be given hereunder shall be given by: (i) Registered or Certified Mail, Return Receipt Requested, postage prepaid; (ii) facsimile or email confirmed by Fiserv Contract Administration; or (iii) nationally recognized courier service to the other party at the addresses listed on the cover page or to such other address or person as a party may designate in writing. All such notices shall be effective upon receipt. 19. DISPUTE RESOLUTION 19.1 General. Except with respect to disputes arising from a misappropriation or misuse of either party's proprietary rights, any dispute or controversy arising out of this Agreement, or its interpretation, shall be submitted to and resolved exclusively by arbitration under the rules then prevailing of the American Arbitration Association, upon written notice of demand for arbitration by the party seeking arbitration, setting forth the specifics of the matter in controversy or the claim being made. The arbitration shall be heard before an arbitrator mutually agreeable to the parties; provided, that if the parties cannot agree on the choice of arbitrator within 10 days after the first party seeking arbitration has given written notice, then the arbitration shall be heard by three arbitrators, one chosen by each party, and the third chosen by those two arbitrators. The arbitrators will be selected from a panel of persons having experience with and knowledge of information technology and at least one of the arbitrators selected will be an attorney. A hearing on the merits of all claims for which arbitration is sought by either party shall be commenced not later than 60 days from the date demand for arbitration is made by the first party seeking arbitration. The arbitrator(s) must render a decision within 10 days after the conclusion of such hearing. Any award in such arbitration shall be final and binding upon the parties and the judgment thereon may be entered in any court of competent jurisdiction. 19.2 Applicable Law. The arbitration shall be governed by the United States Arbitration Act, 9 U.S.C. 1-16. The arbitrators shall apply the substantive law of the State of New York, without reference to provisions relating to conflict of laws. The arbitrators shall not have the power to alter, modify, amend, add to, or subtract from any term or provision of this Agreement, nor to rule upon or grant any extension, renewal, or continuance of this Agreement. The arbitrators shall have the authority to grant any legal remedy available had the parties submitted the dispute to a judicial proceeding. 19.3 Situs. If arbitration is required to resolve any disputes between the parties, the proceedings to resolve the first such dispute shall be held in South Bend, Indiana,, the proceedings to resolve the second such dispute shall be held in Milwaukee, Wisconsin, and the proceedings to resolve any subsequent disputes shall alternate between South Bend, Indiana and Milwaukee, Wisconsin. 20. GENERAL TERMS 20.1 The section headings used herein are inserted only as a matter of convenience and for reference and shall not affect the construction or interpretation of this Agreement. 20.2 Neither party shall be responsible for delays or failures in performance resulting from acts or circumstances reasonably beyond the control of that party, provided that either parties payment obligations shall not be excused under this section. 20.3 This Agreement shall be construed and enforced under the laws of the State of New York, without reference to its provisions relating to conflict of laws. The United Nations Convention of Contracts for the International Sale of Goods shall not apply to this Agreement. 20.4 No action, regardless of form, arising out of this Agreement shall be brought by Client more than 2 years after such cause of action shall have accrued. 20.5 The prevailing party in an action brought against the other to enforce the terms of this Agreement or any rights or obligations hereunder, shall be entitled to receive its reasonable costs and expenses of bringing such action including its reasonable attorneys' fees. 20.6 If any provision of this Agreement is held to be unenforceable, the other provisions shall nevertheless continue in full force and effect. 20.7 The failure of either of the parties to insist upon strict performance of any of the provisions of this Agreement shall not be construed as the waiver of any subsequent default of a similar nature IN WITNESS whereof this Agreement has been executed as of the Effective Date by the following duly authorized representatives: CLIENT: 1ST SOURCE BANK /s/JOHN B. GRIFFITH 11/29/05 - ------------------- -------- Signature Date of Signature JOHN B. GRIFFITH 100 North Michigan Street - ---------------- ------------------------- Printed Name Address (Line 1) SVP and GENERAL COUNSEL South Bend, IN 46601 - ----------------------- -------------- ----- Title Address (Line 2) griffith@1stsource.com EMail Address Telephone FISERV SOLUTIONS, INC.: /s/DAVID SANTI 12/01/05 - -------------- -------- Signature Date of Signature DAVID SANTI 600 Colonial Center Parkway - ----------- --------------------------- Printed Name Address (Line 1) PRESIDENT CBS US Lake Mary, Florida 32746 - ---------------- ------------------------- Title Address (Line 2) 407-513-5200 - ----------------------------- ---------------------------- - ----------------------------- ---------------------------- EMail Address Telephone -----END PRIVACY-ENHANCED MESSAGE-----