10-K 1 d490111d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

Annual Report Pursuant to Section 13 or 15(d)

Of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2012

Commission File Number 1-15817

 

 

OLD NATIONAL BANCORP

(Exact name of the Registrant as specified in its charter)

 

 

 

INDIANA   35-1539838

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

One Main Street

Evansville, Indiana

  47708
(Address of principal executive offices)   (Zip Code)

(812) 464-1294

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act

 

Title of Each Class

 

Name of each exchange on which registered

Common Stock, No Par Value

Preferred Stock Purchase Rights

  New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

 

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No  ¨

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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (s232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (s229.405 of this chapter) is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one)

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

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 Registrant’s voting common stock held by non-affiliates on June 30, 2012, was $1,102,329,460 (based on the closing price on that date of $12.01). In calculating the market value of securities held by non-affiliates of the Registrant, the Registrant has treated as securities held by affiliates as of June 30, 2012, voting stock owned of record by its directors and principal executive officers, and voting stock held by the Registrant’s trust department in a fiduciary capacity for benefit of its directors and principal executive officers. This calculation does not reflect a determination that persons are affiliates for any other purposes.

The number of shares outstanding of the Registrant’s common stock, as of January 31, 2013, was 101,184,000.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Annual Meeting of Shareholders to be held May 9, 2013, are incorporated by reference into Part III of this Form 10-K.

 

 

 


Table of Contents

OLD NATIONAL BANCORP

2012 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

 

         PAGE  
PART I     
Item 1.  

Business

     4   
Item 1A.  

Risk Factors

     14   
Item 1B.  

Unresolved Staff Comments

     21   
Item 2.  

Properties

     21   
Item 3.  

Legal Proceedings

     21   
Item 4.  

Mine Safety Disclosures

     22   
PART II     
Item 5.  

Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     22   
Item 6.  

Selected Financial Data

     25   
Item 7.  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     26   
Item 7A.  

Quantitative and Qualitative Disclosures About Market Risk

     61   
Item 8.  

Financial Statements and Supplementary Data

     61   
Item 9.  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     136   
Item 9A.  

Controls and Procedures

     136   
Item 9B.  

Other Information

     136   
PART III     
Item 10.  

Directors, Executive Officers and Corporate Governance of the Registrant

     137   
Item 11.  

Executive Compensation

     137   
Item 12.  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     137   
Item 13.  

Certain Relationships and Related Transactions, and Director Independence

     137   
Item 14.  

Principal Accounting Fees and Services

     137   
PART IV     
Item 15.  

Exhibits and Financial Statement Schedules

     138   
SIGNATURES      145   

 

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OLD NATIONAL BANCORP

2012 ANNUAL REPORT ON FORM 10-K

FORWARD-LOOKING STATEMENTS

In this report, we have made various statements regarding current expectations or forecasts of future events, which speak only as of the date the statements are made. These statements are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are also made from time-to-time in press releases and in oral statements made by the officers of Old National Bancorp (“Old National,” or the “Company”). Forward-looking statements are identified by the words “expect,” “may,” “could,” “intend,” “project,” “estimate,” “believe”, “anticipate” and similar expressions. Forward-looking statements also include, but are not limited to, statements regarding estimated cost savings, plans and objectives for future operations, the Company’s business and growth strategies, including future acquisitions of banks, regulatory developments, and expectations about performance as well as economic and market conditions and trends.

Such forward-looking statements are based on assumptions and estimates, which although believed to be reasonable, may turn out to be incorrect. Therefore, undue reliance should not be placed upon these estimates and statements. We can not assure that any of these statements, estimates, or beliefs will be realized and actual results may differ from those contemplated in these “forward-looking statements.” We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events, or otherwise. You are advised to consult further disclosures we may make on related subjects in our filings with the SEC. In addition to other factors discussed in this report, some of the important factors that could cause actual results to differ materially from those discussed in the forward-looking statements include the following:

 

   

economic, market, operational, liquidity, credit and interest rate risks associated with our business;

 

   

economic conditions generally and in the financial services industry;

 

   

expected cost savings in connection with the consolidation of recent acquisitions may not be fully realized or realized within the expected time frames, and deposit attrition, customer loss and revenue loss following completed acquisitions may be greater than expected;

 

   

unexpected difficulties and losses related to FDIC-assisted acquisitions, including those resulting from our loss-sharing arrangements with the FDIC;

 

   

increased competition in the financial services industry either nationally or regionally, resulting in, among other things, credit quality deterioration;

 

   

our ability to achieve loan and deposit growth;

 

   

volatility and direction of market interest rates;

 

   

governmental legislation and regulation, including changes in accounting regulation or standards;

 

   

our ability to execute our business plan;

 

   

a weakening of the economy which could materially impact credit quality trends and the ability to generate loans;

 

   

changes in the securities markets; and

 

   

changes in fiscal, monetary and tax policies.

Investors should consider these risks, uncertainties and other factors in addition to risk factors included in our other filings with the SEC.

 

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PART I

ITEM 1. BUSINESS

GENERAL

Old National is a financial holding company incorporated in the State of Indiana and maintains its principal executive office in Evansville, Indiana. We, through our wholly owned banking subsidiary, provide a wide range of services, including commercial and consumer loan and depository services, investment and brokerage services, lease financing and other traditional banking services. Through our non-bank affiliates, we provide services to supplement the banking business including fiduciary and wealth management services, insurance and other financial services. As of December 31, 2012, we employed 2,684 full-time equivalent associates.

COMPANY PROFILE

Old National Bank, our wholly owned banking subsidiary (“Old National Bank”), was founded in 1834 and is the oldest company in Evansville, Indiana. In 1982, Old National was formed; in 2001 we became a financial holding company and we are currently the largest financial holding company headquartered in the state of Indiana. Also in 2001, we completed the consolidation of 21 bank charters enabling us to operate under a common name with consistent product offerings throughout the financial center locations, consolidating back-office operations and allowing us to provide more convenient service to clients. We provide financial services primarily in Indiana, eastern and southeastern Illinois, and central and western Kentucky.

OPERATING SEGMENTS

We operate in two segments: community banking and treasury. Substantially all of our revenues are derived from customers located in, and substantially all of our assets are located in, the United States. A description of each segment follows.

Community Banking Segment

The community banking segment operates through Old National Bank, and has traditionally been the most significant contributor to our revenue and earnings. The primary goal of the community banking segment is to provide products and services that address clients’ needs and help clients reach their financial goals by offering a broad array of quality services. Our financial centers focus on convenience factors such as location, space for private consultations and quick client access to routine transactions.

As of December 31, 2012, Old National Bank operated 180 banking financial centers located primarily in Indiana, Illinois, and Kentucky. The community banking segment primarily consists of lending and depository activities along with merchant cash management, internet banking and other services relating to the general banking business. In addition, the community banking segment includes Indiana Old National Insurance Company (“IONIC”), which reinsures credit life insurance. IONIC also provides property and casualty insurance for Old National and reinsures most of the coverage with non-affiliated carriers.

Lending Activities

We earn interest income on loans as well as fee income from the origination of loans. Lending activities include loans to individuals which primarily consist of home equity lines of credit, residential real estate loans and consumer loans, and loans to commercial clients, which include commercial loans, commercial real estate loans, letters of credit and lease financing. Residential real estate loans are either kept in our loan portfolio or sold to secondary investors, with gains or losses from the sales being recognized.

Depository Activities

We strive to serve individuals and commercial clients by providing depository services that fit their needs at competitive rates. We pay interest on the interest-bearing deposits and receive service fee revenue on various accounts. Deposit accounts include products such as noninterest-bearing demand, negotiable order of withdrawal (“NOW”), savings and money market, and time deposits. Debit and ATM cards provide clients with access to their accounts 24 hours a day at any ATM location. We also provide 24-hour telephone access and online banking as well as other electronic banking services.

 

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Investment and Brokerage Services

We, through a registered third party broker-dealer, provide clients with convenient and professional investment services and a variety of brokerage products. This line of business offers a full array of investment options and investment advice to its clients.

Treasury Segment

Treasury manages investments, wholesale funding, interest rate risk, liquidity and leverage for Old National. Treasury also provides capital markets products, including interest rate derivatives, foreign exchange and industrial revenue bond financing for our commercial clients.

Other

The following lines of business are included in the “other” column for all periods reported:

Wealth Management

Fiduciary and trust services targeted at high net worth individuals are offered through an affiliate trust company under the business name of Old National Trust Company.

Insurance Agency Services

Through our insurance agency subsidiaries, we offer full-service insurance brokerage services including commercial property and casualty, surety, loss control services, employee benefits consulting and administration, and personal insurance. These subsidiaries are insurance agencies that offer products that are issued and underwritten by various insurance companies not affiliated with us.

Purchased Credit Impaired Loans

For internal reporting, purchased credit impaired loans and the associated FDIC indemnification asset reside in the special assets department and are included in the “Other” segment.

Additional information about our business segments is included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Note 23 to the consolidated financial statements.

MARKET AREA

We own the largest Indiana-based bank and one of the largest independent insurance agencies headquartered in Indiana. Operating from a home base in Evansville, Indiana, we have continued to grow our footprint in Indiana and Kentucky with continued expansion in the attractive Louisville, Indianapolis and Lafayette markets. In February 2007, we expanded into Northern Indiana by acquiring St. Joseph Capital Corporation, which had banking offices in Mishawaka and Elkhart, Indiana. In March 2009, we completed the acquisition of the Indiana retail branch banking network of Citizens Financial Group, which consisted of 65 branches and a training facility. The branches are located primarily in the Indianapolis area. On January 1, 2011, we closed on our acquisition of Monroe Bancorp, strengthening our presence in Bloomington, Indiana and the central and south central Indiana markets. On July 29, 2011, we acquired the banking operations of Integra Bank N.A. in an FDIC-assisted transaction. Integra Bank was a full service community bank headquartered in Evansville, Indiana that operated 52 branch locations, primarily in southwest Indiana, southeastern Illinois and western Kentucky. On September 15, 2012, we closed on our acquisition of Indiana Community Bancorp, strengthening our presence in Columbus, Indiana and the south central Indiana market.

 

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The following table reflects the market locations where we have a significant share of the deposit market. The market share data is by metropolitan statistical area. The Evansville, Indiana data includes branches in Henderson, Kentucky. The data includes deposit information for Indiana Community Bancorp, which was acquired on September 15, 2012.

Old National Deposit Market Share and Number of Branch Locations

Deposits as of June 30, 2012

 

Market Location

   Number of
Branches
     Deposit Market
Share Rank
 

Evansville, Indiana

     20         1   

Bloomington, Indiana

     9         1   

Central City, Kentucky

     4         1   

Danville, Illinois

     2         1   

North Vernon, Indiana

     1         1   

Vincennes, Indiana

     4         2   

Washington, Indiana

     3         2   

Columbus, Indiana

     7         2   

Jasper, Indiana

     7         2   

Terre Haute, Indiana

     6         2   

Seymour, Indiana

     3         2   

Carbondale, Illinois

     4         3   

Madison, Indiana

     1         3   

 

Source: FDIC

ACQUISITION AND DIVESTITURE STRATEGY

Since the formation of Old National in 1982, we have acquired more than 40 financial institutions and financial services companies. Future acquisitions and divestitures will be driven by a disciplined financial process and will be consistent with the existing focus on community banking, client relationships and consistent quality earnings. Targeted geographic markets for acquisitions include mid-size markets within or near our existing franchise with average to above average growth rates.

As with previous acquisitions, the consideration paid by us will be in the form of cash, debt or Old National stock. The amount and structure of such consideration is based on reasonable growth and cost savings assumptions and a thorough analysis of the impact on both long- and short-term financial results.

On January 1, 2011, we acquired Monroe Bancorp in an all stock transaction. Monroe Bancorp was headquartered in Bloomington, Indiana and had 15 banking centers. Pursuant to the merger agreement, the shareholders of Monroe Bancorp received approximately 7.6 million shares of Old National Bancorp stock valued at approximately $90.1 million. On January 1, 2011, unaudited financial statements of Monroe Bancorp showed assets of $808.1 million, which included $509.6 million of loans, $166.4 million of securities and $711.5 million of deposits. The acquisition strengthens our deposit market share in the Bloomington, Indiana market and improved our deposit market share rank to first place in 2011.

On June 1, 2011, Old National Bancorp’s wholly owned trust subsidiary, American National Trust and Investment Management Company d/b/a Old National Trust Company (“ONTC”), acquired the trust business of Integra Bank, N.A. As of the closing, the trust business had approximately $328 million in assets under management. Old National paid Integra $1.3 million in an all cash transaction.

 

 

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On July 29, 2011, Old National acquired the banking operations of Integra Bank N.A. (“Integra”) in an FDIC- assisted transaction. Integra was a full service community bank headquartered in Evansville, Indiana that operated 52 branch locations. As part of the purchase and assumption agreement, the Company and the FDIC entered into loss sharing agreements (each, a “loss sharing agreement” and collectively, the “loss sharing agreements”), whereby the FDIC will cover a substantial portion of any future losses on loans (and related unfunded commitments), other real estate owned (“OREO”) and up to 90 days of certain accrued interest on loans. The acquired loans and OREO subject to the loss sharing agreements are referred to collectively as “covered assets.” Under the terms of the loss sharing agreements, the FDIC will reimburse Old National for 80% of losses up to $275.0 million, losses in excess of $275.0 million up to $467.2 million at 0% reimbursement, and 80% of losses in excess of $467.2 million. As of December 31, 2012, we do not expect losses to exceed $275.0 million. Old National will reimburse the FDIC for its share of recoveries with respect to losses for which the FDIC has reimbursed the Bank under the loss sharing agreements. The loss sharing provisions of the agreements for commercial and single family residential mortgage loans are in effect for five and ten years, respectively, from the July 29, 2011 acquisition date and the loss recovery provisions for such loans are in effect for eight years and ten years, respectively, from the acquisition date.

On September 15, 2012, Old National acquired Indiana Community Bancorp in an all stock transaction. Indiana Community Bancorp was headquartered in Columbus, Indiana and had 17 full-service banking centers serving the South Central Indiana area. Pursuant to the merger agreement, the shareholders of Indiana Community Bancorp received approximately 6.6 million shares of Old National Bancorp common stock valued at approximately $88.5 million. Old National assumed assets with a fair value of approximately $906.3 million, including $497.4 million of loans and $784.6 million of deposits. The acquisition strengthened our deposit market share in Columbus, Indiana and south central Indiana market.

COMPETITION

The banking industry and related financial service providers operate in a highly competitive market. Old National competes with financial service providers such as local, regional and national banking institutions, savings and loan associations, credit unions, finance companies, investment brokers, and mortgage banking companies. In addition, Old National’s non-bank services face competition with asset managers and advisory services, money market and mutual fund companies and insurance agencies.

SUPERVISION AND REGULATION

Old National is subject to extensive regulation under federal and state laws. The regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of shareholders and creditors.

Significant elements of the laws and regulations applicable to Old National and its subsidiaries are described below. The description is qualified in its entirety by reference to the full text of the statutes, regulations and policies that are described. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies. A change in statutes, regulations or regulatory policies applicable to Old National and its subsidiaries could have a material effect on the business of the Company.

The Dodd-Frank Act

On July 21, 2010, financial regulatory reform legislation entitled the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the “Dodd-Frank Act”) was signed into law. The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, including provisions that, among other things, will:

 

   

Centralize responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, responsible for implementing, examining and enforcing compliance with federal consumer financial laws.

 

   

Restrict the preemption of state law by federal law and disallow subsidiaries and affiliates of national banks, such as Old National Bank, from availing themselves of such preemption.

 

   

Apply the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies.

 

   

Require the Office of the Comptroller of the Currency to seek to make its capital requirements for national banks, such as Old National Bank, countercyclical so that capital requirements increase in times of economic expansion and decrease in times of economic contraction.

 

   

Require financial holding companies to be well capitalized and well managed. Bank holding companies and banks must also be both well capitalized and well managed in order to acquire banks located outside their home state.

 

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Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminate the ceiling on the size of the Deposit Insurance Fund (“DIF”) and increase the floor on the size of the DIF.

 

   

Impose comprehensive regulation of the over-the-counter derivatives market, which would include certain provisions that would effectively prohibit insured depository institutions from conducting certain derivatives businesses in the institution itself.

 

   

Require large, publicly traded bank holding companies to create a risk committee responsible for the oversight of enterprise risk management.

 

   

Implement corporate governance revisions, including with regard to executive compensation and proxy access by shareholders, that apply to all public companies, not just financial institutions.

 

   

Make permanent the $250,000 limit for federal deposit insurance and increase the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000.

 

   

Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction accounts as well as other accounts.

 

   

Amend the Electronic Fund Transfer Act (“EFTA”) to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer.

The Dodd-Frank Act also creates a new Bureau of Consumer Financial Protection (the “CFPB”) that is responsible for administering federal consumer financial protection laws. The CFPB, which began operations on July 21, 2011, is an independent bureau within the FRB and has broad rule-making, supervisory and examination authority to set and enforce rules in the consumer protection area over financial institutions that have assets of $10.0 billion or more. The Dodd-Frank Act also gives the CFPB expanded data collecting powers for fair lending purposes for both small business and mortgage loans, as well as expanded authority to prevent unfair, deceptive and abusive practices. The consumer complaint function will also be consolidated into the CFPB.

Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on Old National, its customers or the financial industry more generally. However, several provisions of the Dodd-Frank Act have been implemented. In addition to the establishment of the CFPB, the FRB final rule implementing the Dodd-Frank Act’s “Durbin Amendment,” which limits debit card interchange fees, was issued on July 21, 2011 for transactions occurring after September 30, 2011. The final rule established a cap on the fees banks with more than $10 billion in assets can charge merchants for debit card transactions. The fee was set at $0.21 per transaction plus an additional 5 bps of the transaction amount and $0.01 to cover fraud losses. The FRB repealed Regulation Q as mandated by the Dodd-Frank Act on July 21, 2011. Regulation Q was implemented as part of the Glass-Steagall Act in the 1930’s and provided a prohibition against the payment of interest on demand deposits.

While the total impact of the fully implemented Dodd-Frank Act on Old National is not currently known, the impact is expected to be substantial and may have an adverse impact on its financial performance and growth opportunities. Provisions in the legislation that affect the payment of interest on demand deposits and interchange fees are likely to increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate. Provisions in the legislation that revoke the Tier 1 capital treatment of trust preferred securities and otherwise require revisions to the capital requirements of Old National and Old National Bank could require Old National and Old National Bank to seek other sources of capital in the future.

Other Regulatory Agencies and Requirements

Old National is registered as a bank holding company and has elected to be a financial holding company. It is subject to the supervision of, and regulation by, the Board of Governors of the Federal Reserve System (“Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (“BHC Act”). The Federal Reserve has issued regulations under the BHC Act requiring a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. It is the policy of the Federal Reserve that, pursuant to this requirement, a bank holding company should stand ready to use its resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity.

 

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The BHC Act requires the prior approval of the Federal Reserve to acquire more than a 5% voting interest of any bank or bank holding company. Additionally, the BHC Act restricts Old National’s non-banking activities to those which are determined by the Federal Reserve to be closely related to banking and a proper incident thereto.

On October 26, 2001, the USA Patriot Act of 2001 was signed into law. Enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C. on September 11, 2001, the Patriot Act is intended to strengthen U.S. law enforcement’s and the intelligence community’s ability to work cohesively to combat terrorism on a variety of fronts. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and the statute and regulations promulgated under it impose a number of significant obligations on entities subject to its provisions, including: (a) due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non-U.S. persons; (b) standards for verifying customer identification at account opening; (c) rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering; (d) reports by non-financial trades and businesses filed with the U.S. Treasury Department’s (the “Treasury Department” or the “Treasury”) Financial Crimes Enforcement Network for transactions exceeding $10,000; and (e) filing of suspicious activities reports by brokers and dealers if they believe a customer may be violating U.S. laws and regulations.

Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), a bank holding company is required to guarantee the compliance of any insured depository institution subsidiary that may become “undercapitalized” (as defined in FDICIA) with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal bank regulatory agency.

Bank holding companies are required to comply with the Federal Reserve’s risk-based capital guidelines. The Federal Deposit Insurance Corporation (“FDIC”) and the Office of the Comptroller of the Currency (“OCC”) have adopted risk-based capital ratio guidelines to which depository institutions under their respective supervision are subject. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations. Risk-based capital ratios are determined by allocating assets and specified off-balance sheet commitments to four risk-weighted categories, with higher levels of capital being required for the categories perceived as representing greater risk. Old National’s banking affiliate, Old National Bank, met all risk-based capital requirements of the FDIC and OCC as of December 31, 2012. For Old National’s regulatory capital ratios and regulatory requirements as of December 31, 2012, see Note 21 to the consolidated financial statements.

In December 2010 and January 2011, the Basel Committee on Banking Supervision published the final texts of reforms on capital and liquidity generally referred to as “Basel III.” Although Basel III is intended to be implemented by participating countries for large, internationally active banks, its provisions are likely to be considered by United States banking regulators in developing new regulations applicable to other banks in the United States, including Old National Bank.

For banks in the United States, among the most significant provisions of Basel III concerning capital are the following:

 

   

A minimum ratio of common equity to risk-weighted assets reaching 4.5%, plus an additional 2.5% as a capital conservation buffer, by 2019 after a phase-in period.

 

   

A minimum ratio of Tier 1 capital to risk-weighted assets reaching 6.0% by 2019 after a phase-in period.

 

   

A minimum ratio of total capital to risk-weighted assets, plus the additional 2.5% capital conservation buffer, reaching 10.5% by 2019 after a phase -in period.

 

   

An additional countercyclical capital buffer to be imposed by applicable national banking regulators periodically at their discretion, with advance notice.

 

   

Restrictions on capital distributions and discretionary bonuses applicable when capital ratios fall within the buffer zone.

 

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Deduction from common equity of deferred tax assets that depend on future profitability to be realized.

 

   

Increased capital requirements for counterparty credit risk relating to OTC derivatives, repos and securities financing activities.

 

   

For capital instruments issued on or after January 13, 2013 (other than common equity), a loss-absorbency requirement such that the instrument must be written off or converted to common equity if a trigger event occurs, either pursuant to applicable law or at the direction of the banking regulator. A trigger event is an event under which the banking entity would become nonviable without the write-off or conversion, or without an injection of capital from the public sector. The issuer must maintain authorization to issue the requisite shares of common equity if conversion were required.

The Basel III provisions on liquidity include complex criteria establishing a liquidity coverage ratio (“LCR”) and a net stable funding ratio (“NSFR”). The purpose of the LCR is to ensure that a bank maintains adequate unencumbered, high quality liquid assets to meet its liquidity needs for 30 days under a severe liquidity stress scenario. The purpose of the NSFR is to promote more medium and long-term funding of assets and activities, using a one-year horizon. Although Basel III is described as a “final text,” it is subject to the resolution of certain issues and to further guidance and modification, as well as to adoption by United States banking regulators.

When fully phased in on January 1, 2019, Basel III requires banks to maintain the following new standards and introduces a new capital measure “Common Equity Tier 1”, or “CET1”. Basel III increases the CET1 to risk-weighted assets to 4.5%, and introduces a capital conservation buffer of an additional 2.5% of common equity to risk-weighted assets, raising the target CET1 to risk-weighted assets ratio to 7%. It requires banks to maintain a minimum ratio of Tier 1 capital to risk weighted assets of at least 6.0%, plus the capital conservation buffer effectively resulting in Tier 1 capital ratio of 8.5%. Basel III increases the minimum total capital ratio to 8.0% plus the capital conservation buffer, increasing the minimum total capital ratio to 10.5%. Basel III also introduces a non-risk adjusted tier 1 leverage ratio of 3%, based on a measure of total exposure rather than total assets, and new liquidity.

On June 7, 2012, the federal bank regulatory agencies issued a series of proposed rules that would revise their risk-based and leverage capital requirements and their method for calculating risk-weighted assets to make them consistent with Basel III and certain provisions of the Dodd-Frank Act. The proposed rules would apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more, and top-tier savings and loan holding companies (“banking organizations”). Among other things, the proposed rules establish a new Common Equity Tier 1 minimum capital requirement of 4.5% and a higher minimum Tier 1 capital requirement of 6.0%. The proposed rules would also increase the required capital for certain categories of assets, including higher-risk residential mortgages, higher-risk construction real estate loans and certain exposures related to securitizations.

Additionally, the U.S. implementation of Basel III contemplates that, for banking organizations with less than $15 billion in assets, the ability to treat trust preferred securities as Tier 1 capital would be phased out over a ten-year period. The proposed rules also required unrealized gains and losses on certain securities holdings to be included for purposes of calculating regulatory capital requirements. The proposed rules limit a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of a specified amount of Common Equity Tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements.

The Basel III implementation proposal provides for a number of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. Under current capital standards, the effects of accumulated other comprehensive income items included in capital are excluded for the purposes of determining regulatory capital ratios. Under the Basel III Proposal, the effects of certain accumulated other comprehensive items are not excluded, which could result in significant variations in the level of capital depending upon the impact of interest rate fluctuations on the fair value of the Corporation’s securities portfolio. The Basel III Proposal also requires the phase-out of certain hybrid securities, such as trust preferred securities, as Tier 1 capital of bank holding companies in equal installments between 2013 and 2016. Trust preferred securities no longer included in Tier 1 capital may nonetheless be included as a component of Tier 2 capital.

 

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Implementation of the deductions and other adjustments to CET1 will begin on January 1, 2014 and will be phased-in over a five-year period (20% per year). The implementation of the capital conservation buffer will begin on January 1, 2016 at the 0.625% level and be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).

The Basel III implementation proposal would also revise the “prompt corrective action” regulations described below by (i) introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category, with the minimum Tier 1 capital ratio for well-capitalized status being 8% (as compared to the current 6%); and (iii) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3% leverage ratio and still be adequately capitalized. The Basel III proposal does not change the total risk-based capital requirement for any category.

Management believes that, as of December 31, 2012, Old National and Old National Bank would meet all capital adequacy requirements under the proposed rules on a fully phased-in basis if such requirements were currently effective. There can be no guarantee that the rule proposals will be adopted in their current form, what changes may be made before adoption, or when ultimate adoption will occur. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Corporation’s net income and return on equity.

Old National Bank is subject to the provisions of the National Bank Act, is supervised, regulated and examined by the OCC, and is subject to the rules and regulations of the OCC, Federal Reserve and the FDIC. A substantial portion of Old National’s cash revenue is derived from dividends paid to it by Old National Bank. These dividends are subject to various legal and regulatory restrictions as summarized in Note 21 to the consolidated financial statements.

Both federal and state law extensively regulate various aspects of the banking business, such as reserve requirements, truth-in-lending and truth-in-savings disclosures, equal credit opportunity, fair credit reporting, trading in securities and other aspects of banking operations. Branching by Old National Bank is subject to the jurisdiction and requires notice to or the prior approval of the OCC.

Old National and Old National Bank are subject to the Federal Reserve Act, which restricts financial transactions between banks and affiliated companies. The statute limits credit transactions between banks, affiliated companies and its executive officers and its affiliates. The statute prescribes terms and conditions for bank affiliate transactions deemed to be consistent with safe and sound banking practices, and restricts the types of collateral security permitted in connection with a bank’s extension of credit to an affiliate. Additionally, all transactions with an affiliate must be on terms substantially the same or at least as favorable to the institution as those prevailing at the time for comparable transactions with nonaffiliated parties.

FDICIA accomplished a number of sweeping changes in the regulation of depository institutions, including Old National Bank. FDICIA requires, among other things, federal bank regulatory authorities to take “prompt corrective action” with respect to banks which do not meet minimum capital requirements.

Under current prompt corrective action regulations, a bank will be (i) “well capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if the institution has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater and is not “well capitalized”; (iii) “undercapitalized” if the institution has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a leverage ratio of less than 4.0%; (iv) “significantly undercapitalized” if the institution has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0% or a leverage ratio of less than 3.0%; and (v) “critically undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. A bank’s capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.

 

 

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FDICIA generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be “undercapitalized.” “Undercapitalized” institutions are subject to growth limitations and are required to submit a capital restoration plan. The agencies may not accept such a plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The bank holding company must also provide appropriate assurances of performance. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.”

“Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.

Management believes that, as of December 31, 2012, Old National Bank was “well capitalized” based on the aforementioned ratios.

FDICIA further directed each federal banking agency to prescribe standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, management compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses, a minimum ratio of market value to book value of publicly traded shares and such other standards as the agency deems appropriate.

The Gramm-Leach-Bliley Act (“GLBA”) permits bank holding companies which have elected to become financial holding companies to engage in a substantially broader range of non-banking activities, including securities, investment advice and insurance activities, than is permissible for bank holding companies that have not elected to become financial holding companies. Old National has elected to be a financial holding company. As a result, Old National may underwrite and sell securities and insurance. It may acquire, or be acquired by, brokerage firms and insurance underwriters.

GLBA established new requirements for financial institutions to provide enhanced privacy protections to customers. In June of 2000, the Federal banking agencies jointly adopted a final regulation providing for the implementation of these protections. Financial institutions are required to provide notice to consumers which details its privacy policies and practices, describes under what conditions a financial institution may disclose nonpublic personal information about consumers to nonaffiliated third parties and provides an “opt-out” method which enables consumers to prevent the financial institution from disclosing customer information to nonaffiliated third parties. Financial institutions were required to be in compliance with the final regulation by July 1, 2001, and Old National was in compliance at such date and continues to be in compliance.

A major focus of governmental policy on financial institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 (the “USA Patriot Act”) substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution, including causing applicable bank regulatory authorities not to approve merger or acquisition transactions when regulatory approval is required or to prohibit such transactions even if approval is not required.

 

 

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We are currently subject to a consent order with the OCC relating to our Bank Secrecy Act/Anti-Money Laundering Program. See “Risk Factors — A failure by Old National Bank to satisfy the terms and conditions of the Consent Order it consented and agreed to with the Office of the Comptroller of the Currency may subject it to monetary penalties and impact future regulatory approvals.”

In October 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted. The EESA authorized the Treasury Department to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in a troubled asset relief program (“TARP”). The purpose of TARP was to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. The Treasury Department allocated $350 billion towards the TARP Capital Purchase Program (“CPP”). Under the CPP, Treasury purchased debt or equity securities from participating institutions. The TARP also included direct purchases or guarantees of troubled assets of financial institutions. Participants in the CPP are subject to executive compensation limits and are encouraged to expand their lending and mortgage loan modifications. Old National participated in CPP, but on March 31, 2009, Old National repurchased all of the $100 million in preferred, non-voting stock that was sold to the Treasury Department as part of the CPP. In May 2009, Old National repurchased the warrants for up to 813,000 shares of the Company’s common stock issued by the Company to the Treasury Department on December 12, 2008 for $1.2 million. This repurchase was the final phase required of Old National to end its participation in the CPP.

EESA also increased FDIC deposit insurance on most accounts from $100,000 to $250,000. The Dodd-Frank Act made permanent the $250,000 deposit insurance limit for insured deposits.

Following a systemic risk determination, the FDIC established a Temporary Liquidity Guarantee Program (“TLGP”) on October 14, 2008. The TLGP includes the Transaction Account Guarantee Program (“TAGP”), which provided unlimited deposit insurance coverage through December 31, 2009 for noninterest-bearing transaction accounts (typically business checking accounts) and certain funds swept into noninterest-bearing savings accounts. Institutions participating in the TAGP pay a 10 basis points fee (annualized) on the balance of each covered account in excess of $250,000, while the extra deposit insurance is in place. The TAGP was extended through December 31, 2010. The enactment of the Dodd-Frank Act provided unlimited federal deposit insurance until December 31, 2012 for noninterest bearing demand transaction accounts at all insured depository institutions.

On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law by President Obama. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs. In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on all current and future TARP recipients, including Old National, until the institution has repaid the Treasury, which is now permitted under ARRA without penalty and without the need to raise new capital, subject to the Treasury’s consultation with the recipient’s appropriate regulatory agency. Old National has been a TARP recipient, but has exercised its right to repay Treasury and is no longer subject to the compensation and corporate expenditure limits imposed by ARRA on TARP recipients.

In addition to the matters discussed above, Old National Bank is subject to additional regulation of its activities, including a variety of consumer protection regulations affecting its lending, deposit and collection activities and regulations affecting secondary mortgage market activities. The earnings of financial institutions are also affected by general economic conditions and prevailing interest rates, both domestic and foreign, and by the monetary and fiscal policies of the United States government and its various agencies, particularly the Federal Reserve.

Additional legislative and administrative actions affecting the banking industry may be considered by Congress, state legislatures and various regulatory agencies, including those referred to above. It cannot be predicted with certainty whether such legislative or administrative action will be enacted or the extent to which the banking industry in general, or Old National and Old National Bank in particular, would be affected.

 

 

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AVAILABLE INFORMATION

All reports filed electronically by Old National with the Securities and Exchange Commission (“SEC”), including the annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy and information statements, other information and amendments to those reports filed or furnished (if applicable), are accessible at no cost on Old National’s web site at www.oldnational.com as soon as reasonably practicable after electronically submitting such materials to the SEC. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC, and Old National’s filings are accessible on the SEC’s web site at www.sec.gov. The public may read and copy any materials filed by Old National with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

 

ITEM 1A. RISK FACTORS

Old National’s business could be harmed by any of the risks noted below. In analyzing whether to make or to continue an investment in Old National, investors should consider, among other factors, the following:

Risks Related to Old National’s Business

A failure by Old National Bank to satisfy the conditions and obligations of the Consent Order it consented and agreed to with the Office of the Comptroller of the Currency (“OCC”) may subject it to monetary penalties and impact future regulatory approvals.

Old National Bank is subject to certain conditions and obligations of a Consent Order (the “Order”) it consented and agreed to with the OCC, Old National Bank’s federal banking regulator, relating to Old National Bank’s Bank Secrecy Act/Anti-Money Laundering Program. Among other things, the Order requires the ongoing implementation of a system of internal controls, independent testing and training programs designed to ensure full compliance with the Bank Secrecy Act (“BSA”) and to review account and transaction activity to determine whether suspicious activity was timely identified and reported by Old National Bank. The OCC did not identify any systemic undetected criminal activity or money laundering and the Order does not call for the payment of a civil monetary penalty. While the Order is in effect, it may impact Old National’s ability to obtain regulatory approval for merger and acquisition activity. While Old National Bank is implementing or has implemented corrective action for each deficiency and expects to satisfy all of the requirements of the Order in a timely fashion, material failure to comply with the Order could result in enforcement actions by the OCC, including the imposition of operating and expansion restrictions and monetary penalties.

Economic conditions have affected and could continue to adversely affect our revenues and profits.

From December 2007 through June 2009, the U.S. economy was in recession. Business activity across a wide range of industries and regions in the U.S. was greatly reduced. Although economic conditions have begun to slowly improve, certain sectors, such as real estate, remain weak and unemployment remains high. Local governments and many businesses are still facing serious difficulties due to lower consumer spending and the lack of liquidity in the credit markets.

Market conditions also led to the failure or merger of several prominent financial institutions and numerous regional and community-based financial institutions. These failures, as well as projected future failures, have had a significant negative impact on the capitalization level of the deposit insurance fund of the FDIC, which, in turn, has led to a significant increase in deposit insurance premiums paid by financial institutions.

Old National’s financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services that Old National offers, is highly dependent upon the business environment in the markets where Old National operates and in the United States as a whole. A favorable business environment is generally characterized by, among other factors, economic growth, efficient capital markets, low inflation, low unemployment, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters, terrorist acts or a combination of these or other factors.

 

 

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The business environment has been adverse for many households and businesses in the United States and worldwide. While economic conditions in the United States and worldwide have begun to improve, there can be no assurance that this improvement will continue. Such conditions could adversely affect the credit quality of Old National’s loans, results of operations and financial condition.

In response to economic and market conditions, from time to time we have undertaken initiatives to reduce our cost structure where appropriate. These initiatives, as well as any future workforce and facilities reductions, may not be sufficient to meet current and future changes in economic and market conditions and allow us to achieve profitability. In addition, costs actually incurred in connection with our restructuring actions may be higher than our estimates of such costs and/or may not lead to the anticipated cost savings. Unless and until the economy, loan demand, credit quality and consumer confidence improve, it is unlikely that revenues will increase significantly, and may be reduced further.

If Old National’s actual loan losses exceed Old National’s allowance for loan losses, Old National’s net income will decrease.

Old National makes various assumptions and judgments about the collectibility of Old National’s loan portfolio, including the creditworthiness of Old National’s borrowers and the value of the real estate and other assets serving as collateral for the repayment of Old National’s loans. Despite Old National’s underwriting and monitoring practices, the effect of the declining economy could negatively impact the ability of Old National’s borrowers to repay loans in a timely manner and could also negatively impact collateral values. As a result, Old National may experience significant loan losses that could have a material adverse effect on Old National’s operating results. Since Old National must use assumptions regarding individual loans and the economy, Old National’s current allowance for loan losses may not be sufficient to cover actual loan losses. Old National’s assumptions may not anticipate the severity or duration of the current credit cycle and Old National may need to significantly increase Old National’s provision for losses on loans if one or more of Old National’s larger loans or credit relationships becomes delinquent or if Old National expands its commercial real estate and commercial lending. In addition, federal and state regulators periodically review Old National’s allowance for loan losses and may require Old National to increase the provision for loan losses or recognize loan charge-offs. Material additions to Old National’s allowance would materially decrease Old National’s net income. There can be no assurance that Old National’s monitoring procedures and policies will reduce certain lending risks or that Old National’s allowance for loan losses will be adequate to cover actual losses.

Old National’s loan portfolio includes loans with a higher risk of loss.

Old National Bank originates commercial real estate loans, commercial loans, agricultural real estate loans, agricultural loans, consumer loans, and residential real estate loans primarily within Old National’s market areas. Commercial real estate, commercial, consumer, and agricultural loans may expose a lender to greater credit risk than loans secured by residential real estate because the collateral securing these loans may not be sold as easily as residential real estate. These loans also have greater credit risk than residential real estate for the following reasons:

 

   

Commercial Real Estate Loans. Repayment is dependent upon income being generated in amounts sufficient to cover operating expenses and debt service.

 

   

Commercial Loans. Repayment is dependent upon the successful operation of the borrower’s business.

 

   

Consumer Loans. Consumer loans (such as personal lines of credit) are collateralized, if at all, with assets that may not provide an adequate source of payment of the loan due to depreciation, damage, or loss.

 

   

Agricultural Loans. Repayment is dependent upon the successful operation of the business, which is greatly dependent on many things outside the control of either Old National Bank or the borrowers. These factors include weather, commodity prices, and interest rates.

 

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We face risks with respect to expansion.

We have acquired, and may continue to acquire, other financial institutions or parts of those institutions in the future, and we may engage in de novo branch expansion. We may also consider and enter into new lines of business or offer new products or services.

We may incur substantial costs to expand, and we can give no assurance such expansion will result in the levels of profits we seek. There can be no assurance that integration efforts for any mergers or acquisitions will be successful. Also, we may issue equity securities in connection with acquisitions, which could cause ownership and economic dilution to our current shareholders. There is no assurance that, following any mergers or acquisitions, our integration efforts will be successful or that, after giving effect to the acquisition, we will achieve profits comparable to, or better than, our historical experience.

Acquisitions and mergers involve a number of expenses and risks, including:

 

   

the time and costs associated with identifying potential new markets, as well as acquisition and merger targets;

 

   

the estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target institution may not be accurate;

 

   

the time and costs of evaluating new markets, hiring experienced local management and opening new offices, and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;

 

   

our ability to finance an acquisition and possible dilution to our existing shareholders;

 

   

the diversion of our management’s attention to the negotiation of a transaction, and the integration of the operations and personnel of the combined businesses;

 

   

entry into new markets where we lack experience;

 

   

the introduction of new products and services into our business;

 

   

the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on our results of operations; and

 

   

the risk of loss of key employees and customers.

In the current economic environment, we anticipate that in addition to opportunities to acquire other banks in privately negotiated transactions, we may also have opportunities to bid to acquire the assets and liabilities of failed banks in FDIC-assisted transactions. These acquisitions involve risks similar to acquiring existing banks. Because FDIC-assisted acquisitions are structured in a manner that would not allow us the time normally associated with due diligence investigations prior to committing to purchase the target bank or preparing for integrations of an acquired bank, we may face additional risks in FDIC-assisted transactions. These risks include, among other things:

 

   

loss of customers of the failed bank;

 

   

strain on management resources related to collection and management of problem loans;

 

   

problems related to integration of personnel and operating systems;

 

 

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the ultimate collectibility of claims with the FDIC under the shared loss agreement are dependent upon the performance of the underlying covered assets, the passage of time and our ability to service loans in accordance with the shared loss agreement; and

 

   

losses may exceed our estimates and move us into a tranche where we have 0% coverage under our loss sharing agreements with the FDIC.

Our growth or future losses may require us to raise additional capital in the future, but that capital may not be available when it is needed or the cost of that capital may be very high.

We are required by regulatory authorities to maintain adequate levels of capital to support our operations. We anticipate that our capital resources will satisfy our capital requirements for the foreseeable future. We may at some point need to raise additional capital to support continued growth or losses, both internally and through acquisitions. Any capital we obtain may result in the dilution of the interests of existing holders of our common stock.

Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time (which are outside our control) and on our financial condition and performance. Accordingly, we cannot make assurances of our ability to raise additional capital if needed, or if the terms will be acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired and our financial condition and liquidity could be materially and negatively affected.

Our wholesale funding sources may prove insufficient to replace deposits or support our future growth.

As a part of our liquidity management, we use a number of funding sources in addition to core deposit growth and repayments and maturities of loans and investments. These sources include brokered certificates of deposit, repurchase agreements, and federal funds purchased. Negative operating results or changes in industry conditions could lead to an inability to replace these additional funding sources at maturity. Our financial flexibility could be constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In this case, our results of operations and financial condition would be negatively affected.

Our Accounting Estimates and Risk Management Processes Rely On Analytical and Forecasting Models

The processes that we use to estimate probable loan losses and to measure the fair value of financial instruments, as well as the processes used to estimate the effects of changing interest rates and other market measures on our financial condition and results of operations, depend upon the use of analytical and forecasting models. These models reflect assumptions that may not be accurate, particularly in times of market stress or other unforeseen circumstances. Even if these assumptions are adequate, the models may prove to be inadequate or inaccurate because of other flaws in their design or their implementation. If our models for determining interest rate risk and asset-liability management are inadequate, we may incur increased or unexpected losses upon changes in market interest rates or other market measures. If our models for determining probable loan losses are inadequate, the allowance for loan losses may not be sufficient to support future charge-offs. If our models to measure the fair value of financial instruments are inadequate, the fair value of such financial instruments may fluctuate unexpectedly or may not accurately reflect what we could realize upon sale or settlement of such financial instruments. Any such failure in our analytical or forecasting models could have a material adverse effect on our business, financial condition and results of operations.

The Repeal Of Federal Prohibitions On Payment Of Interest On Demand Deposits Could Increase Our Interest Expense

All federal prohibitions on the ability of financial institutions to pay interest on demand deposit accounts were repealed as part of the Dodd-Frank Act beginning on July 21, 2011. As a result, some financial institutions have commenced offering interest on demand deposits to compete for customers. We cannot predict what interest rates other institutions may offer as market interest rates begin to increase. Our interest expense will increase and our net interest margin will decrease if we begin offering interest on demand deposits to attract additional customers or maintain current customers, which could have a material adverse effect on our business, financial condition and results of operations.

 

 

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If Old National forecloses on collateral property, Old National may be subject to the increased costs associated with the ownership of real property, resulting in reduced revenues.

Old National may have to foreclose on collateral property to protect Old National’s investment and may thereafter own and operate such property, in which case Old National will be exposed to the risks inherent in the ownership of real estate. The amount that Old National, as a mortgagee, may realize after a default is dependent upon factors outside of Old National’s control, including, but not limited to: (i) general or local economic conditions; (ii) neighborhood values; (iii) interest rates; (iv) real estate tax rates; (v) operating expenses of the mortgaged properties; (vi) environmental remediation liabilities; (vii) ability to obtain and maintain adequate occupancy of the properties; (viii) zoning laws; (ix) governmental rules, regulations and fiscal policies; and (x) acts of God. Certain expenditures associated with the ownership of real estate, principally real estate taxes, insurance, and maintenance costs, may adversely affect the income from the real estate. Therefore, the cost of operating real property may exceed the income earned from such property, and Old National may have to advance funds in order to protect Old National’s investment, or Old National may be required to dispose of the real property at a loss. The foregoing expenditures and costs could adversely affect Old National’s ability to generate revenues, resulting in reduced levels of profitability.

Old National operates in an extremely competitive market, and Old National’s business will suffer if Old National is unable to compete effectively.

In Old National’s market area, the Company encounters significant competition from other commercial banks, savings and loan associations, credit unions, mortgage banking firms, consumer finance companies securities brokerage firms, insurance companies, money market mutual funds and other financial intermediaries. The Company’s competitors may have substantially greater resources and lending limits than Old National does and may offer services that Old National does not or cannot provide. Old National’s profitability depends upon Old National’s continued ability to compete successfully in Old National’s market area.

The loss of key members of Old National’s senior management team could adversely affect Old National’s business.

Old National believes that Old National’s success depends largely on the efforts and abilities of Old National’s senior management. Their experience and industry contacts significantly benefit Old National. The competition for qualified personnel in the financial services industry is intense, and the loss of any of Old National’s key personnel or an inability to continue to attract, retain and motivate key personnel could adversely affect Old National’s business.

A breach of information security or compliance breach by one of our agents or vendors could negatively affect Old National’s reputation and business.

Old National relies upon a variety of computing platforms and networks over the internet for the purposes of data processing, communication and information exchange. Despite the safeguards instituted by Old National, such systems are susceptible to a breach of security. In addition, Old National relies on the services of a variety of third-party vendors to meet Old National’s data processing and communication needs. The occurrence of any failures, interruptions or security breaches of Old National’s information systems or our vendors information systems could damage our reputation, result in a loss of customer business, and expose us to civil litigation and possible financial loss. Such costs and/or losses could materially affect Old National’s earnings.

Fiduciary Activity Risk Factor

Old National Is Subject To Claims and Litigation Pertaining To Fiduciary Responsibility

From time to time, customers make claims and take legal action pertaining to Old National’s performance of its fiduciary responsibilities. If such claims and legal actions are not resolved in a manner favorable to Old National they may result in significant financial liability and/or adversely affect the market perception of Old National and its products and services as well as impact customer demand for those products and services. Any financial liability or reputational damage could have a material adverse effect on the Old National’s business, which, in turn, could have a material adverse effect on the Old National’s financial condition and results of operations.

 

 

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Risks Related to the Banking Industry

Old National operates in a highly regulated environment, and changes in laws and regulations to which Old National is subject may adversely affect Old National’s results of operations.

Old National operates in a highly regulated environment and is subject to extensive regulation, supervision and examination by the Office of Comptroller of the Currency (“OCC”), the Federal Deposit Insurance Corporation (“FDIC”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and the State of Indiana. Such regulation and supervision of the activities in which an institution may engage is primarily intended for the protection of the depositors and federal deposit insurance funds. In addition, the Treasury has certain supervisory and oversight duties and responsibilities under EESA and the CPP. See “Business—Supervision and Regulation” herein. Applicable laws and regulations may change, and such changes may adversely affect Old National’s business. The Dodd-Frank Act, enacted in July 2010, instituted major changes to the banking and financial institutions regulatory regimes in light of the recent performance of and government intervention in the financial services sector. Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on Old National. Provisions in the legislation that affect the payment of interest on demand deposits and interchange fees are likely to increase the costs associated with deposits as well as place limitation on certain revenues those deposits may generate. Provisions in the legislation that revoke the Tier 1 capital treatment of trust preferred securities and otherwise require revisions to the capital requirements of Old National and Old National Bank could require Old National and Old National Bank to seek other sources of capital in the future. In addition, certain provisions in the legislation that do not currently apply to Old National may become effective if Old National grows and its consolidated assets increase to over ten billion.

Regulatory authorities also have extensive discretion in connection with their supervisory and enforcement activities, including but not limited to the imposition of restrictions on the operation of an institution, the classification of assets by the institution, the adequacy of an institution’s Bank Secrecy Act/Anti Money Laundering program management, and the adequacy of an institution’s allowance for loan losses. Any change in such regulation and oversight, whether in the form of restrictions on activities, regulatory policy, regulations, or legislation, including but not limited to changes in the regulations governing institutions, could have a material impact on Old National and its operations.

Changes in economic or political conditions could adversely affect Old National’s earnings, as the ability of Old National’s borrowers to repay loans, and the value of the collateral securing such loans, decline.

Old National’s success depends, to a certain extent, upon economic or political conditions, local and national, as well as governmental monetary policies. Conditions such as recession, unemployment, changes in interest rates, inflation, money supply and other factors beyond Old National’s control may adversely affect its asset quality, deposit levels and loan demand and, therefore, Old National’s earnings. Because Old National has a significant amount of commercial real estate loans, decreases in real estate values could adversely affect the value of property used as collateral. Adverse changes in the economy may also have a negative effect on the ability of Old National’s borrowers to make timely repayments of their loans, which would have an adverse impact on Old National’s earnings. In addition, substantially all of Old National’s loans are to individuals and businesses in Old National’s market area. Consequently, any economic decline in Old National’s primary market areas, which include Indiana, Kentucky and Illinois, could have an adverse impact on Old National’s earnings.

Changes in interest rates could adversely affect Old National’s results of operations and financial condition.

Old National’s earnings depend substantially on Old National’s interest rate spread, which is the difference between (i) the rates Old National earns on loans, securities and other earning assets and (ii) the interest rates Old National pays on deposits and other borrowings. These rates are highly sensitive to many factors beyond Old National’s control, including general economic conditions and the policies of various governmental and regulatory authorities. If market interest rates rise, Old National will have competitive pressures to increase the rates that Old National pays on deposits, which could result in a decrease of Old National’s net interest income. If market interest rates decline, Old National could experience fixed rate loan prepayments and higher investment portfolio cash flows, resulting in a lower yield on earnings assets.

 

 

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Our Internal Operations are Subject to a Number of Risks.

Old National’s internal operations are subject to certain risks, including but not limited to, data processing system failures and errors, customer or employee fraud and catastrophic failures resulting from terrorist acts or natural disasters. Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements. This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.

The banking industry is undergoing technological innovation at a fast pace. To keep up with its competition, Old National needs to stay abreast of innovations and evaluate those technologies that will enable it to compete on a cost-effective basis. The cost of such technology, including personnel, can be high in both absolute and relative terms. There can be no assurance, given the fast pace of change and innovation, that Old National’s technology, either purchased or developed internally, will meet or continue to meet the needs of Old National.

Our earnings could be adversely impacted by incidences of fraud and compliance failures that are not within our direct control.

Financial institutions are inherently exposed to fraud risk. A fraud can be perpetrated by a customer of the Bank, an employee, a vendor, or members of the general public. We are most subject to fraud and compliance risk in connection with the origination of loans, ACH transactions, ATM transactions and checking transactions. Our largest fraud risk, associated with the origination of loans, includes the intentional misstatement of information in property appraisals or other underwriting documentation provided to us by third parties. Compliance risk is the risk that loans are not originated in compliance with applicable laws and regulations and our standards. There can be no assurance that we can prevent or detect acts of fraud or violation of law or our compliance standards by the third parties that we deal with. Repeated incidences of fraud or compliance failures would adversely impact the performance of our loan portfolio.

Risks Related to Old National’s Stock

We may not be able to pay dividends in the future in accordance with past practice.

Old National has traditionally paid a quarterly dividend to common stockholders. The payment of dividends is subject to legal and regulatory restrictions. Any payment of dividends in the future will depend, in large part, on Old National’s earnings, capital requirements, financial condition and other factors considered relevant by Old National’s Board of Directors.

The price of Old National’s common stock may be volatile, which may result in losses for investors.

General market price declines or market volatility in the future could adversely affect the price of Old National’s common stock. In addition, the following factors may cause the market price for shares of Old National’s common stock to fluctuate:

 

   

announcements of developments related to Old National’s business;

 

   

fluctuations in Old National’s results of operations;

 

   

sales or purchases of substantial amounts of Old National’s securities in the marketplace;

 

 

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general conditions in Old National’s banking niche or the worldwide economy;

 

   

a shortfall or excess in revenues or earnings compared to securities analysts’ expectations;

 

   

changes in analysts’ recommendations or projections; and

 

   

Old National’s announcement of new acquisitions or other projects.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

As of December 31, 2012, Old National and its affiliates operated a total of 180 banking centers, loan production or other financial services offices, primarily in the states of Indiana, Illinois and Kentucky. Of these facilities, 38 were owned.

The executive offices of Old National are located at 1 Main Street, Evansville, Indiana. This building, which houses Old National’s general corporate functions, is leased from an unaffiliated third party. The lease term expires December 31, 2031, and provides for the tenant’s option to extend the term of the lease for four five-year periods. In addition, we lease 142 financial centers from unaffiliated third parties. The terms of these leases range from six months to twenty-four years. See Note 19 to the consolidated financial statements.

ITEM 3. LEGAL PROCEEDINGS

In the normal course of business, Old National Bancorp and its subsidiaries have been named, from time to time, as defendants in various legal actions. Certain of the actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages.

Old National contests liability and/or the amount of damages as appropriate in each pending matter. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or indeterminate damages or where investigations and proceedings are in the early stages, Old National cannot predict with certainty the loss or range of loss, if any, related to such matters, how or if such matters will be resolved, when they will ultimately be resolved, or what the eventual settlement, or other relief, if any, might be. Subject to the foregoing, Old National believes, based on current knowledge and after consultation with counsel, that the outcome of such pending matters will not have a material adverse effect on the consolidated financial condition of Old National, although the outcome of such matters could be material to Old National’s operating results and cash flows for a particular future period, depending on, among other things, the level of Old National’s revenues or income for such period. Old National will accrue for a loss contingency if (1) it is probable that a future event will occur and confirm the loss and (2) the amount of the loss can be reasonably estimated.

In November 2002, several beneficiaries of certain trusts filed a complaint against Old National and Old National Trust Company in the United States District Court for the Western District of Kentucky relating to the administration of the trusts in 1997. This litigation was fully and finally settled in the first quarter of 2012. The Company had previously accrued $2 million in the third quarter of 2011 in anticipation of negotiating the final settlement and resolution of the matter. The matter was fully settled for the amount of the accrual. However, a portion of the settlement funds were put temporarily in escrow to account for uncertain contingencies. These funds, less contingencies (if any), were released to the beneficiaries in December 2012 pursuant to the terms of the settlement agreement.

In November 2010, Old National was named in a class action lawsuit in Vanderburgh County Circuit Court challenging Old National Bank’s checking account practices associated with the assessment of overdraft fees. On May 1, 2012, the plaintiff was granted permission to file a First Amended Complaint which names additional plaintiffs and amends certain claims. The plaintiffs seek damages and other relief, including restitution. Old National believes it has meritorious defenses to the claims brought by the plaintiffs. At this phase of the litigation, it is not possible for management of Old National to determine the probability of a material adverse outcome or reasonably estimate the amount of any loss. No class has yet been certified and discovery is ongoing. On June 13, 2012, Old National filed a motion to dismiss the First Amended Complaint, which has not yet been ruled upon. On September 7, 2012, the plaintiffs filed a motion for class certification.

 

 

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ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Old National’s common stock is traded on the New York Stock Exchange (“NYSE”) under the ticker symbol ONB. The following table lists the high and low closing sales prices as reported by the NYSE, share volume and dividend data for 2012 and 2011:

 

     Price Per Share      Share      Dividend  
     High      Low      Volume      Declared  

2012

           

First Quarter

   $ 13.29       $ 11.52         35,989,100       $ 0.09   

Second Quarter

     13.21         10.92         26,520,600         0.09   

Third Quarter

     14.10         11.84         25,206,900         0.09   

Fourth Quarter

     13.90         10.94         31,430,300         0.09   

2011

           

First Quarter

   $ 12.15       $ 10.35         29,575,800       $ 0.07   

Second Quarter

     11.33         10.16         34,157,500         0.07   

Third Quarter

     11.05         8.67         52,288,900         0.07   

Fourth Quarter

     11.99         9.05         47,713,600         0.07   

There were 23,525 shareholders of record as of December 31, 2012. Old National declared cash dividends of $0.36 per share during the year ended December 31, 2012 and $0.28 per share during the year ended December 31, 2011. Old National’s ability to pay cash dividends depends primarily on cash dividends received from Old National Bank. Dividend payments from Old National Bank are subject to various regulatory restrictions. See Note 21 to the consolidated financial statements for additional information.

The following table summarizes the purchases of equity securities made by Old National during the fourth quarter of 2012:

 

Period

   Total
Number
of Shares
Purchased
     Average
Price
Paid Per
Share
     Total
Number of
Shares
Purchased
as Part of
Publicly
Announced
Plans or
Programs
     Maximum
Number of
Shares that
May Yet Be
Purchased
Under the
Plans or
Programs
 

10/01/12—10/31/12

     600       $ 13.75         600         1,933,564   

11/01/12—11/30/12

     250,176         12.16         250,176         1,683,388   

12/01/12—12/31/12

     9,567         11.87         9,567         1,673,821   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     260,343       $ 12.15         260,343         1,673,821   
  

 

 

    

 

 

    

 

 

    

 

 

 

On January 26, 2012, the Board of Directors approved the repurchase of up to 2.0 million shares of common stock over a twelve month period beginning January 26, 2012 and ending January 31, 2013. During the fourth quarter of 2012, Old National repurchased 250,000 shares on the open market. During the twelve months ended December 31, 2012, Old National also repurchased a limited number of shares associated with employee share-based incentive programs.

 

 

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Subsequent to year-end, the Board of Directors approved the repurchase of up to 2.0 million shares of common stock over a twelve month period that runs through January 31, 2014. On January 24, 2013, the Board of Directors also declared an increase in its quarterly common stock dividend to $.10 per share, an 11.1% increase over the previous cash dividend level of $.09 per share. Old National’s recent financial performance and strong capital position allowed it to increase the cash dividend.

EQUITY COMPENSATION PLAN INFORMATION

The following table contains information concerning the 2008 Equity Incentive Plan approved by security holders, as of December 31, 2012.

2008 EQUITY COMPENSATION PLAN

 

     Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights
     Weighted-average
exercise price of
outstanding
options, warrants
and rights
     Number of securities
remaining available
for future issuance
under equity
compensation plans
(excluding securities
reflected in column (a))
 

Plan Category

   (a)      (b)      (c)  

Equity compensation plans approved by security holders

     4,095,556       $ 17.71         3,535,002   

Equity compensation plans not approved by security holders

     —           —           —     
  

 

 

    

 

 

    

 

 

 

Total

     4,095,556       $ 17.71         3,535,002   
  

 

 

    

 

 

    

 

 

 

The following table compares cumulative five-year total shareholder returns, assuming reinvestment of dividends, for the Company’s common stock to cumulative total returns of a broad-based equity market index and two published industry indices.

 

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LOGO

The comparison of shareholder returns (change in December year end stock price plus reinvested dividends) for each of the periods assumes that $100 was invested on December 31, 2007, in common stock of each of the Company, the S&P Small Cap 600 Index, the NYSE Financial Index and the SNL Bank and Thrift Index with investment weighted on the basis of market capitalization.

 

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ITEM 6. SELECTED FINANCIAL DATA

 

(dollars in thousands, except per share data)

   2012     2011     2010     2009     2008  

Operating Results

          

Net interest income

   $ 308,757      $ 272,873      $ 218,416      $ 231,399      $ 243,325   

Conversion to fully taxable equivalent (1)

     13,188        11,821        13,482        20,831        19,326   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income—tax equivalent basis

     321,945        284,694        231,898        252,230        262,651   

Provision for loan losses

     5,030        7,473        30,781        63,280        51,464   

Noninterest income

     189,816        182,883        170,150        163,460        166,969   

Noninterest expense

     365,758        348,521        314,305        338,956        297,229   

Net income available to common shareholders

     91,675        72,460        38,214        9,845        62,180   

Common Share Data (2)

          

Weighted average diluted shares

     96,833        94,772        86,928        71,367        65,776   

Net income (diluted)

   $ 0.95      $ 0.76      $ 0.44      $ 0.14      $ 0.95   

Cash dividends

     0.36        0.28        0.28        0.44        0.69   

Common dividend payout ratio (3)

     37.80        36.59        63.75        308.59        73.51   

Book value at year-end

     11.81        10.92        10.08        9.68        9.56   

Stock price at year-end

     11.87        11.65        11.89        12.43        18.16   

Balance Sheet Data (at December 31)

          

Loans (4)

   $ 5,209,185      $ 4,771,731      $ 3,747,270      $ 3,908,276      $ 4,777,514   

Total assets

     9,543,623        8,609,683        7,263,892        8,005,335        7,873,890   

Deposits

     7,278,953        6,611,563        5,462,925        5,903,488        5,422,287   

Other borrowings

     237,493        290,774        421,911        699,059        834,867   

Shareholders’ equity

     1,194,565        1,033,556        878,805        843,826        730,865   

Performance Ratios

          

Return on average assets (ROA)

     1.04     0.86     0.50     0.17     0.82

Return on average common shareholders’ equity (ROE)

     8.34        7.24        4.40        1.41        9.49   

Average equity to average assets

     12.49        11.94        11.46        9.06        8.67   

Net interest margin (5)

     4.23        3.87        3.40        3.50        3.82   

Efficiency ratio (6)

     71.83        73.80        79.25        80.45        69.39   

Asset Quality (7)

          

Net charge-offs to average loans

     0.17     0.49     0.75     1.40     0.87

Allowance for loan losses to ending loans

     1.05        1.22        1.93        1.81        1.41   

Allowance for loan losses

   $ 54,763      $ 58,060      $ 72,309      $ 69,548      $ 67,087   

Underperforming assets (8)

     301,919        340,543        77,108        78,666        69,883   

Other Data

          

Full-time equivalent employees

     2,684        2,551        2,491        2,812        2,507   

Branches and financial centers

     180        183        161        172        117   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Calculated using the federal statutory tax rate in effect of 35% for all periods adjusted for the TEFRA interest disallowance applicable to certain tax-exempt obligations.
(2) Diluted data assumes the exercise of stock options and the vesting of restricted stock.
(3) Cash dividends divided by income available to common stockholders.
(4) Includes residential loans and finance leases held for sale.
(5) Defined as net interest income on a tax equivalent basis as a percentage of average earning assets.
(6) Defined as noninterest expense before amortization of intangibles as a percent of fully taxable equivalent net interest income and noninterest income, excluding net gains from securities transactions. This presentation excludes intangible amortization and net securities gains, as is common in other company disclosures, and better aligns with true operating performance.
(7) Excludes residential loans and finance leases held for sale.
(8) Includes nonaccrual loans, renegotiated loans, loans 90 days past due still accruing and other real estate owned. Includes $130.1 million and $215.7 million of covered assets in 2012 and 2011, respectively, acquired in an FDIC assisted transaction, which are covered by loss sharing agreements with the FDIC providing for specified loss protection.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is an analysis of our results of operations for the fiscal years ended December 31, 2012, 2011 and 2010, and financial condition as of December 31, 2012 and 2011. This discussion and analysis should be read in conjunction with our consolidated financial statements and related notes. This discussion contains forward-looking statements concerning our business. Readers are cautioned that, by their nature, forward-looking statements are based on estimates and assumptions and are subject to risks, uncertainties, and other factors. Actual results may differ materially from our expectations that are expressed or implied by any forward-looking statement. The discussion in Item 1A, “Risk Factors,” lists some of the factors that could cause our actual results to vary materially from those expressed or implied by any forward-looking statements, and such discussion is incorporated into this discussion by reference.

GENERAL OVERVIEW

Old National is a financial holding company incorporated in the State of Indiana and maintains its principal executive offices in Evansville, Indiana. Old National, through Old National Bank, provides a wide range of services, including commercial and consumer loan and depository services, lease financing and other traditional banking services. Old National also provides services to supplement the traditional banking business including fiduciary and wealth management services, investment and brokerage services, investment consulting, insurance and other financial services.

The Company’s basic mission is to be THE community bank in the cities and towns it serves. The Company focuses on establishing and maintaining long-term relationships with customers, and is committed to serving the financial needs of the communities in its market area. Old National provides financial services primarily in Indiana, eastern and southeastern Illinois, and central and western Kentucky.

CORPORATE DEVELOPMENTS IN FISCAL 2012

Net income for 2012 was $91.7 million, an increase of $19.2 million from 2011. Diluted earnings per share available to common shareholders were $0.95 per share, an increase of $0.19 per share from 2011.

The improvement in 2012 net income was primarily the result of accretion income associated with acquired loans, lower cost funding sources, modest organic loan growth, and improved credit. Partially offsetting the higher net revenue were higher noninterest expenses associated with our recent acquisitions.

The Company successfully integrated Indiana Community Bancorp at the end of the third quarter. This transaction strengthens our position as the third largest branch network in Indiana and allows us to expand our services into Columbus, Indiana and other vibrant regions in the south central Indiana market.

Subsequent to year-end, the Company also announced its intent to enter into the southwest lower Michigan market through the acquisition of 24 Bank of America branches. The entry into this new market and the full ramp-up of lenders at the former Indiana Community Bancorp locations give rise to our favorable commercial loan growth outlook.

BUSINESS OUTLOOK

While we believe the interest rate environment will continue to pose challenges for 2013 revenue growth, our clients are expressing more optimism regarding the state of the economy.

Our goals for 2013 are much the same as they were in 2012: increase revenue, reduce expenses and target partnership opportunities that align with our financial and strategic goals.

 

   

While we remain committed to a risk-conscious approach to lending, we know how vital it is to generate new loan growth in 2013 and beyond. We believe our new partnerships, and the new client base they represent, position us well to achieve this growth.

 

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As we did in 2012, we will continue to look for ways to enhance the Company’s efficiency ratio through process improvements, organizational streamlining and other cost reduction strategies.

 

   

We continue to target additional partnerships. We are focused on expanding our wealth management business and community banks in growth markets that are either within or near our existing franchise. Such strategic consolidations should improve the Company’s bottom line while expanding our distribution network, which helps build long-term shareholder value.

RESULTS OF OPERATIONS

The following table sets forth certain income statement information of Old National for the years ended December 31, 2012, 2011, and 2010:

 

(dollars in thousands)

   2012     2011     2010  

Income Statement Summary:

      

Net interest income

   $ 308,757      $ 272,873      $ 218,416   

Provision for loan losses

     5,030        7,473        30,781   

Noninterest income

     189,816        182,883        170,150   

Noninterest expense

     365,758        348,521        314,305   

Other Data:

      

Return on average common equity

     8.34     7.24     4.40

Efficiency ratio (1)

     71.83     73.80     79.25

Tier 1 leverage ratio

     8.56     8.29     9.01

Net charge-offs to average loans

     0.17     0.49     0.75
  

 

 

   

 

 

   

 

 

 

 

(1) Efficiency ratio is defined as noninterest expense before amortization of intangibles as a percent of fully taxable equivalent net interest income and noninterest income, excluding net gains from securities transactions. This presentation excludes intangible amortization and net securities gains, as is common in other company disclosures, and better aligns with true operating performance. This is a non-GAAP financial measure that management believes to be helpful in understanding Old National’s results of operations.

Comparison of Fiscal Years 2012 and 2011

Net Interest Income

Net interest income is the most significant component of our earnings, comprising over 61% of 2012 revenues. Net interest income and margin are influenced by many factors, primarily the volume and mix of earning assets, funding sources and interest rate fluctuations. Other factors include level of accretion income on purchased loans, prepayment risk on mortgage and investment-related assets and the composition and maturity of earning assets and interest-bearing liabilities. Loans typically generate more interest income than investment securities with similar maturities. Funding from client deposits generally cost less than wholesale funding sources. Factors such as general economic activity, Federal Reserve Board monetary policy and price volatility of competing alternative investments, can also exert significant influence on our ability to optimize the mix of assets and funding and the net interest income and margin.

Net interest income is the excess of interest received from earning assets over interest paid on interest-bearing liabilities. For analytical purposes, net interest income is also presented in the table that follows, adjusted to a taxable equivalent basis to reflect what our tax-exempt assets would need to yield in order to achieve the same after-tax yield as a taxable asset. We used the federal statutory tax rate in effect of 35% for all periods adjusted for the TEFRA interest disallowance applicable to certain tax-exempt obligations. This analysis portrays the income tax benefits associated in tax-exempt assets and helps to facilitate a comparison between taxable and tax-exempt assets. Management believes that it is a standard practice in the banking industry to present net interest margin and net interest income on a fully taxable equivalent basis. Therefore, management believes these measures provide useful information for both management and investors by allowing them to make peer comparisons.

 

 

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(dollars in thousands)

   2012     2011     2010  

Net interest income

   $ 308,757      $ 272,873      $ 218,416   

Conversion to fully taxable equivalent

     13,188        11,821        13,482   
  

 

 

   

 

 

   

 

 

 

Net interest income—taxable equivalent basis

   $ 321,945      $ 284,694      $ 231,898   
  

 

 

   

 

 

   

 

 

 

Average earning assets

     7,617,060        7,359,092        6,814,607   

Net interest margin

     4.05     3.71     3.21

Net interest margin—taxable equivalent basis

     4.23     3.87     3.40
  

 

 

   

 

 

   

 

 

 

Net interest income was $308.8 million in 2012, a 13.2% increase from the $272.9 million reported in 2011. Taxable equivalent net interest income was $321.9 million in 2012, a 13.1% increase from the $284.7 million reported in 2011. The net interest margin on a fully taxable equivalent basis was 4.23% for 2012, a 36 basis point increase compared to the 3.87% reported in 2011. The increase in both net interest income and net interest margin is primarily due to the acquisition of Integra Bank on July 29, 2011 and Indiana Community Bancorp (“IBT”) on September 15, 2012 combined with a change in the mix of interest earning assets and interest-bearing liabilities. The accretion associated with the purchased assets benefited net interest margin by 75 basis points in 2012 compared to 50 basis points in 2011. We expect this benefit to decline over time. The yield on average earning assets increased 10 basis points from 4.60% to 4.70% while the cost of interest-bearing liabilities decreased 32 basis points from 0.96% to 0.64%. Average earning assets increased by $258.0 million, or 3.5%. Average interest-bearing liabilities increased $28.8 million, or 0.5%. The increase in average earning assets consisted of a $418.5 million increase in loans, a $36.8 million decrease in lower yielding investment securities and a $123.7 million decrease in money market and other interest-earning investments. The increase in average interest-bearing liabilities consisted of a $113.2 million increase in interest-bearing deposits, a $50.3 million increase in short-term borrowings and a $134.7 million decrease in other borrowings. Noninterest-bearing deposits increased by $272.8 million.

Significantly affecting average earning assets during 2012 was the increase in the size of the loan portfolio combined with the reduction in the size of the investment portfolio and the decrease in interest earning cash balances at the Federal Reserve. Included in average earning assets for 2012 are approximately $169.3 million from the Indiana Community Bancorp acquisition, which was completed on September 15, 2012, and $543.5 million from the Integra Bank acquisition, which was completed on July 29, 2011. Included in average earning assets for 2011 was $319.5 million from the Integra Bank acquisition. The increase in average loans during 2012 is primarily a result of the Indiana Community Bancorp and Integra Bank acquisitions. However, in 2012 we continued to experience growth in our residential mortgage loan portfolio and late in the year began to experience modest growth in our commercial loan portfolio. The loan portfolio, which generally has an average yield higher than the investment portfolio, was approximately 63% of interest earning assets at December 31, 2012.

Positively affecting margin was an increase in noninterest-bearing demand deposits combined with decreases in time deposits and other borrowings. During the fourth quarter of 2012, we terminated $50.0 million of FHLB advances. On June 30, 2012 we redeemed $13.0 million of subordinated notes and $3.0 million of trust preferred securities. During 2011, we prepaid $119.2 million of FHLB advances and $80.0 million of structured repurchase agreements. In the fourth quarter of 2011, $150.0 million of subordinated bank notes matured. Year over year, time deposits and other borrowings, which have an average interest rate higher than other types of deposits, have decreased as a percent of total funding. Year over year, noninterest-bearing demand deposits have increased as a percent of total funding.

The following table presents a three-year average balance sheet and for each major asset and liability category, its related interest income and yield or its expense and rate for the years ended December 31.

 

 

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THREE-YEAR AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS

 

     2012     2011     2010  

(tax equivalent basis, dollars in thousands)

   Average
Balance
    Interest
& Fees
     Yield/
Rate
    Average
Balance
    Interest
& Fees
     Yield/
Rate
    Average
Balance
    Interest
& Fees
     Yield/
Rate
 

Earning Assets

                     

Money market and other interest- earning investments (7)

   $ 29,161      $ 54         0.18   $ 152,848      $ 362         0.24   $ 177,786      $ 431         0.24

Investment securities: (6)

                     

U.S. Treasury & Government-sponsored agencies (1)

     1,826,297        41,790         2.29        1,969,590        52,369         2.66        2,150,562        77,208         3.59   

States and political subdivisions (3)

     684,648        37,464         5.47        580,851        34,135         5.88        536,295        33,181         6.19   

Other securities

     214,556        8,162         3.80        211,862        9,102         4.30        198,747        9,307         4.68   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total investment securities

     2,725,501        87,416         3.21        2,762,303        95,606         3.46        2,885,604        119,696         4.15   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Loans: (2)

                     

Commercial (3) (4)

     1,309,457        64,783         4.95        1,326,746        63,953         4.82        1,271,515        56,153         4.42   

Commercial real estate

     1,370,321        98,897         7.22        1,308,401        78,912         6.03        1,007,636        44,992         4.47   

Residential real estate (5)

     1,197,046        53,830         4.50        847,722        41,267         4.87        464,676        26,209         5.64   

Consumer, net of unearned income

     985,574        52,907         5.37        961,072        58,314         6.07        1,007,390        62,849         6.24   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total loans (4) (5)

     4,862,398        270,417         5.56        4,443,941        242,446         5.46        3,751,217        190,203         5.07   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total earning assets

     7,617,060      $ 357,887         4.70     7,359,092      $ 338,414         4.60     6,814,607      $ 310,330         4.55
    

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

 

Less: Allowance for loan losses

     (56,127          (70,753          (73,868     

Non-Earning Assets

                     

Cash and due from banks

     156,452             152,162             124,565        

Other assets

     1,083,165             944,172             721,142        
  

 

 

        

 

 

        

 

 

      

Total assets

   $ 8,800,550           $ 8,384,673           $ 7,586,446        
  

 

 

        

 

 

        

 

 

      

Interest-Bearing Liabilities

                     

NOW deposits

   $ 1,608,643      $ 485         0.03   $ 1,472,710      $ 587         0.04   $ 1,221,352      $ 411         0.03

Savings deposits

     1,728,887        3,735         0.22        1,384,294        3,948         0.29        1,043,289        3,134         0.30   

Money market deposits

     288,986        285         0.10        328,550        337         0.10        361,166        357         0.10   

Time deposits

     1,319,958        22,537         1.71        1,647,729        31,039         1.88        1,753,561        44,706         2.55   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing deposits

     4,946,474        27,042         0.55        4,833,283        35,911         0.74        4,379,368        48,608         1.11   

Short-term borrowings

     413,921        539         0.13        363,623        550         0.15        328,535        662         0.20   

Other borrowings

     280,219        8,361         2.98        414,902        17,259         4.16        615,006        29,162         4.74   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing liabilities

   $ 5,640,614      $ 35,942         0.64     5,611,808      $ 53,720         0.96     5,322,909      $ 78,432         1.47
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Noninterest-Bearing Liabilities

                     

Demand deposits

     1,828,750             1,555,946             1,182,653        

Other liabilities

     232,226             215,730             211,651        

Shareholders’ equity

     1,098,960             1,001,189             869,233        
  

 

 

        

 

 

        

 

 

      

Total liabilities and shareholders’ equity

   $ 8,800,550           $ 8,384,673           $ 7,586,446        
  

 

 

        

 

 

        

 

 

      

Interest Margin Recap

                     

Interest income/average earning assets

     $ 357,887         4.70     $ 338,414         4.60     $ 310,330         4.55

Interest expense/average earning assets

       35,942         0.47          53,720         0.73          78,432         1.15   
    

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

 

Net interest income and margin

     $ 321,945         4.23     $ 284,694         3.87     $ 231,898         3.40
    

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

 

 

(1) Includes U.S. Government-sponsored entities, agency mortgage-backed securities and $30.2 million of non-agency mortgage-backed securities at December 31, 2012.
(2) Includes principal balances of nonaccrual loans. Interest income relating to nonaccrual loans is included only if received.
(3) Interest on state and political subdivision investment securities and commercial loans includes the effect of taxable equivalent adjustments of $8.8 million and $4.4 million, respectively, in 2012; $7.3 million and $4.5 million, respectively, in 2011; and $8.5 million and $5.0 million, respectively, in 2010; using the federal statutory tax rate in effect of 35% for all periods adjusted for the TEFRA interest disallowance applicable to certain tax-exempt obligations.
(4) Includes finance leases held for sale.
(5) Includes residential loans held for sale.
(6) Changes in fair value are reflected in the average balance; however, yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.
(7) The 2012, 2011 and 2010 average balances include $23.5 million, $146.0 million and $152.3 million, respectively, of required and excess balances held at the Federal Reserve.

 

 

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The following table shows fluctuations in net interest income attributable to changes in the average balances of assets and liabilities and the yields earned or rates paid for the years ended December 31.

NET INTEREST INCOME—RATE/VOLUME ANALYSIS (tax equivalent basis, dollars in thousands)

 

     2012 vs. 2011     2011 vs. 2010  
     Total     Attributed to     Total     Attributed to  
     Change     Volume     Rate     Change     Volume     Rate  

Interest Income

            

Money market and other interest- earning investments

   $ (308   $ (260   $ (48   $ (69   $ (59   $ (10

Investment securities (1)

     (8,190     (1,226     (6,964     (24,090     (4,691     (19,399

Loans (1)

     27,971        23,051        4,920        52,243        36,459        15,784   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest income

     19,473        21,565        (2,092     28,084        31,709        (3,625
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest Expense

            

NOW deposits

     (102     47        (149     176        92        84   

Savings deposits

     (213     863        (1,076     814        998        (184

Money market deposits

     (52     (39     (13     (20     (33     13   

Time deposits

     (8,502     (5,885     (2,617     (13,667     (2,346     (11,321

Short-term borrowings

     (11     70        (81     (112     61        (173

Other borrowings

     (8,898     (4,810     (4,088     (11,903     (8,906     (2,997
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest expense

     (17,778     (9,754     (8,024     (24,712     (10,134     (14,578
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

   $ 37,251      $ 31,319      $ 5,932      $ 52,796      $ 41,843      $ 10,953   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The variance not solely due to rate or volume is allocated equally between the rate and volume variances.

 

(1) Interest on investment securities and loans includes the effect of taxable equivalent adjustments of $8.8 million and $4.4 million, respectively, in 2012; $7.3 million and $4.5 million, respectively, in 2011; and $8.5 million and $5.0 million, respectively, in 2010; using the federal statutory rate in effect of 35% for all periods adjusted for the TEFRA interest disallowance applicable to certain tax-exempt obligations.

Provision for Loan Losses

The provision for loan losses was $5.0 million in 2012, a $2.5 million decrease from the $7.5 million recorded in 2011. Impacting the provision over the past twelve months are the following factors: (1) the loss factors applied to our performing loan portfolio have decreased over time as charge-offs were substantially lower, (2) the continuing trend in improved credit quality, and (3) the percentage of our legacy loan portfolio consisting of those loans where higher loss factors are applied (commercial and commercial real estate loans) fell while the percentage of our loan portfolio consisting of those loans where lower loss factors are applied (residential loans) increased. For additional information about non-performing loans, charge-offs and additional items impacting the provision, refer to the “Risk Management—Credit Risk” section of Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

Noninterest Income

We generate revenues in the form of noninterest income through client fees and sales commissions from our core banking franchise and other related businesses, such as wealth management, investment consulting, investment products and insurance. This source of revenue has decreased as a percentage of total revenue to 38.1% in 2012 compared to 40.1% in 2011.

Noninterest income for 2012 was $189.8 million, an increase of $6.9 million, or 3.8% compared to $182.9 million reported for 2011. The improvement in 2012 resulted from a $6.3 million increase in net securities gains, a $1.1 million increase in wealth management fees, a $1.6 million increase in investment product fees, a $1.1 million increase in revenue from company-owned life insurance and a $3.0 million increase in other income. Partially offsetting these increases were a $1.2 million decrease in debit card and ATM card fees, a $1.4 million decrease in gain on sale leaseback transactions and a $3.8 million decrease from changes in the FDIC indemnification asset.

Despite a full year of fee revenue from the Integra acquisition and a little over three months of fee revenue from Indiana Community Bancorp, service charges and overdraft fees, our largest source of noninterest income, declined to $51.5 million in 2012, a $0.4 million decrease from $51.9 million in 2011. This appears to be a negative trend in the industry and will be a focus of management in 2013.

 

 

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Net securities gains were $13.6 million during 2012 compared to $7.3 million for 2011. Included in 2012 is $15.0 million of security gains partially offset by $1.4 million of other-than-temporary-impairment charges on two pooled trust preferred securities and six non-agency mortgage-backed securities. Included in 2011 is $8.7 million of security gains partially offset by $1.4 million of other-than-temporary-impairment on one pooled trust preferred security and three non-agency mortgage-backed securities. Sales of securities continued during 2011 and 2012 as we adjusted the composition of the investment portfolio to manage the effective duration of the portfolio and reduce the leverage on the balance sheet as proceeds from securities sales were used to reduce other borrowings.

Wealth management fees, which are dependent on the managed assets performance, continue to be impacted by uncertainties in the investment markets but did increase by $1.1 million to $21.5 million in 2012. The increase was primarily due to the acquisition of Indiana Community Bancorp on September 15, 2012 and the trust business of Integra Bank on June 1, 2011.

Debit card and ATM fees decreased by $1.2 million to $24.0 million in 2012 as compared to $25.2 million in 2011. A decrease in interchange income is the primary reason for the decrease.

Investment product fees were $12.7 million in 2012 compared to $11.1 million in 2011. The increase is primarily a result of increases in mutual fund fees and other investment advisory fees as investment markets improved in 2012.

Revenue from company-owned life insurance was $6.4 million in 2012 compared to $5.3 million in 2011. We anticipate this revenue will continue to slowly improve.

The $1.4 million decrease in gain on sale leaseback transactions is primarily due to the repurchase of a branch in 2011 and acceleration of the deferred gain.

Other income increased $3.0 million in 2012 as compared to 2011. The increase was primarily as a result of increases in customer derivative fee revenue, rental income from an operating lease and other miscellaneous income.

The following table presents changes in the components of noninterest income for the years ended December 31.

NONINTEREST INCOME

 

                       % Change From
Prior Year
 

(dollars in thousands)

   2012     2011     2010     2012     2011  

Wealth management fees

   $ 21,549      $ 20,460      $ 16,120        5.3      26.9 

Service charges on deposit accounts

     51,483        51,862        50,018        (0.7     3.7   

ATM fees

     24,006        25,199        22,967        (4.7     9.7   

Mortgage banking revenue

     3,742        3,250        2,230        15.1        45.7   

Insurance premiums and commissions

     37,103        36,957        36,463        0.4        1.4   

Investment product fees

     12,714        11,068        9,192        14.9        20.4   

Company-owned life insurance

     6,452        5,322        4,052        21.2        31.3   

Other income

     15,261        12,219        7,967        24.9        53.4   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total fee and service charge income

     172,310        166,337        149,009        3.6        11.6   

Net securities gains

     15,052        8,691        17,124        73.2        (49.2

Impairment on available-for-sale securities

     (1,414     (1,409     (3,927     (0.4     64.1   

Gain on derivatives

     820        974        1,492        (15.8     (34.7

Gain on sale leasebacks

     6,423        7,864        6,452        (18.3     21.9   

Change in FDIC indemnification asset

     (3,375     426        —          N/M        N/M   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total noninterest income

   $ 189,816      $ 182,883      $ 170,150        3.8      7.5 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Noninterest income to total revenue (1)

     37.1     39.1     42.3    
  

 

 

   

 

 

   

 

 

     

 

(1) Total revenue includes the effect of a taxable equivalent adjustment of $13.2 million in 2012, $11.8 million in 2011 and $13.5 million in 2010.

N/M = Not meaningful

 

 

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Table of Contents

Noninterest Income Related to Covered Assets

Income and expense associated with the FDIC loss sharing agreements is reflected in the change in the FDIC indemnification asset. This balance includes discount accretion, gains on the write-up of the FDIC indemnification asset, and expense from the reduction of the FDIC indemnification asset upon the removal of loans, OREO and unfunded loan commitments. Loans are removed when they have been fully paid off, fully charged off, sold or transferred to OREO. The change in the FDIC indemnification asset also includes income due to the FDIC, as well as the income statement effects of other loss share transactions.

For 2012, adjustments to the FDIC indemnification asset resulted in noninterest expense of $3.4 million. This compares to noninterest income of $0.4 million in 2011. The decrease in income is primarily the result of improvements in our loan loss expectations, which was partially offset by impairment of other real estate.

Noninterest Expense

Noninterest expense for 2012 totaled $365.8 million, an increase of $17.3 million, or 4.9% from the $348.5 million recorded in 2011. Included in 2012 is approximately $10.2 million of noninterest expense related to Indiana Community Bancorp, which was acquired on September 15, 2012. This amount includes approximately $7.8 million of acquisition and integration expenses. Also included in 2012 is approximately $26.6 million of noninterest expense for Integra Bank, which was acquired on July 29, 2011. Noninterest expense for Integra Bank for 2011 was $25.9 million. The 2011 amount for Integra Bank includes approximately $11.1 million of acquisition and integration costs. Also included in 2012 is a $6.4 million increase in expense related to the reinstatement of our performance-based incentive compensation plan.

Salaries and benefits, the largest component of noninterest expense, totaled $193.9 million in 2012, compared to $189.5 million in 2011, an increase of $4.4 million, or 2.3%. Included in 2012 is $6.0 million of salaries and benefit expense associated with former IBT associates, which includes severance and retention accruals. Partially offsetting the increase from IBT is a reduction of approximately $6.8 million in salaries and benefits expense associated with former Integra Bank associates. Also included in 2012 is a $6.4 million increase in expense related to a full year of the reinstatement of our performance-based incentive compensation plan and a $1.1 million increase in pension expense. Partially offsetting these increases are a $0.7 million decrease in restricted stock expense, a $0.2 million decrease in hospitalization expense, a $0.2 million decrease in long-term disability insurance and our cost containment efforts.

Marketing expense was $7.5 million for 2012 compared to $6.0 million for 2011. The increase is attributable to higher levels of charitable contributions and sponsorships in 2012.

Professional fees decreased $2.9 million for 2012 as compared to 2011. The decrease is primarily attributable to legal and other professional fees associated with the acquisition of Integra Bank in 2011. Continued compliance with the June 4, 2012, consent order issued by our primary regulator is expected to result in increased professional fees during the first quarter of 2013 as the Company continues to progress on this project. The consent order requires the Bank to, among other things: continue to review, update, and implement a written institution-wide, ongoing BSA/AML risk assessment that accurately identifies BSA/AML risks; ensure that Bank management reviews, updates, and implements its risk-based processes to obtain and analyze appropriate customer due diligence information to monitor for and investigate suspicious activity; ensure adherence to a written program for appropriate identification, analyzing and monitoring of transactions with greater than normal risk; maintain an effective BSA independent testing function; and ensure and maintain sufficient personnel with requisite expertise and skills who receive adequate on-going training.

Loan expense increased $2.3 million for 2012 as compared to 2011. The increase is primarily attributable to loan expense associated with the acquisition of Integra Bank.

Supply expense was $2.7 million for 2012 compared to $3.8 million for 2011. 2011 included costs associated with the acquisition of Integra Bank.

 

 

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Loss on debt extinguishment was $1.2 million higher in 2012 due to the termination of $50 million of Federal Home Loan Bank advances and related swaps in the fourth quarter of 2012, compared to minimal debt extinguishment costs in 2011.

FDIC assessment expense was $6.0 million for 2012 compared to $7.5 million for 2011. The decrease is primarily due to a lower assessment rate.

Other real estate owned expense was $17.1 million for 2012 compared to $2.0 million for 2011. The increase is primarily due to expense related to decreased valuations of other real estate owned acquired in our FDIC assisted transaction. Eighty percent of these impairment losses are reimbursable by the FDIC upon ultimate sale of the property.

The following table presents changes in the components of noninterest expense for the years ended December 31.

NONINTEREST EXPENSE

 

                          % Change From
Prior Year
 

(dollars in thousands)

   2012      2011      2010      2012     2011  

Salaries and employee benefits

   $ 193,874       $ 189,539       $ 170,601         2.3      11.1 

Occupancy

     50,929         51,054         46,410         (0.2     10.0   

Equipment

     11,744         11,720         10,641         0.2        10.1   

Marketing

     7,451         5,990         5,720         24.4        4.7   

Data processing

     22,014         22,971         21,409         (4.2     7.3   

Communications

     10,939         10,406         9,803         5.1        6.2   

Professional fees

     12,030         14,959         8,253         (19.6     81.3   

Loan expense

     7,037         4,734         3,936         48.6        20.3   

Supplies

     2,719         3,762         2,935         (27.7     28.2   

Loss on extinguishment of debt

     1,949         789         6,107         N/M        (87.1

FDIC assessment

     5,991         7,523         8,370         (20.4     (10.1

Other real estate owned expense

     17,136         1,992         2,613         N/M        (23.8

Amortization of intangibles

     7,941         8,829         6,130         (10.1     44.0   

Other expense

     14,004         14,253         11,377         (1.7     25.3   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total noninterest expense

   $ 365,758       $ 348,521       $ 314,305         4.9      10.9 
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Noninterest Expense Related to Covered Assets

Noninterest expense related to covered assets are included in OREO expense, legal and professional expense and other covered asset-related expenses, and may be subject to FDIC reimbursement. Expenses must meet certain FDIC criteria in order for the expense amounts to be reimbursed. Certain amounts reflected in these balances may not be reimbursed by the FDIC if they do not meet the criteria.

$828 thousand, or twenty percent of the expense associated with holding and maintaining covered assets assumed in the Integra acquisition, are not reimbursable by the FDIC and were recorded as noninterest expense during 2012. The remaining eighty percent was recorded as a receivable from the FDIC. Additional non-reimbursable expenses of $444 thousand associated with holding and maintaining covered assets assumed in the Integra acquisition were also recorded in noninterest expense during 2012.

$223 thousand, or twenty percent of the expense associated with holding and maintaining covered assets assumed in the Integra acquisition, are not reimbursable by the FDIC and were recorded as noninterest expense during 2011. The remaining eighty percent was recorded as a receivable from the FDIC. Additional non-reimbursable expenses of $133 thousand associated with holding and maintaining covered assets assumed in the Integra acquisition were also recorded in noninterest expense during 2011.

 

 

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Provision for Income Taxes

We record a provision for income taxes currently payable and for income taxes payable or benefits to be received in the future, which arise due to timing differences in the recognition of certain items for financial statement and income tax purposes. The major difference between the effective tax rate applied to our financial statement income and the federal statutory tax rate is caused by interest on tax-exempt securities and loans. The tax rate was effectively the same for 2012 and 2011. See Note 12 to the consolidated financial statements for additional details on Old National’s income tax provision.

Comparison of Fiscal Years 2011 and 2010

In 2011, we generated net income of $72.5 million and diluted net income per share of $0.76 compared to $38.2 million and $0.44, respectively in 2010. The 2011 earnings included a $54.5 million increase in net interest income, a $12.7 million increase in noninterest income and $23.3 million decrease in the provision for loan losses. Offsetting these increases to net income in 2011 was a $34.2 million increase in noninterest expense and a $22.0 million increase in income tax expense.

Taxable equivalent net interest income was $284.7 million in 2011, a 22.8% increase from the $231.9 million reported in 2010. The net interest margin was 3.87% for 2011, a 47 basis point increase compared to 3.40% reported for 2010. Average earning assets increased by $544.5 million during 2011 and the yield on average earning assets increased 5 basis points from 4.55% to 4.60%. Average interest-bearing liabilities increased $288.9 million and the cost of interest-bearing liabilities decreased from 1.47% to 0.96%.

The provision for loan losses was $7.5 million in 2011, a $23.3 million decrease from the $30.8 million recorded in 2010. The lower provision in 2011 was attributable to the following factors: (1) the loss factors applied to our performing loan portfolio have decreased during 2011 compared to 2010 as charge-offs were substantially lower, (2) apart from those loans acquired in our two acquisitions, which are substantially accounted for at fair value, our total loans decreased $16.2 million from December 31, 2010 to December 31, 2011, and (3) the percentage of our loan portfolio consisting of those loans where higher loss factors are applied (commercial and commercial real estate loans) fell to 48% in 2011 compared to 58% in 2010 while the percentage of our loan portfolio consisting of those loans where lower loss factors are applied (residential loans) increased to 21% in 2011 compared to 18% in 2010.

Noninterest income for 2011 was $182.9 million, an increase of $12.7 million, or 7.5% from the $170.2 million reported for 2010. Net securities gains were $7.3 million during 2011 compared to $13.2 million for 2010. Included in 2011 is $8.7 million of security gains partially offset by $1.4 million of other-than-temporary-impairment on one pooled trust preferred security and three non-agency mortgage-backed securities. Sales of securities continued during 2010 and 2011 as we adjusted the composition of the investment portfolio to manage the effective duration of the portfolio and reduce the leverage on the balance sheet as proceeds from securities sales were used to reduce other borrowings. Also affecting noninterest income in 2011 was a $4.3 million increase in wealth management fees, a $2.2 million increase in debit card and ATM card fees, a $1.8 million increase in investment product fees, a $1.8 million increase in service charges on deposit accounts and a $4.3 million increase in other income. Partially offsetting these increases was a $0.5 million decrease in gains on derivatives.

Income and expense associated with the FDIC loss sharing agreements is reflected in the change in the FDIC indemnification asset. This balance includes discount accretion, gains on the write-up of the FDIC indemnification asset, and expense from the reduction of the FDIC indemnification asset upon the removal of loans, OREO and unfunded loan commitments. Loans are removed when they have been fully paid off, fully charged off, sold or transferred to OREO. The change in the FDIC indemnification asset also includes income due to the FDIC, as well as the income statement effects of other loss share transactions. The net change in the FDIC indemnification asset was $0.4 million for 2011 and was attributable to indemnification asset accretion.

Noninterest expense for 2011 totaled $348.5 million, an increase of $34.2 million, or 10.9% from the $314.3 million recorded in 2010. The acquisition of Monroe Bancorp and Integra Bank were the primary reasons for the increase in noninterest expense. Noninterest expense for Monroe Bancorp totaled approximately $21.2 million and included $6.6 million of acquisition and integration costs. Noninterest expense for Integra Bank totaled $25.9 million from July 29, 2011 to December 31, 2011. This amount included approximately $11.1 million of acquisition and integration expenses. Also included in 2011 is a $3.6 million increase in performance-based incentive compensation expense and $2.0 million accrued for a litigation settlement.

 

 

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Noninterest expense related to covered assets are included in OREO expense, legal and professional expense and other covered asset-related expenses, and may be subject to FDIC reimbursement. Expenses must meet certain FDIC criteria in order for the expense amounts to be reimbursed. Certain amounts reflected in these balances may not be reimbursed by the FDIC if they do not meet the criteria.

$223 thousand, or twenty percent of the expense associated with holding and maintaining covered assets assumed in the Integra acquisition, are not reimbursable by the FDIC and were recorded as noninterest expense during 2011. The remaining eighty percent was recorded as a receivable from the FDIC. Additional non-reimbursable expenses of $133 thousand associated with holding and maintaining covered assets assumed in the Integra acquisition were also recorded in noninterest expense during 2011.

The provision for income taxes was $27.3 million in 2011 compared to $5.3 million in 2010. Old National’s effective tax rate was 27.4% in 2011 compared to 12.1% in 2010. The effective tax rate varied significantly from 2010 to 2011 due to an increase in pre-tax income while tax-exempt income had decreased.

BUSINESS LINE RESULTS

We operate in two operating segments: community banking and treasury. The following table summarizes our business line results for the years ended December 31.

BUSINESS LINE RESULTS

 

(dollars in thousands)

   2012     2011     2010  

Community banking

   $ 142,378      $ 129,446      $ 73,108   

Treasury

     (17,651     (29,905     (26,310

Other

     3,058        221        (3,318
  

 

 

   

 

 

   

 

 

 

Income (loss) before income taxes

   $ 127,785      $ 99,762      $ 43,480   
  

 

 

   

 

 

   

 

 

 

The 2012 community banking segment profit increased $12.9 million from 2011 levels, primarily as a result of the acquisitions of Indiana Community Bancorp and Integra Bank, which occurred on July 29, 2011. The 2011 community banking segment profit increased $56.3 million from 2010 levels, primarily as a result of the acquisitions of Monroe Bancorp and Integra Bank and a decrease in provision for loan loss expense.

The 2012 treasury segment profit increased $12.3 million from 2011 primarily as a result of the $6.4 million increase in net securities gains in 2012. The 2011 treasury segment profit decreased $3.6 million from 2010 primarily as a result of the $5.9 million decrease in net securities gains in 2011.

The 2012 “other” segment profit increased approximately $2.8 million from 2011 primarily as a result of the increased wealth management revenue. The 2011 “other” segment profit increased approximately $3.5 million from 2010 primarily as a result of the increased trust business associated with the Monroe Bancorp and Integra acquisitions.

FINANCIAL CONDITION

Overview

At December 31, 2012, our total assets were $9.544 billion, a 10.8% increase from $8.610 billion at December 31, 2011. The increase is primarily a result of the acquisition of Indiana Community Bancorp, which occurred on September 15, 2012. We are continuing to reduce our reliance on higher cost deposits and other borrowings. Earning assets, comprised of investment securities, portfolio loans, loans and leases held for sale, money market investments and interest earning accounts with the Federal Reserve, were $8.200 billion at December 31, 2012, an increase of $807.1 million, or 10.9%, from $7.392 billion at December 31, 2011. The increase in earning assets is primarily a result of the acquisition of Indiana Community Bancorp. Year over year, time deposits and other borrowings, which have an average interest rate higher that other types of deposits, have decreased as a percent of total funding. Year over year, noninterest-bearing demand deposits have increased as a percent of total funding.

 

 

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Investment Securities

We classify investment securities primarily as available-for-sale to give management the flexibility to sell the securities prior to maturity if needed, based on fluctuating interest rates or changes in our funding requirements. However, we also have $56.6 million of 15- and 20-year fixed-rate mortgage pass-through securities, $173.9 million of U.S. government-sponsored entity and agency securities and $169.3 million of state and political subdivision securities in our held-to-maturity investment portfolio at December 31, 2012. During the third quarter of 2012, approximately $46.1 million of state and political subdivision securities were transferred from the held-to-maturity portfolio to the available-for-sale portfolio due to changes in circumstances associated with the Office of Management and Budget’s report outlining sequestration and the implications for taxable Build America Bonds. The $1.0 million, net of tax, unrealized holding gain was reclassified out of other comprehensive income on the date of transfer.

Trading securities, which consist of mutual funds held in a trust associated with deferred compensation plans for former Monroe Bancorp directors and executives, are recorded at fair value and totaled $3.1 million at December 31, 2012 compared to $2.8 million at December 31, 2011.

At December 31, 2012, the investment securities portfolio was $2.945 billion compared to $2.590 billion at December 31, 2011, an increase of 13.7%. Investment securities represented 35.9% of earning assets at December 31, 2012, compared to 35.0% at December 31, 2011. Included in the investment securities portfolio at December 31, 2012 is approximately $116.4 million related to our acquisition of Indiana Community Bancorp. We adjusted the composition of the investment portfolio to manage the effective duration of the portfolio and reduce the leverage on the balance sheet as proceeds from securities sales were used to reduce other borrowings. Stronger commercial loan demand in the future and management’s efforts to deleverage the balance sheet could result in a reduction in the securities portfolio. As of December 31, 2012, management does not intend to sell any securities with an unrealized loss position and does not believe the Company will be required to sell such securities.

The investment securities available-for-sale portfolio had net unrealized gains of $64.0 million at December 31, 2012, compared to net unrealized gains of $40.5 million at December 31, 2011. A $1.4 million charge was recorded during 2012 related to other-than-temporary-impairment on two pooled trust preferred securities and six non-agency mortgage-backed securities. A $1.4 million charge was recorded during 2011 related to other-than-temporary-impairment on one pooled trust preferred security and three non-agency mortgage-backed securities. See Note 1 to the consolidated financial statements for the impact of other-than-temporary-impairment in other comprehensive income and Note 3 to the consolidated financial statements for details on management’s evaluation of securities for other-than-temporary-impairment.

The investment portfolio had an effective duration of 3.71% at December 31, 2012, compared to 3.63% at December 31, 2011. Effective duration measures the percentage change in value of the portfolio in response to a change in interest rates. The weighted average yields on available-for-sale investment securities were 2.99% in 2012 and 3.32% in 2011. The average yields on the held-to-maturity portfolio were 3.90% in 2012 and 3.96% in 2011.

At December 31, 2012, Old National had a concentration of investment securities issued by the state of Indiana and its political subdivisions with an aggregate market value of $273.8 million, which represented 22.9% of shareholders’ equity. At December 31, 2011, Old National had a concentration of investment securities issued by the state of Indiana and its political subdivisions with an aggregate market value of $268.4 million, which represented 26.0% of shareholders’ equity. There were no other concentrations of investment securities issued by an individual state and its political subdivisions that were greater than 10% of shareholders’ equity.

Loan Portfolio

We lend primarily to consumers and small to medium-sized commercial and commercial real estate clients in various industries including manufacturing, agribusiness, transportation, mining, wholesaling and retailing. Our policy is to concentrate our lending activity in the geographic market areas we serve, primarily Indiana, Illinois and Kentucky.

 

 

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The following table, including covered loans, presents the composition of the loan portfolio at December 31.

LOAN PORTFOLIO AT YEAR-END

 

(dollars in thousands)

   2012      2011      2010      2009      2008      Four-Year
Growth Rate
 

Commercial

   $ 1,392,459       $ 1,341,409       $ 1,211,399       $ 1,287,168       $ 1,897,966         (7.5 )% 

Commercial real estate

     1,438,709         1,393,304         942,395         1,062,910         1,154,916         5.6   

Consumer credit

     1,004,827         990,061         924,952         1,082,017         1,210,951         (4.6
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans excluding residential real estate

     3,835,995         3,724,774         3,078,746         3,432,095         4,263,833         (2.6

Residential real estate

     1,360,599         1,042,429         664,705         403,391         496,526         28.7   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans

     5,196,594         4,767,203         3,743,451         3,835,486         4,760,359         2.2 
                 

 

 

 

Less: Allowance for loan losses

     54,763         58,060         72,309         69,548         67,087      
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

Net loans

   $ 5,141,831       $ 4,709,143       $ 3,671,142       $ 3,765,938       $ 4,693,272      
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

Commercial and Commercial Real Estate Loans

At December 31, 2012, commercial loans increased $51.1 million while commercial real estate loans increased $45.4 million, respectively, from December 31, 2011. Included in the commercial loan total for December 31, 2012 is approximately $62.2 million related to our acquisition of Indiana Community Bancorp. Included in the commercial real estate loan total for December 31, 2012 is approximately $197.8 million related to our acquisition of Indiana Community Bancorp. During 2012, we sold $1.7 million of commercial and commercial real estate loans. Net recoveries of $0.7 million were recorded related to these sales. We sold $5.4 million of commercial and commercial real estate loans during 2011. No write-down was recorded against the allowance for loan losses related to these sales. Loan demand in our markets remains soft. However, if you exclude covered loans and the recently acquired IBT loans, we did experience modest loan growth in the commercial portfolio during 2012.

The following table presents the maturity distribution and rate sensitivity of commercial loans and an analysis of these loans that have predetermined and floating interest rates. A significant percentage of commercial loans are due within one year, reflecting the short-term nature of a large portion of these loans.

DISTRIBUTION OF COMMERCIAL LOAN MATURITIES AT DECEMBER 31, 2012

 

(dollars in thousands)

   Within
1 Year
     1 - 5 Years      Beyond
5 Years
     Total  

Interest rates:

           

Predetermined

   $ 310,905       $ 254,029       $ 116,758       $ 681,692   

Floating

     444,261         188,472         78,034         710,767   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 755,166       $ 442,501       $ 194,792       $ 1,392,459   
  

 

 

    

 

 

    

 

 

    

 

 

 

Consumer Loans

Consumer loans, including automobile loans, personal and home equity loans and lines of credit, increased $14.8 million or 1.5% at December 31, 2012, compared to December 31, 2011. Included in the total for December 31, 2012 is approximately $72.8 million related to our acquisition of Indiana Community Bancorp.

Residential Real Estate Loans

Residential real estate loans, primarily 1-4 family properties, were $1.361 billion at December 31, 2012, an increase of $318.2 million or 30.5% from December 31, 2011. In addition to organic loan production, December 31, 2012 totals also include approximately $74.5 million acquired from Indiana Community Bancorp. The majority of the growth in residential real estate loans began in the fourth quarter of 2010, primarily as a result of a new mortgage product that was introduced. At December 31, 2012, this new product had an average FICO score of 779, an average loan to value ratio of 59% and an average duration of 17.4 years. We have also retained more of our loan originations to partially offset the slow loan demand from our traditional commercial customers.

 

 

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Allowance for Loan Losses

To provide for the risk of loss inherent in extending credit, we maintain an allowance for loan losses. The determination of the allowance is based upon the size and current risk characteristics of the loan portfolio and includes an assessment of individual problem loans, actual loss experience, current economic events and regulatory guidance. Additional information about our Allowance for Loan Losses is included in the “Risk Management—Credit Risk” section of Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Notes 1 and 5 to the consolidated financial statements.

At December 31, 2012, the allowance for loan losses was $54.8 million, a decrease of $3.3 million compared to $58.1 million at December 31, 2011. As a percentage of total loans, the allowance decreased to 1.05% at December 31, 2012, from 1.22% at December 31, 2011. During 2012, the provision for loan losses was $5.0 million, a decrease of $2.5 million from the $7.5 million recorded in 2011. Impacting the provision over the past twelve months are the following factors: (1) the loss factors applied to our performing loan portfolio have decreased over time as charge-offs were substantially lower, (2) the continuing trend in improved credit quality, and (3) the percentage of our legacy loan portfolio consisting of those loans where higher loss factors are applied (commercial and commercial real estate loans) fell while the percentage of our loan portfolio consisting of those loans where lower loss factors are applied (residential loans) increased.

For commercial loans, the reserve decreased by $5.3 million at December 31, 2012, compared to December 31, 2011. The reserve as a percentage of the commercial loan portfolio decreased to 1.10% at December 31, 2012, from 1.64% at December 31, 2011. For commercial real estate loans, the reserve decreased by $0.5 million at December 31, 2012, compared to December 31, 2011. The reserve as a percentage of the commercial real estate loan portfolio decreased to 2.10% at December 31, 2012, from 2.52% at December 31, 2011. Nonaccrual loans, excluding covered loans, increased $35.1 million since December 31, 2011 primarily as a result of the IBT acquisition. Criticized and classified loans increased $62.4 million from December 31, 2011, also primarily as a result of the IBT acquisition. During 2012, other classified assets, which consist of investment securities downgraded below investment grade, decreased $47.7 million.

The reserve for residential real estate loans as a percentage of that portfolio decreased to 0.28% at December 31, 2012, from 0.35% at December 31, 2011. The reserve for consumer loans decreased to 0.48% at December 31, 2012, from 0.79% at December 31, 2011.

Allowance for Losses on Unfunded Commitments

We maintain an allowance for losses on unfunded commercial lending commitments and letters of credit to provide for the risk of loss inherent in these arrangements. The allowance is computed using a methodology similar to that used to determine the allowance for loan losses, modified to take into account the probability of a drawdown on the commitment. This allowance is reported as a liability on the balance sheet within accrued expenses and other liabilities, while the corresponding provision for these loan losses is recorded as a component of other expense. As of December 31, 2012 and 2011, the allowance for losses on unfunded commitments was $4.0 million and $4.8 million, respectively.

Residential Loans Held for Sale

At December 31, 2012, loans held for sale is made up entirely of mortgage loans held for immediate sale in the secondary market with servicing released. These loans are sold at or prior to origination at a contracted price to an outside investor on a best efforts basis and remain on the Company’s balance sheet for a short period of time (typically 30 to 60 days). These loans are sold without recourse and the Company has experienced minimal requests to repurchase loans due to the standard representations and warranties and have experienced no material losses. Mortgage originations are subject to volatility due to interest rates and home sales. Residential loans held for sale have declined since the end of 2009, as we have retained certain of our loan originations to partially offset the slow loan demand from our traditional commercial customers. Residential loans held for sale were $12.6 million at December 31, 2012, compared to $4.5 million at December 31, 2011.

 

 

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We elected the fair value option under FASB ASC 825-10, Financial Instruments (SFAS No. 159) for residential loans held for sale. The aggregate fair value exceeded the unpaid principal balances by $0.4 million as of December 31, 2012. At December 31, 2011, the aggregate fair value exceeded the unpaid principal balance by $0.1 million.

Covered Assets

On July 29, 2011, Old National acquired the banking operations of Integra Bank N.A. (“Integra”) in an FDIC assisted transaction. The Company entered into separate loss sharing agreements with the FDIC providing for specified credit loss protection for substantially all acquired single family residential loans, commercial loans, and other real estate owned (“OREO”). Loans comprise the majority of the assets acquired and are subject to loss share agreements with the FDIC whereby Old National is indemnified against 80% of losses up to $275.0 million, losses in excess of $275.0 million up to $467.2 million at 0% reimbursement, and 80% of losses in excess of $467.2 million with respect to covered assets. As of December 31, 2012, we do not expect losses to exceed $275.0 million.

A summary of covered assets is presented below:

 

(dollars in thousands)

   December 31,
2012
     December 31,
2011
 

Loans, net of discount & allowance

   $ 366,617       $ 625,417   

Other real estate owned

     26,137         30,443   
  

 

 

    

 

 

 

Total covered assets

   $ 392,754       $ 655,860   
  

 

 

    

 

 

 

FDIC Indemnification Asset

Because the FDIC will reimburse Old National for losses incurred on certain acquired loans, an indemnification asset is recorded at fair value at the acquisition date. The indemnification asset is recognized at the same time as the indemnified loans, and measured on the same basis, subject to collectibility or contractual limitations. The indemnification asset, on the acquisition date, reflects the reimbursements expected to be received from the FDIC, using an appropriate discount rate, which reflects counterparty credit risk and other uncertainties. Reimbursement claims are submitted to the FDIC and the receivable is reduced when the FDIC pays the claim. At December 31, 2012, the FDIC indemnification asset was $115.7 million and was comprised of a $107.4 million FDIC indemnification asset and a $8.3 million FDIC loss share receivable. The loss share receivable represents the current reimbursable amounts from the FDIC that have not yet been received. The indemnification asset represents the cash flows the Company expects to collect from the FDIC under the loss sharing agreements and the amount related to the estimated improvements in cash flow expectations that are being amortized over the same period for which those improved cash flows are being accreted into income. At December 31, 2012, $99.5 million of the FDIC indemnification asset is related to expected indemnification payments and $7.9 million is expected to be amortized against future accreted interest income.

A summary of activity for the indemnification asset and loss share receivable is presented below:

 

(dollars in thousands)

      

Balance at January 1, 2012

   $ 167,714   

Adjustments not reflected in income

  

Established through acquisitions

     —      

Cash received from the FDIC

     (48,223

Other

     (378

Adjustments reflected in income

  

(Amortization) accretion

     (13,128

Impairment

     1,069   

Write-downs/sale of other real estate

     12,637   

Recovery amounts due to FDIC

     (3,223

Other

     (730
  

 

 

 

Balance at December 31, 2012

   $ 115,738   
  

 

 

 

 

 

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Goodwill and Other Intangible Assets

Goodwill and other intangible assets at December 31, 2012, totaled $368.0 million, an increase of $81.2 million compared to $286.8 million at December 31, 2011. During the third quarter of 2012, we recorded $88.7 million of goodwill and other intangible assets associated with the acquisition of Indiana Community Bancorp, of which $86.0 million is included in the “Community Banking” column and $2.7 million is included in the “Other” column for segment reporting.

Assets Held for Sale

Assets held for sale were $15.0 million at December 31, 2012 compared to $16.9 million at December 31, 2011. Included in assets held for sale are thirteen financial centers associated with the Integra acquisition, four facilities associated with the Monroe Bancorp acquisition and two facilities associated with the Indiana Community Bancorp acquisition.

Other Assets

Other assets have increased $27.6 million, or 13.2%, since December 31, 2011 primarily as a result of an increase in deferred tax assets, which was partially offset by fluctuations in the fair value of derivative financial instruments.

Funding

Total average funding, comprised of deposits and wholesale borrowings, was $7.469 billion at December 31, 2012, an increase of 4.2% from $7.168 billion at December 31, 2011. Total deposits were $7.279 billion, including $5.998 billion in transaction accounts and $1.281 billion in time deposits at December 31, 2012. Total deposits increased 10.1% or $667.4 million compared to December 31, 2011. Included in total deposits at December 31, 2012 are $642.1 million from the acquisition of Indiana Community Bancorp. Noninterest-bearing demand deposits increased 16.2% or $279.2 million compared to December 31, 2011. Savings deposits increased 19.0% or $299.0 million. NOW deposits increased 16.5% or $258.6 million compared to December 31, 2011. Money market deposits decreased 1.0%, or $3.0 million, while time deposits decreased 11.5% or $166.4 million compared to December 31, 2011. We continue to experience an increase in noninterest-bearing demand deposits.

We use wholesale funding to augment deposit funding and to help maintain our desired interest rate risk position. Wholesale borrowing as a percentage of total funding was 10.2% at December 31, 2012, compared to 9.8% at December 31, 2011. Included in wholesale funding at December 31, 2012 is $17.9 million from the acquisition of Indiana Community Bancorp. Short-term borrowings have increased $165.0 million since December 31, 2011 while long-term borrowings have decreased $53.3 million compared to December 31, 2011. During the fourth quarter of 2012, we terminated $50.0 million of FHLB advances. On June 30, 2012 we redeemed $13.0 million of subordinated notes and $3.0 million of trust preferred securities. During 2011, we prepaid $119.2 million of FHLB advances and $80.0 million of structured repurchase agreements. In the fourth quarter of 2011, $150.0 million of subordinated bank notes matured. See Notes 10 and 11 to the consolidated financial statements for additional details on our financing activities.

 

 

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The following table presents changes in the average balances of all funding sources for the years ended December 31.

FUNDING SOURCES—AVERAGE BALANCES

 

                          % Change From
Prior Year
 

(dollars in thousands)

   2012      2011      2010      2012     2011  

Demand deposits

   $ 1,828,750       $ 1,555,946       $ 1,182,653         17.5      31.6 

NOW deposits

     1,608,643         1,472,710         1,221,352         9.2        20.6   

Savings deposits

     1,728,887         1,384,294         1,043,289         24.9        32.7   

Money market deposits

     288,986         328,550         361,166         (12.0     (9.0

Time deposits

     1,319,958         1,647,729         1,753,561         (19.9     (6.0
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total deposits

     6,775,224         6,389,229         5,562,021         6.0        14.9   

Short-term borrowings

     413,921         363,623         328,535         13.8        10.7   

Other borrowings

     280,219         414,902         615,006         (32.5     (32.5
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total funding sources

   $ 7,469,364       $ 7,167,754       $ 6,505,562         4.2      10.2 
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

The following table presents a maturity distribution for certificates of deposit with denominations of $100,000 or more at December 31.

CERTIFICATES OF DEPOSIT, $100,000 AND OVER

 

            Maturity Distribution  

(dollars in thousands)

   Year-End
Balance
     1-90
Days
     91-180
Days
     181-365
Days
     Beyond
1 Year
 

2012

   $ 365,458       $ 53,790       $ 50,926       $ 118,818       $ 141,924   

2011

     421,874         64,423         80,925         87,799         188,727   

2010

     466,293         73,376         30,591         121,153         241,173   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Capital

Shareholders’ equity totaled $1.195 billion or 12.5% of total assets at December 31, 2012, and $1.034 billion or 12.0% of total assets at December 31, 2011. The December 31, 2012 balance includes approximately $88.5 million from the approximately 6.6 million shares of common stock that were issued in the acquisition of Indiana Community Bancorp.

We paid cash dividends of $0.36 per share in 2012, which decreased equity by $34.7 million. We declared cash dividends on common stock of $0.28 per share in 2011, which decreased equity by $26.5 million. We repurchased shares of our stock, reducing shareholders’ equity by $4.0 million in 2012 and $1.5 million in 2011. During the fourth quarter of 2012, we repurchased 250,000 shares of our common stock under our buyback program. The remaining repurchases related primarily to our employee stock based compensation plans. The change in unrealized losses on investment securities increased equity by $13.0 million in 2012 and increased equity by $19.9 million in 2011. Shares issued for reinvested dividends, stock options, restricted stock and stock compensation plans increased shareholders’ equity by $4.7 million in 2012, compared to $4.0 million in 2011.

Capital Adequacy

Old National and the banking industry are subject to various regulatory capital requirements administered by the federal banking agencies. For additional information on capital adequacy see Note 21 to the consolidated financial statements.

 

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RISK MANAGEMENT

Overview

Management, with the oversight of the Board of Directors through its Risk and Credit Policy Committee and its Funds Management Committee, has in place company-wide structures, processes, and controls for managing and mitigating risk. The following discussion addresses the three major risks we face: credit, market, and liquidity.

Credit Risk

Credit risk represents the risk of loss arising from an obligor’s inability or failure to meet contractual payment or performance terms. Our primary credit risks result from our investment and lending activities.

Investment Activities

Within our securities portfolio, the non-agency collateralized mortgage obligations represent the greatest exposure to the current instability in the residential real estate and credit markets. At December 31, 2012, we had seven non-agency collateralized mortgage obligations with a market value of $30.2 million, or approximately 1.2% of the available-for-sale securities portfolio. Six of these securities are rated below investment grade. The unrealized gain on these securities at December 31, 2012, was approximately $0.8 million.

While the overall residential real estate market has stabilized, we expect conditions to remain uncertain for the foreseeable future. Deterioration in the performance of the underlying loan collateral could result in deterioration in the performance of our asset-backed securities. Six non-agency mortgage-backed securities were rated below investment grade as of December 31, 2012. During the third quarter of 2012, we sold three non-agency mortgage-backed securities with an amortized cost of approximately $39.5 million that were below investment grade. During the second quarter of 2012, we sold one non-agency mortgage-backed security with an amortized cost of approximately $1.4 million that was below investment grade. During 2012, we experienced $0.9 million of other-than-temporary-impairment losses on six of these securities, all of which was recorded as a credit loss in earnings. During 2011, we experienced $2.3 million of other-than-temporary-impairment losses on three of these securities, of which $0.5 million was recorded as a credit loss in earnings and $1.8 million is included in other comprehensive income.

We also carry a higher exposure to loss in our pooled trust preferred securities, which are collateralized debt obligations, due to illiquidity in that market and the performance of the underlying collateral. At December 31, 2012, we had pooled trust preferred securities with a fair value of approximately $9.4 million, or 0.4% of the available-for-sale securities portfolio. During 2012, we experienced $0.5 million of other-than-temporary-impairment on two of these securities, all of which was recorded as a credit loss in earnings. These securities remained classified as available-for-sale and at December 31, 2012, the unrealized loss on our pooled trust preferred securities was approximately $15.5 million. During 2011, we experienced $0.9 million of other-than-temporary-impairment on one of these securities, all of which was recorded as a credit loss in earnings.

The remaining mortgage-backed securities are backed by U.S. government-sponsored or federal agencies. Municipal bonds, corporate bonds and other debt securities are evaluated by reviewing the credit-worthiness of the issuer and general market conditions. We do not have the intent to sell these securities and it is likely that we will not be required to sell these securities before their anticipated recovery.

Included in the held-to-maturity category at December 31, 2012 are approximately $56.6 million of agency mortgage-backed securities and $169.3 million of municipal securities at amortized cost.

Counterparty Exposure

Counterparty exposure is the risk that the other party in a financial transaction will not fulfill its obligation in a financial transaction. We define counterparty exposure as nonperformance risk in transactions involving federal funds sold and purchased, repurchase agreements, correspondent bank relationships, and derivative contracts with companies in the financial services industry. Old National’s net counterparty exposure was an asset of $514.1 million at December 31, 2012.

 

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Lending Activities

Commercial

Commercial and industrial loans are made primarily for the purpose of financing equipment acquisition, expansion, working capital, and other general business purposes. Lease financing consists of direct financing leases and are used by commercial customers to finance capital purchases ranging from computer equipment to transportation equipment. The credit decisions for these transactions are based upon an assessment of the overall financial capacity of the applicant. A determination is made as to the applicant’s ability to repay in accordance with the proposed terms as well as an overall assessment of the risks involved. In addition to an evaluation of the applicant’s financial condition, a determination is made of the probable adequacy of the primary and secondary sources of repayment, such as additional collateral or personal guarantees, to be relied upon in the transaction. Credit agency reports of the applicant’s credit history supplement the analysis of the applicant’s creditworthiness.

Commercial mortgages and construction loans are offered to real estate investors, developers, and builders primarily domiciled in the geographic market areas we serve, primarily Indiana, Illinois and Kentucky. These loans are secured by first mortgages on real estate at loan-to-value (“LTV”) margins deemed appropriate for the property type, quality, location and sponsorship. Generally, these LTV ratios do not exceed 80%. The commercial properties are predominantly non-residential properties such as retail centers, apartments, industrial properties and, to a lesser extent, more specialized properties. Substantially all of our commercial real estate loans are secured by properties located in our primary market area.

In the underwriting of our commercial real estate loans, we obtain appraisals for the underlying properties. Decisions to lend are based on the economic viability of the property and the creditworthiness of the borrower. In evaluating a proposed commercial real estate loan, we primarily emphasize the ratio of the property’s projected net cash flows to the loan’s debt service requirement. The debt service coverage ratio normally is not less than 120% and it is computed after deduction for a vacancy factor and property expenses as appropriate. In addition, a personal guarantee of the loan or a portion thereof is often required from the principal(s) of the borrower. We require title insurance insuring the priority of our lien, fire, and extended coverage casualty insurance, and flood insurance, if appropriate, in order to protect our security interest in the underlying property. In addition, business interruption insurance or other insurance may be required.

Construction loans are underwritten against projected cash flows derived from rental income, business income from an owner-occupant or the sale of the property to an end-user. We may mitigate the risks associated with these types of loans by requiring fixed-price construction contracts, performance and payment bonding, controlled disbursements, and pre-sale contracts or pre-lease agreements.

Consumer

We offer a variety of first mortgage and junior lien loans to consumers within our markets, with residential home mortgages comprising our largest consumer loan category. These loans are secured by a primary residence and are underwritten using traditional underwriting systems to assess the credit risks of the consumer. Decisions are primarily based on LTV ratios, debt-to-income (“DTI”) ratios, liquidity and credit scores. A maximum LTV ratio of 80% is generally required, although higher levels are permitted with mortgage insurance or other mitigating factors. We offer fixed rate mortgages and variable rate mortgages with interest rates that are subject to change every year after the first, third, fifth, or seventh year, depending on the product and are based on fully-indexed rates such as the London Interbank Offered Rate (“LIBOR”). We do not offer interest-only loans, payment-option facilities, sub-prime loans, or any product with negative amortization.

Home equity loans are secured primarily by second mortgages on residential property of the borrower. The underwriting terms for the home equity product generally permits borrowing availability, in the aggregate, up to 90% of the appraised value of the collateral property at the time of origination. We offer fixed and variable rate home equity loans, with variable rate loans underwritten at fully-indexed rates. Decisions are primarily based on LTV ratios, DTI ratios, liquidity, and credit scores. We do not offer home equity loan products with reduced documentation.

 

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Automobile loans include loans and leases secured by new or used automobiles. We originate automobile loans and leases primarily on an indirect basis through selected dealerships. We require borrowers to maintain collision insurance on automobiles securing consumer loans, with us listed as loss payee. Our procedures for underwriting automobile loans include an assessment of an applicant’s overall financial capacity, including credit history and the ability to meet existing obligations and payments on the proposed loan. Although an applicant’s creditworthiness is the primary consideration, the underwriting process also includes a comparison of the value of the collateral security to the proposed loan amount.

Asset Quality

Community-based lending personnel, along with region-based independent underwriting and analytic support staff, extend credit under guidelines established and administered by our Risk and Credit Policy Committee. This committee, which meets quarterly, is made up of outside directors. The committee monitors credit quality through its review of information such as delinquencies, credit exposures, peer comparisons, problem loans and charge-offs. In addition, the committee reviews and approves recommended loan policy changes to assure it remains appropriate for the current lending environment.

We lend primarily to small- and medium-sized commercial and commercial real estate clients in various industries including manufacturing, agribusiness, transportation, mining, wholesaling and retailing. At December 31, 2012, we had no concentration of loans in any single industry exceeding 10% of our portfolio and had no exposure to foreign borrowers or sovereign debt. Our policy is to concentrate our lending activity in the geographic market areas we serve, primarily Indiana, Illinois and Kentucky. We continue to be affected by weakness in the economy of our principal markets. Management expects that trends in under-performing, criticized and classified loans will be influenced by the degree to which the economy strengthens or weakens.

On January 1, 2011, Old National closed on its acquisition of Monroe Bancorp. As of December 31, 2012, acquired loans totaled $335.0 million and there was $0.6 million of other real estate owned. In accordance with accounting for business combinations, there was no allowance brought forward on any of the acquired loans, as the credit losses evident in the loans were included in the determination of the fair value of the loans at the acquisition date. Old National reviewed the acquired loans and determined that as of December 31, 2012, $5.2 million met the definition of criticized, $5.7 million were considered classified, and $21.3 million were doubtful. Our current preference would be to work these loans and avoid foreclosure actions unless additional credit deterioration becomes apparent. These assets are included in our summary of under-performing, criticized and classified assets found below.

During the third quarter of 2011, Old National acquired the banking operations of Integra Bank in an FDIC assisted transaction. As of December 31, 2012, acquired loans totaled $417.7 million and there was $26.1 million of other real estate owned. The Company entered into separate loss sharing agreements with the FDIC providing for specified credit loss protection for substantially all acquired single family residential loans, commercial loans, and other real estate owned. In accordance with accounting for business combinations, there was no allowance brought forward on any of the acquired loans, as the credit losses evident in the loans were included in the determination of the fair value of the loans at the acquisition date. At December 31, 2012, approximately $366.6 million of loans, net of allowance, and $26.1 million of other real estate owned are covered by the loss sharing agreements. Under the terms of the loss sharing agreements, the FDIC will reimburse Old National for 80% of losses up to $275.0 million. These covered assets are included in our summary of under-performing, criticized and classified assets found below.

 

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On September 15, 2012, Old National closed on its acquisition of Indiana Community Bancorp (“IBT”). As of December 31, 2012, acquired loans totaled $407.2 million and there was $2.0 million of other real estate owned. In accordance with accounting for business combinations, there was no allowance brought forward on any of the acquired loans, as the credit losses evident in the loans were included in the determination of the fair value of the loans at the acquisition date. Old National reviewed the acquired loans and determined that as of December 31, 2012, $15.3 million met the definition of criticized, $23.9 million were considered classified, and $57.7 million were doubtful. Our current preference would be to work these loans and avoid foreclosure actions unless additional credit deterioration becomes apparent. These assets are included in our summary of under-performing, criticized and classified assets found below.

Summary of under-performing, criticized and classified assets:

 

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ASSET QUALITY

 

(dollars in thousands)

   2012     2011     2010     2009     2008  

Nonaccrual loans

          

Commercial

   $ 36,766      $ 34,104      $ 25,488      $ 24,257      $ 20,276   

Commercial real estate

     95,829        66,187        30,416        24,854        32,118   

Residential real estate

     11,986        10,247        8,719        9,621        5,474   

Consumer

     5,809        4,790        6,322        8,284        6,173   

Covered loans (5)

     103,946        182,880        —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonaccrual loans (6)

     254,336        298,208        70,945        67,016        64,041   

Renegotiated loans not on nonaccrual

         —          —          —     

Noncovered loans

     9,155        1,325        —          —          —     

Covered loans

     35        —          —          —          —     

Past due loans still accruing (90 days or more):

          

Commercial

     322        358        79        1,754        848   

Commercial real estate

     236        279        —          72        143   

Residential real estate

     66        —          —          —          —     

Consumer

     438        473        493        1,675        1,917   

Covered loans (5)

     15        2,338        —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total past due loans

     1,077        3,448        572        3,501        2,908   

Other real estate owned

     11,179        7,119        5,591        8,149        2,934   

Other real estate owned, covered (5)

     26,137        30,443        —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total under-performing assets

   $ 301,919      $ 340,543      $ 77,108      $ 78,666      $ 69,883   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Classified loans (includes nonaccrual, renegotiated, past due 90 days and other problem loans)

   $ 233,445      $ 204,120      $ 174,341      $ 157,063      $ 180,118   

Classified loans, covered (5)

     121,977        200,221        —          —          —     

Other classified assets (3)

     59,202        106,880        105,572        161,160        34,543   

Criticized loans

     113,264        80,148        84,017        103,512        124,855   

Criticized loans, covered (5)

     9,344        23,034        —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total criticized and classified assets

   $ 537,232      $ 614,403      $ 363,930      $ 421,735      $ 339,516   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Asset Quality Ratios including covered assets:

          

Non-performing loans/total loans (1) (2)

     5.07     6.28     1.90     1.75     1.35

Under-performing assets/total loans and foreclosed properties (1)

     5.77        7.09        2.06        2.05        1.47   

Under-performing assets/total assets

     3.16        3.96        1.06        0.98        0.89   

Allowance for loan losses/ under-performing assets (4)

     18.14        17.05        93.78        88.41        96.00   

Asset Quality Ratios excluding covered assets:

          

Non-performing loans/total loans (1) (2)

     3.31        2.82        1.90        1.75        1.35   

Under-performing assets/total loans and foreclosed properties (1)

     3.55        3.01        2.06        2.05        1.47   

Under-performing assets/total assets

     1.80        1.45        1.06        0.98        0.89   

Allowance for loan losses/ under-performing assets (4)

     28.55        45.74        93.78        88.41        96.00   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Loans exclude residential loans held for sale and leases held for sale.
(2) Non-performing loans include nonaccrual and renegotiated loans.
(3) Includes 6 pooled trust preferred securities, 6 non-agency mortgage-backed securities and 4 corporate securities at December 31, 2012.
(4) Because the acquired loans from Monroe, Integra and Indiana Community were recorded at fair value in accordance with ASC 805 at the date of acquisition, the credit risk is incorporated in the fair value recorded. No allowance for loan losses is recorded on the acquisition date.
(5) The Company entered into separate loss sharing agreements with the FDIC providing for specified credit loss protection for substantially all acquired single family residential loans, commercial loans and other real estate owned. At December 31, 2012, we expect eighty percent of any losses incurred on these covered assets to be reimbursed to Old National by the FDIC.
(6) Includes approximately $156.8 million of purchased credit impaired loans that are categorized as nonaccrual because the collection of principal or interest is doubtful. These loans are accounted for under FASB ASC 310-30 and accordingly treated as performing assets.

 

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Nonaccrual loans decreased $43.9 million from December 31, 2011 to December 31, 2012 primarily as a result of a decrease in our covered nonaccrual loans. Included in nonaccrual loans at December 31, 2012 is $57.7 million related to the loans acquired from Indiana Community Bancorp.

Interest income of approximately $6.0 million and $8.1 million would have been recorded on nonaccrual and renegotiated loans outstanding at December 31, 2012 and 2011, respectively, if such loans had been accruing interest throughout the year in accordance with their original terms. Excluding purchased credit impaired loans accounted for under ASC 310-30, the amount of interest income actually recorded on nonaccrual and renegotiated loans was $1.7 million and $1.8 million in 2012 and 2011, respectively. Approximately $243.0 million, or 95.5%, of nonaccrual loans were less than thirty days delinquent at December 31, 2012. We had $22.1 million of renegotiated loans which are included in nonaccrual loans at December 31, 2012 and $11.7 million of renegotiated loans which were included in nonaccrual loans at December 31, 2011.

Criticized and classified assets decreased $77.2 million from December 31, 2011 to December 31, 2012, primarily as a result of decreases in covered criticized and classified assets and other classified assets. Included in criticized and classified assets at December 31 2012 is $96.9 million related to the loans acquired from Indiana Community Bancorp. Other classified assets include investment securities that fell below investment grade rating.

Other real estate owned (“OREO”) decreased $0.2 million from December 31, 2011 to December 31, 2012. Included in other real estate owned at December 31, 2012 is $2.0 million related to the Indiana Community Bancorp acquisition.

Old National may choose to restructure the contractual terms of certain loans. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit Old National by increasing the ultimate probability of collection.

Any loans that are modified are reviewed by Old National to identify if a troubled debt restructuring (“TDR”) has occurred, which is when for economic or legal reasons related to a borrower’s financial difficulties, the Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status. During the twelve months ended December 31, 2012, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan, an extension of the maturity date at a stated rate of interest lower than the current market rate of new debt with similar risk, or a permanent reduction of the recorded investment of the loan.

Loans modified in a troubled debt restructuring are typically placed on nonaccrual status until the Company determines the future collection of principal and interest is reasonably assured, which generally requires that the borrower demonstrate a period of performance according to the restructured terms for six months.

If the Company is unable to resolve a nonperforming loan issue the credit will be charged off when it is apparent there will be a loss. For large commercial type loans, each relationship is individually analyzed for evidence of apparent loss based on quantitative benchmarks or subjectively based upon certain events or particular circumstances. It is Old National’s policy to charge off small commercial loans scored through our small business credit center with contractual balances under $250,000 that have been placed on nonaccrual status or became ninety days or more delinquent, without regard to the collateral position. For residential and consumer loans, a charge off is recorded at the time foreclosure is initiated or when the loan becomes 120 to 180 days past due, whichever is earlier.

For commercial and industrial troubled debt restructurings, an allocated reserve is established within the allowance for loan losses for the difference between the carrying value of the loan and its computed fair value. To determine the fair value of the loan, one of the following methods is selected: (1) the present value of expected cash flows discounted at the loan’s original effective interest rate, (2) the loan’s observable market price, or (3) the fair value of the collateral value, if the loan is collateral dependent. The allocated reserve is established as the difference between the carrying value of the loan and the collectable value. If there are significant changes in the amount or timing of the loan’s expected future cash flows, impairment is recalculated and the valuation allowance is adjusted accordingly.

 

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For consumer and residential troubled debt restructurings, an additional amount is added to the loan loss reserve that represents the difference in the present value of the cash flows between the original terms and the new terms of the modified loan, using the original effective interest rate of the loan as a discount rate.

At December 31, 2012, our troubled debt restructurings consisted of $12.7 million of commercial loans, $18.4 million of commercial real estate loans, $0.5 million of consumer loans and $0.5 million of residential loans, totaling $32.1 million. Approximately $22.1 million of the troubled debt restructurings at December 31, 2012 were included with nonaccrual loans. As of December 31, 2012, Old National has allocated specific reserves of $3.7 million to commercial loans and $0.8 million to commercial real estate loans for loans that have been modified in troubled debt restructurings. At December 31, 2011, our troubled debt restructurings consisted of $7.1 million of commercial loans, $5.8 million of commercial real estate loans and $0.1 million of consumer loans, totaling $13.0 million. Approximately $11.7 million of the troubled debt restructurings at December 31, 2011 were included with nonaccrual loans. As of December 31, 2011, Old National has allocated specific reserves of $1.3 million to commercial loans and $0.2 million to commercial real estate loans for loans that have been modified in troubled debt restructurings.

The terms of certain other loans were modified during the twelve months ended December 31, 2012 that did not meet the definition of a troubled debt restructuring. It is our process to review all classified and criticized loans that, during the period, have been renewed, have entered into a forbearance agreement, have gone from principal and interest to interest only, or have extended the maturity date. In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on its debt in the foreseeable future without the modification. The evaluation is performed under the Company’s internal underwriting policy. We also evaluate whether a concession has been granted or if we were adequately compensated through a market interest rate, additional collateral or a bona fide guarantee. We also consider whether the modification was insignificant relative to the other terms of the agreement or if the delay in a payment was 90 days or less.

Purchased credit impaired (“PCI”) loans would not be considered impaired until after the point at which there has been a degradation of cash flows below our expected cash flows at acquisition. If a PCI loan is subsequently modified, and meets the definition of a TDR, it will be removed from PCI accounting and accounted for as a TDR only if the PCI loan was being accounted for individually. If the purchased credit impaired loan is being accounted for as part of a pool, it will not be removed from the pool.

In general, once a modified loan is considered a TDR, the loan will always be considered a TDR, and therefore impaired, until it is paid in full, otherwise settled, sold or charged off. However, our policy also permits for loans to be removed from troubled debt restructuring status in the years following the restructuring if the following two conditions are met: (1) The restructuring agreement specifies an interest rate equal to or greater than the rate that the Company was willing to accept at the time of the restructuring for a new loan with comparable risk, and (2) the loan is not impaired based on the terms specified by the restructuring agreement.

To provide for the risk of loss inherent in extending credit, we maintain an allowance for loan losses. The allowance is maintained at a level believed adequate by management to absorb probable losses incurred in the loan portfolio. Management’s evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, pools of homogeneous loans, historical loss experience, and assessments of the impact of current economic conditions on the portfolio.

 

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The activity in our allowance for loan losses is as follows:

ALLOWANCE FOR LOAN LOSSES

 

(dollars in thousands)

   2012     2011     2010     2009     2008  

Balance, January 1

   $ 58,060      $ 72,309      $ 69,548      $ 67,087      $ 56,463   

Loans charged-off:

          

Commercial

     7,636        10,300        11,967        36,682        12,402   

Commercial real estate

     4,386        12,319        10,196        21,886        21,991   

Residential real estate

     2,204        1,945        2,296        1,315        1,442   

Consumer credit

     8,094        10,335        16,848        18,156        15,385   

Write-downs on loans transferred to held for sale

     —          —          —          572        —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total charge-offs

     22,320        34,899        41,307        78,611        51,220   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Recoveries on charged-off loans:

          

Commercial

     5,166        4,330        5,060        4,865        2,689   

Commercial real estate

     5,104        2,302        2,041        7,458        2,570   

Residential real estate

     464        319        172        135        272   

Consumer credit

     3,259        6,226        6,014        5,334        4,849   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total recoveries

     13,993        13,177        13,287        17,792        10,380   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs

     8,327        21,722        28,020        60,819        40,840   

Provision charged to expense

     5,030        7,473        30,781        63,280        51,464   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31

   $ 54,763      $ 58,060      $ 72,309      $ 69,548      $ 67,087   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Average loans for the year (1)

   $ 4,857,522      $ 4,440,467      $ 3,722,861      $ 4,330,247      $ 4,695,950   

Asset Quality Ratios:

          

Allowance/year-end loans (1)

     1.05     1.22     1.93     1.81     1.41

Allowance/average loans (1)

     1.13        1.31        1.94        1.61        1.43   

Net charge-offs/average loans (2)

     0.17        0.49        0.75        1.40        0.87   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Loans exclude residential loans held for sale and leases held for sale.
(2) Net charge-offs include write-downs on loans transferred to held for sale.

In conjunction with the significant decrease in impaired assets during since 2011, the allowance for loan losses declined $3.3 million, or 5.7%, from December 31, 2011 to December 31, 2012. The lower allowance for loan losses and provision expense were attributable to the following factors: (1) the loss factors applied to our performing loan portfolio have decreased over time as charge-offs were substantially lower, (2) the continuing trend in improved credit quality, and (3) the percentage of our legacy loan portfolio consisting of those loans where higher loss factors are applied (commercial and commercial real estate loans) fell while the percentage of our loan portfolio consisting of those loans where lower loss factors are applied (residential loans) increased.

Net charge-offs totaled $8.3 million in 2012 and $21.7 million in 2011. There were no industry segments representing a significant share of total net charge-offs. Net charge-offs to average loans declined to 0.17% for 2012 compared to 0.49% for 2011. The allowance to average loans, which ranged from 1.13% to 1.94% for the last five years, was 1.13% at December 31, 2012. Management will continue its efforts to reduce the level of non-performing loans and may consider the possibility of additional sales of troubled and non-performing loans, which could result in additional write-downs to the allowance for loan losses.

Because the acquired loans from Monroe Bancorp, Integra Bank and Indiana Community Bancorp were recorded at fair value in accordance with ASC 805 at the date of acquisition, the credit risk is incorporated in the fair value recorded. No allowance for loan losses is recorded on the acquisition date. As the fair value mark is accreted into income over future periods, a reserve will be established to absorb credit deterioration or adverse changes in expected cash flows. Through December 31, 2012, $4.3 million and $5.7 million had been reserved for these purchased credits from Monroe Bancorp and Integra Bank, respectively.

 

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The following table provides additional details of the following components of the allowance for loan losses, including FAS 5 (Accounting for Contingencies), FAS 114 (Accounting by Creditors for Impairment of a Loan) and SOP 03-3 (Accounting for Certain Loans or Debt Securities Acquired in a Transfer):

 

                 Purchased Loans  
     Legacy     Covered     Non-covered  

(dollars in thousands)

   FAS 5     FAS 114     FAS 5     FAS 114      SOP 03-3     FAS 5     FAS 114     SOP 03-3  

Loan balance

   $ 3,987,266      $ 49,432      $ 117,095      $ 405       $ 254,833      $ 672,377      $ 23,725      $ 91,461   

Remaining purchase discount

     —          —          9,392        —           135,063        29,684        11,813        38,128   

Allowance, January 1, 2012

     43,920        11,027        —          —           943        325        167        1,678   

Charge-offs

     (8,681     (6,942     (1,952        1,007        (1,130     (2,126     (2,496

Recoveries

     6,041        6,215        132           (412     544        836        637   

Provision expense

     (4,880     (1,930     1,820           4,178        312        1,045        4,485   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Allowance, December 31, 2012

   $ 36,400      $ 8,370      $ —        $  —         $ 5,716      $ 51      ($ 78   $ 4,304   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

We also maintain an allowance for losses on unfunded commercial lending commitments and letters of credit to provide for the risk of loss inherent in these arrangements. The allowance is computed using a methodology similar to that used to determine the allowance for loan losses, modified to take into account the probability of a drawdown on the commitment. The $4.0 million reserve for unfunded loan commitments at December 31, 2012 is classified as a liability account on the balance sheet. The reserve for unfunded loan commitments was $4.8 million at December 31, 2011. The lower reserve is the result of improved loss rates.

The following table details the allowance for loan losses by loan category and the percent of loans in each category compared to total loans at December 31.

ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES BY CATEGORY OF LOANS

AND THE PERCENTAGE OF LOANS BY CATEGORY TO TOTAL LOANS

 

     2012     2011     2010     2009     2008  

(dollars in thousands)

   Amount      Percent
of Loans
to Total
Loans
    Amount      Percent
of Loans
to Total
Loans
    Amount      Percent
of Loans
to Total
Loans
    Amount      Percent
of Loans
to Total
Loans
    Amount      Percent
of Loans
to Total
Loans
 

Commercial

   $ 14,642         25.7    $ 19,959         25.5    $ 26,204         32.3    $ 26,869         33.6    $ 29,254         39.9 

Commercial real estate

     26,391         24.2        26,862         22.4        32,654         25.2        27,138         27.7        22,362         24.2   

Residential real estate

     3,677         25.5        3,516         20.9        2,309         17.8        1,688         10.5        2,067         10.4   

Consumer credit

     4,337         17.4        6,780         18.1        11,142         24.7        13,853         28.2        13,404         25.5   

Covered loans

     5,716         7.2        943         13.1        —                  —                  —             
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 54,763         100.0    $ 58,060         100.0    $ 72,309         100.0    $ 69,548         100.0    $ 67,087         100.0 
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Market Risk

Market risk is the risk that the estimated fair value of our assets, liabilities, and derivative financial instruments will decline as a result of changes in interest rates or financial market volatility, or that our net income will be significantly reduced by interest rate changes.

The objective of our interest rate management process is to maximize net interest income while operating within acceptable limits established for interest rate risk and maintaining adequate levels of funding and liquidity.

Potential cash flows, sales, or replacement value of many of our assets and liabilities, especially those that earn or pay interest, are sensitive to changes in the general level of interest rates. This interest rate risk arises primarily from our normal business activities of gathering deposits and extending loans. Many factors affect our exposure to changes in interest rates, such as general economic and financial conditions, customer preferences, historical pricing relationships, and re-pricing characteristics of financial instruments. Our earnings can also be affected by the monetary and fiscal policies of the U.S. Government and its agencies, particularly the Federal Reserve Board.

 

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In managing interest rate risk, we, through the Funds Management Committee, a committee of the Board of Directors, establish guidelines, for asset and liability management, including measurement of short and long-term sensitivities to changes in interest rates. Based on the results of our analysis, we may use different techniques to manage changing trends in interest rates including:

 

   

adjusting balance sheet mix or altering interest rate characteristics of assets and liabilities;

 

   

changing product pricing strategies;

 

   

modifying characteristics of the investment securities portfolio; or

 

   

using derivative financial instruments, to a limited degree.

A key element in our ongoing process is to measure and monitor interest rate risk using a Net Interest Income at Risk simulation to model the interest rate sensitivity of the balance sheet and to quantify the impact of changing interest rates on the Company. The model quantifies the effects of various possible interest rate scenarios on projected net interest income over a one-year and a two-year cumulative horizon. The model assumes a semi-static balance sheet and measures the impact on net interest income relative to a base case scenario of hypothetical changes in interest rates over 24 months. The scenarios include prepayment assumptions, changes in the level of interest rates, the shape of the yield curve, and spreads between market interest rates in order to capture the impact from re-pricing, yield curve, option, and basis risks.

Our simulation scenarios assume the following market interest rates with an instantaneous shift from current interest rates.

 

     Hypothetical LIBOR/Swap Yield Curves, December 31, 2012  
     3-Month     6-Month     1-Year     2-Year     3-Year     5-Year     10-Year     20-Year     30-Year  

+ 3.00%

     3.31     3.51     3.84     3.39     3.50     3.86     4.84     5.61     5.80

+ 2.00%

     2.31     2.51     2.84     2.39     2.50     2.86     3.84     4.61     4.80

+ 1.00%

     1.31     1.51     1.84     1.39     1.50     1.86     2.84     3.61     3.80

Yield Curve at 12/31

     0.31     0.51     0.84     0.39     0.50     0.86     1.84     2.61     2.80

- 1.00%

     NA        NA        NA        NA        NA        NA        NA        NA        NA   

100 bp flattening of curve

                  

Short end

     1.31     1.51     1.84     1.39     0.50     0.86     1.84     2.61     2.80

Long end

     0.31     0.51     0.84     0.39     0.50     0.86     0.84     1.61     1.80

100 bp steepening of curve

                  

Short end

     0.00     0.00     0.00     0.00     0.50     0.86     1.84     2.61     2.80

Long end

     0.31     0.51     0.84     0.39     0.50     0.86     2.84     3.61     3.80

A key element in the measurement and modeling of interest rate risk are the re-pricing assumptions of our transaction deposit accounts, which have no contractual maturity dates. We assume this deposit base is comprised of both core and more volatile balances and consists of both non-interest bearing and interest bearing accounts. Core deposit balances are assumed to be less interest rate sensitive and provide longer term funding. Volatile balances are assumed to be more interest rate sensitive and shorter in term. As part of our semi-static balance sheet modeling, we assume interest rates paid on the volatile deposits move in conjunction with changes in interest rates, in order to retain these deposits. This may include current non-interest bearing accounts.

Results of our simulation modeling project that our net interest income could change as follows over one-year and two-year horizons, relative to our base case scenarios at December 31st.

 

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Table of Contents
     Changes in Net Interest Income
One Year Horizon
 
     12/31/2012     12/31/2011  

Immediate

Change in the

Level of Interest

Rates

   Net
Interest Income
(000s)
     $ Change
(000s)
    % Change     Net
Interest Income
(000s)
     $ Change
(000s)
    % Change  

+ 3.00%

     243,859         (18,361     -7.00     244,698         (10,636     -4.17

+ 2.00%

     252,653         (9,567     -3.65     250,677         (4,657     -1.82

+ 1.00%

     261,770         (451     -0.17     256,623         1,288        0.50

Yield Curve at 12/31

     262,220         —           0.00     255,335         —          0.00

- 1.00%

     NA         NA        NA        NA         NA        NA   

100 bp flattening of curve

              

Short end

     256,099         (6,121     -2.33     NA         NA        NA   

Long end

     258,273         (3,947     -1.51     NA         NA        NA   

100 bp steepening of curve

              

Short end

     260,493         (1,727     -0.66     NA         NA        NA   

Long end

     265,748         3,528        1.35     NA         NA        NA   

 

     Changes in Net Interest Income
Two Year Cumulative Horizon
 
     12/31/2012     12/31/2011  

Immediate

Change in the

Level of Interest

Rates

   Net
Interest Income
(000s)
     $ Change
(000s)
    % Change     Net
Interest Income
(000s)
     $ Change
(000s)
    % Change  

+ 3.00%

     502,180         (15,156     -2.93     498,109         (4,365     -0.87

+ 2.00%

     516,920         (416     -0.08     507,800         5,326        1.06

+ 1.00%

     527,570         10,234        1.98     513,313         10,839        2.16

Yield Curve at 12/31

     517,336         —           0.00     502,474         —          0.00

- 1.00%

     NA         NA        NA        NA         NA        NA   

100 bp flattening of curve

              

Short end