10-Q 1 sce-2019331x10q.htm 10-Q SRCE 1ST QUARTER 2019 Wdesk | Document

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2019

OR

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                     to                    

Commission file number 0-6233
corplogo3a02a12.jpg
(Exact name of registrant as specified in its charter)
INDIANA
 
35-1068133
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
100 North Michigan Street
 
 
South Bend, IN
 
46601
(Address of principal executive offices)
 
(Zip Code)
 
(574) 235-2000
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  x  Yes  o No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  x Yes  o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company.  See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.  (Check one):
Large accelerated filer x
 
Accelerated filer o
 
 
 
Non-accelerated filer o
 
Smaller reporting company o
 
 
 
 
 
Emerging growth company o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o Yes  x No
Number of shares of common stock outstanding as of April 12, 2019 — 25,667,953 shares
 



TABLE OF CONTENTS

 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
EXHIBITS
 
 
 
 
 
 
 
 
 


2




1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Unaudited - Dollars in thousands)
 
March 31,
2019
 
December 31,
2018
ASSETS
 

 
 

Cash and due from banks
$
64,619

 
$
94,907

Federal funds sold and interest bearing deposits with other banks
3,062

 
4,172

Investment securities available-for-sale
1,002,809

 
990,129

Other investments
28,404

 
28,404

Mortgages held for sale
9,210

 
11,290

Loans and leases, net of unearned discount:
 

 
 
Commercial and agricultural
1,146,031

 
1,073,205

Auto and light truck
554,078

 
559,987

Medium and heavy duty truck
285,631

 
283,544

Aircraft
830,437

 
803,111

Construction equipment
641,035

 
645,239

Commercial real estate
818,459

 
809,886

Residential real estate and home equity
514,719

 
523,855

Consumer
135,797

 
136,637

Total loans and leases
4,926,187

 
4,835,464

Reserve for loan and lease losses
(101,852
)
 
(100,469
)
Net loans and leases
4,824,335

 
4,734,995

Equipment owned under operating leases, net
131,594

 
134,440

Net premises and equipment
51,357

 
52,139

Goodwill and intangible assets
83,992

 
83,998

Accrued income and other assets
179,704

 
159,271

Total assets
$
6,379,086

 
$
6,293,745

 
 
 
 
LIABILITIES
 

 
 

Deposits:
 

 
 

Noninterest-bearing demand
$
1,146,647

 
$
1,217,120

Interest-bearing deposits:
 
 
 
Interest-bearing demand
1,560,840

 
1,614,959

Savings
851,564

 
822,477

Time
1,565,040

 
1,467,766

Total interest-bearing deposits
3,977,444

 
3,905,202

Total deposits
5,124,091

 
5,122,322

Short-term borrowings:
 

 
 

Federal funds purchased and securities sold under agreements to repurchase
149,172

 
113,627

Other short-term borrowings
106,216

 
85,717

Total short-term borrowings
255,388

 
199,344

Long-term debt and mandatorily redeemable securities
71,439

 
71,123

Subordinated notes
58,764

 
58,764

Accrued expenses and other liabilities
88,303

 
78,602

Total liabilities
5,597,985

 
5,530,155

 
 
 
 
SHAREHOLDERS’ EQUITY
 

 
 

Preferred stock; no par value
 

 
 

Authorized 10,000,000 shares; none issued or outstanding

 

Common stock; no par value
 

 
 
Authorized 40,000,000 shares; issued 28,205,674 at March 31, 2019 and December 31, 2018
436,538

 
436,538

Retained earnings
414,428

 
398,980

Cost of common stock in treasury (2,537,741 shares at March 31, 2019 and 2,421,946 shares at December 31, 2018)
(69,136
)
 
(62,760
)
Accumulated other comprehensive loss
(3,408
)
 
(10,676
)
Total shareholders’ equity
778,422

 
762,082

Noncontrolling interests
$
2,679

 
$
1,508

Total equity
$
781,101

 
$
763,590

Total liabilities and equity
$
6,379,086

 
$
6,293,745

The accompanying notes are a part of the consolidated financial statements.

3


1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited - Dollars in thousands, except per share amounts)
 
Three Months Ended 
 March 31,
 
2019
 
2018
Interest income:
 

 
 

Loans and leases
$
62,683

 
$
53,691

Investment securities, taxable
5,515

 
4,608

Investment securities, tax-exempt
385

 
531

Other
438

 
408

Total interest income
69,021

 
59,238

Interest expense:
 

 
 

Deposits
11,470

 
6,562

Short-term borrowings
931

 
776

Subordinated notes
928

 
883

Long-term debt and mandatorily redeemable securities
744

 
485

Total interest expense
14,073

 
8,706

Net interest income
54,948

 
50,532

Provision for loan and lease losses
4,918

 
3,786

Net interest income after provision for loan and lease losses
50,030

 
46,746

Noninterest income:
 

 
 

Trust and wealth advisory
4,858

 
5,188

Service charges on deposit accounts
2,498

 
2,484

Debit card
3,220

 
3,103

Mortgage banking
936

 
884

Insurance commissions
2,174

 
1,958

Equipment rental
7,982

 
7,755

Losses on investment securities available-for-sale

 
(345
)
Other
2,456

 
2,780

Total noninterest income
24,124

 
23,807

Noninterest expense:
 

 
 

Salaries and employee benefits
23,495

 
22,531

Net occupancy
2,772

 
2,866

Furniture and equipment
6,024

 
5,455

Depreciation – leased equipment
6,524

 
6,428

Professional fees
1,598

 
2,017

Supplies and communication
1,493

 
1,553

FDIC and other insurance
645

 
698

Business development and marketing
949

 
1,533

Loan and lease collection and repossession
1,361

 
951

Other
343

 
1,525

Total noninterest expense
45,204

 
45,557

Income before income taxes
28,950

 
24,996

Income tax expense
6,754

 
5,880

Net income
$
22,196

 
$
19,116

Net (income) loss attributable to noncontrolling interests

 

Net income available to common shareholders
22,196

 
19,116

Per common share:
 

 
 

Basic net income per common share
$
0.86

 
$
0.73

Diluted net income per common share
$
0.86

 
$
0.73

Cash dividends
$
0.27

 
$
0.22

Basic weighted average common shares outstanding
25,759,186

 
25,950,386

Diluted weighted average common shares outstanding
25,759,186

 
25,950,386

The accompanying notes are a part of the consolidated financial statements.

4


1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited - Dollars in thousands)
 
Three Months Ended 
 March 31,
 
2019
 
2018
Net income
$
22,196

 
$
19,116

Other comprehensive income (loss):
 

 
 

Unrealized appreciation (depreciation) of available-for-sale securities
9,573

 
(9,414
)
Reclassification adjustment for realized losses included in net income

 
345

Income tax effect
(2,305
)
 
2,184

Other comprehensive income (loss), net of tax
7,268

 
(6,885
)
Comprehensive income
29,464

 
12,231

Comprehensive (income) loss attributable to noncontrolling interests

 

Comprehensive income available to common shareholders
$
29,464

 
$
12,231

The accompanying notes are a part of the consolidated financial statements.

1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Unaudited - Dollars in thousands, except per share amounts)
 
Preferred
Stock
 
Common
Stock
 
Retained
Earnings
 
Cost of
Common
Stock
in Treasury
 
Accumulated
Other
Comprehensive
Income (Loss), Net
 
Total Shareholders' Equity
 
Noncontrolling Interests
 
Total Equity
Balance at January 1, 2018
$

 
$
436,538

 
$
339,959

 
$
(54,628
)
 
$
(3,332
)
 
$
718,537

 
$

 
$
718,537

Cumulative-effect adjustment

 

 
718

 

 
(718
)
 

 

 

Balance at January 1, 2018, adjusted

 
436,538

 
340,677

 
(54,628
)
 
(4,050
)
 
718,537

 

 
718,537

Net income

 

 
19,116

 

 

 
19,116

 

 
19,116

Other comprehensive loss

 

 

 

 
(6,885
)
 
(6,885
)
 

 
(6,885
)
Issuance of 34,191 common shares under stock based compensation awards

 

 
535

 
811

 

 
1,346

 

 
1,346

Cost of 15,784 shares of common stock acquired for treasury

 

 

 
(785
)
 

 
(785
)
 

 
(785
)
Common stock dividend ($0.22 per share)

 

 
(5,720
)
 

 

 
(5,720
)
 

 
(5,720
)
Balance at March 31, 2018
$

 
$
436,538

 
$
354,608

 
$
(54,602
)
 
$
(10,935
)
 
$
725,609

 
$

 
725,609

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at January 1, 2019
$

 
$
436,538

 
$
398,980

 
$
(62,760
)
 
$
(10,676
)
 
$
762,082

 
$
1,508

 
$
763,590

Cumulative-effect adjustment

 

 
(301
)
 

 

 
(301
)
 

 
(301
)
Balance at January 1, 2019, adjusted

 
436,538

 
398,679

 
(62,760
)
 
(10,676
)
 
761,781

 
1,508

 
763,289

Net income

 

 
22,196

 

 

 
22,196

 

 
22,196

Other comprehensive income

 

 

 

 
7,268

 
7,268

 

 
7,268

Issuance of 38,365 common shares under stock based compensation awards

 

 
533

 
882

 

 
1,415

 

 
1,415

Cost of 154,160 shares of common stock acquired for treasury

 

 

 
(7,258
)
 

 
(7,258
)
 

 
(7,258
)
Common stock dividend ($0.27 per share)

 

 
(6,980
)
 

 

 
(6,980
)
 

 
(6,980
)
Contributions from noncontrolling interests

 

 

 

 

 

 
1,171

 
1,171

Balance at March 31, 2019
$

 
$
436,538

 
$
414,428

 
$
(69,136
)
 
$
(3,408
)
 
$
778,422

 
$
2,679

 
$
781,101

The accompanying notes are a part of the consolidated financial statements.


5


1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited - Dollars in thousands)
 
Three Months Ended March 31,
 
2019
 
2018
Operating activities:
 

 
 

Net income
$
22,196

 
$
19,116

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Provision for loan and lease losses
4,918

 
3,786

Depreciation of premises and equipment
1,466

 
1,321

Depreciation of equipment owned and leased to others
6,524

 
6,428

Stock-based compensation
673

 
880

Amortization of investment securities premiums and accretion of discounts, net
824

 
764

Amortization of mortgage servicing rights
233

 
236

Deferred income taxes
444

 
(7,531
)
Losses on investment securities available-for-sale

 
345

Originations of loans held for sale, net of principal collected
(19,966
)
 
(17,032
)
Proceeds from the sales of loans held for sale
22,534

 
21,960

Net gain on sale of loans held for sale
(488
)
 
(431
)
Net gain on sale of other real estate and repossessions
(167
)
 
(6
)
Net (gain) loss on sale of premises and equipment
(1,288
)
 
2

Change in interest receivable
(2,696
)
 
(1,806
)
Change in interest payable
2,427

 
1,120

Change in other assets
1,808

 
4,825

Change in other liabilities
(7,814
)
 
323

Other
598

 
(30
)
Net change in operating activities
32,226

 
34,270

Investing activities:
 

 
 

Proceeds from sales of investment securities available-for-sale

 
11,739

Proceeds from maturities and paydowns of investment securities available-for-sale
28,840

 
47,265

Purchases of investment securities available-for-sale
(33,072
)
 
(107,225
)
Proceeds from liquidation of partnership investment

 
1,868

Net change in other investments

 
(1,312
)
Loans sold or participated to others
2,862

 
14,310

Net change in loans and leases
(106,059
)
 
(178,326
)
Net change in equipment owned under operating leases
(3,678
)
 
(10,976
)
Purchases of premises and equipment
(2,821
)
 
(1,566
)
Proceeds from disposal of premises and equipment
3,426

 
17

Proceeds from sales of other real estate and repossessions
4,044

 
425

Net change in investing activities
(106,458
)
 
(223,781
)
Financing activities:
 

 
 

Net change in demand deposits and savings accounts
(95,505
)
 
(81,827
)
Net change in time deposits
97,274

 
110,422

Net change in short-term borrowings
56,044

 
141,369

Payments on long-term debt
(1,718
)
 
(636
)
Acquisition of treasury stock
(7,258
)
 
(785
)
Contributions from noncontrolling interests
1,171

 

Cash dividends paid on common stock
(7,174
)
 
(5,913
)
Net change in financing activities
42,834

 
162,630

 
 
 
 
Net change in cash and cash equivalents
(31,398
)
 
(26,881
)
Cash and cash equivalents, beginning of year
99,079

 
78,033

Cash and cash equivalents, end of period
$
67,681

 
$
51,152

Supplemental Information:
 

 
 

Non-cash transactions:
 

 
 

Loans transferred to other real estate and repossessed assets
$
8,939

 
$
259

Common stock matching contribution to Employee Stock Ownership and Profit Sharing Plan
300

 
583

Right of use assets obtained in exchange for lease obligations
1,058

 

The accompanying notes are a part of the consolidated financial statements.

6


1ST SOURCE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1 — Accounting Policies
1st Source Corporation is a bank holding company headquartered in South Bend, Indiana that provides, through its subsidiaries (collectively referred to as “1st Source” or “the Company”), a broad array of financial products and services.
Basis of Presentation – The accompanying unaudited consolidated financial statements reflect all adjustments (all of which are normal and recurring in nature) which are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, the results of operations, changes in comprehensive income, changes in shareholders’ equity, and cash flows for the periods presented. These unaudited consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) have been omitted.
The Notes to the Consolidated Financial Statements appearing in 1st Source Corporation’s Annual Report on Form 10-K (2018 Annual Report), which include descriptions of significant accounting policies, should be read in conjunction with these interim financial statements. The Consolidated Statement of Financial Condition at December 31, 2018 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements. Certain amounts in the prior period consolidated financial statements have been reclassified to conform to the current period presentation.
Use of Estimates in the Preparation of Financial Statements – Financial statements prepared in accordance with GAAP require the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the reporting period. Actual results could differ from those estimates.
Loans and Leases – Loans are stated at the principal amount outstanding, net of unamortized deferred loan origination fees and costs and net of unearned income. Interest income is accrued as earned based on unpaid principal balances. Origination fees and direct loan and lease origination costs are deferred, and the net amount amortized to interest income over the estimated life of the related loan or lease. Loan commitment fees are deferred and amortized into other income over the commitment period.
Direct financing leases are carried at the aggregate of lease payments plus estimated residual value of the leased property, net of unamortized deferred lease origination fees and costs and unearned income. Interest income on direct financing leases is recognized over the term of the lease to achieve a constant periodic rate of return on the outstanding investment. Effective January 1, 2019, as part of the new leasing standard, only those costs incurred as a direct result of closing a lease transaction can be capitalized. All existing deferrals will continue to be amortized over the estimated life of the lease while all new incremental direct costs will be expensed immediately.
The accrual of interest on loans and leases is discontinued when a loan or lease becomes contractually delinquent for 90 days, or when an individual analysis of a borrower’s credit worthiness indicates a credit should be placed on nonperforming status, except for residential mortgage loans and consumer loans that are well secured and in the process of collection. Residential mortgage loans are placed on nonaccrual at the time the loan is placed in foreclosure. When interest accruals are discontinued, interest credited to income in the current year is reversed and interest accrued in the prior year is charged to the reserve for loan and lease losses. However, in some cases, the Company may elect to continue the accrual of interest when the net realizable value of collateral is sufficient to cover the principal and accrued interest. When a loan or lease is classified as nonaccrual and the future collectability of the recorded loan or lease balance is doubtful, collections on interest and principal are applied as a reduction to principal outstanding. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured, which is typically evidenced by a sustained repayment performance of at least six months.
A loan or lease is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or lease agreement. Interest on impaired loans and leases, which are not classified as nonaccrual, is recognized on the accrual basis. The Company evaluates loans and leases exceeding $100,000 for impairment and establishes a specific reserve as a component of the reserve for loan and lease losses when it is probable all amounts due will not be collected pursuant to the contractual terms of the loan or lease and the recorded investment in the loan or lease exceeds its fair value.

7


Loans and leases that have been modified and economic concessions have been granted to borrowers who have experienced financial difficulties are considered a troubled debt restructuring (TDR) and, by definition, are deemed an impaired loan. These concessions typically result from the Company’s loss mitigation activities and may include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Certain TDRs are classified as nonperforming at the time of restructuring and typically are returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period of at least six months.
When the Company modifies loans and leases in a TDR, it evaluates any possible impairment similar to other impaired loans based on the present value of expected future cash flows, discounted at the contractual interest rate of the original loan or lease agreement, or uses the current fair value of the collateral, less selling costs for collateral dependent loans. If the Company determines that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through a reserve for loan and lease losses estimate or a charge-off to the reserve for loan and lease losses. In periods subsequent to modification, the Company evaluates all TDRs, including those that have payment defaults, for possible impairment and recognizes impairment through the reserve for loan and lease losses.
Equipment Owned Under Operating Leases As a lessor, the Company finances various types of construction equipment, medium and heavy duty trucks, automobiles and other equipment under leases classified as operating leases. The equipment underlying the operating leases is reported at cost, net of accumulated depreciation, in the Consolidated Statements of Financial Condition. These operating lease arrangements require the lessee to make a fixed monthly rental payment over a specified lease term generally ranging from three to seven years. Revenue consists of the contractual lease payments and is recognized on a straight-line basis over the lease term and reported as noninterest income. Leased assets are being depreciated on a straight-line method over the lease term to the estimate of the equipment’s fair market value at lease termination, also referred to as “residual” value. The depreciation of these operating lease assets is reported as Noninterest Expense on the Consolidated Statements of Income. For automobile leases, fair value is based upon published industry market guides. For other equipment leases, fair value may be based upon observable market prices, third-party valuations, or prices received on sales of similar assets at the end of the lease term. These residual values are reviewed annually to ensure the recorded amount does not exceed the fair market value at the lease termination. At the end of the lease, the operating lease asset is either purchased by the lessee or returned to the Company. The Company is responsible for the payment of personal property taxes which is reported as Other Expense on the Consolidated Statements of Income. The lessee is responsible for reimbursing the Company for personal property taxes which is reported as Other Income on the Consolidated Statements of Income. The Company excludes sales taxes and other similar taxes from being reported as lease revenue with an associated expense.
Lease Commitments – The Company leases certain banking center locations, office space, land and billboards. In determining whether a contract contains a lease, the Company examines the contract to ensure an asset was specifically identified and that the Company has control of use over the asset. To determine whether a lease is classified as operating or finance, the Company performs an economic life test on all building leases with greater than a twenty year term. Further, the Company performs a fair value test to identify any leases that have a present value of future lease payments over the lease term that is greater than 90% of the fair value of the building. The Company only capitalizes leases with an initial lease liability equal to or over $2,000.
At lease inception, the Company determines the lease term by adding together the minimum lease term and all optional renewal periods that it is reasonably certain to renew. The Company determines this on each lease by considering all relevant contract-based, asset-based, market-based, and entity-based economic factors. Generally, the exercise of lease renewal options is at the Company’s sole discretion. The lease term is used to determine whether a lease is operating or finance and is used to calculate straight-line rent expense. Additionally, the depreciable life of leasehold improvements is limited by the expected lease term.
Operating lease rentals are expensed on a straight-line basis over the life of the lease beginning on the date the Company takes possession of the property. Rent expense and variable lease costs are included in Net Occupancy Expense on the Company’s Consolidated Statements of Income. Included in variable lease costs are leases with rent escalations based on recent financial indices, such as the Consumer Price Index, where the Company estimates future rent increases and records the actual difference to variable costs. Certain leases require the Company to pay common area maintenance, real estate taxes, insurance and other operating expenses associated with the leases premises. These expenses are classified in Net Occupancy Expense, consistent with similar costs for owned locations. There are no residual value guarantees or restrictions or covenants imposed by leases.
The Company accounts for lease and nonlease components together as a single lease component by class of underlying asset. Operating lease obligations with an initial term longer than 12 months are recorded with a right of use asset and a lease liability in the Consolidated Statements of Financial Condition. Operating lease obligations with an initial term of 12 months or less are expensed in the Consolidated Statements of Income on a straight-line basis over the lease term.
The discount rate used in determining the lease liability and related right of use asset is based upon what would be obtained by the Company for similar loans as an incremental rate as of the date of origination or renewal.

8


Revenue Recognition – The Company recognizes revenues as they are earned based on contractual terms, as transactions occur, or as services are provided and collectability is reasonably assured. The Company’s principal source of revenue is interest income from loans and leases and investment securities. The Company also earns noninterest income from various banking and financial services offered primarily through 1st Source Bank (Bank) and its subsidiaries.
Interest IncomeThe largest source of revenue for the Company is interest income which is primarily recognized on an accrual basis according to nondiscretionary formulas in written contracts, such as loan and lease agreements or investment securities contracts.
Noninterest IncomeThe Company earns noninterest income through a variety of financial and transaction services provided to corporate and consumer clients such as trust and wealth advisory, deposit account, debit card, mortgage banking, insurance, and equipment rental services. Revenue is recorded for noninterest income based on the contractual terms for the service or transaction performed. In certain circumstances, noninterest income is reported net of associated expenses.
Note 2 — Recent Accounting Pronouncements
Leases: In March 2019, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2019-01 “Leases (Topic 842): Codification Improvements.” These amendments align the guidance for fair value of the underlying asset by lessors that are not manufacturers or dealers in Topic 842 with that of existing guidance. The ASU also requires lessors within the scope of Topic 842, Financial Services-Depository Lending, to present all “principal payments received under leases” within investing activities on the Consolidated Statements of Cash Flows. Finally, the ASU exempts both lessees and lessors from having to provide certain interim disclosures in the fiscal year in which a company adopts the new leases standard. The guidance is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early application is permitted. An entity should apply the amendments as of the date that it first applied Topic 842, using the same transition methodology in accordance with paragraph 842-10-65-1(c). The Company adopted Topic 842 on January 1, 2019 and applied the amendments in ASU 2019-01 as of the same date and it did not have a material impact on its accounting and disclosures.
Intangibles - Internal-Use Software: In August 2018, the FASB issued ASU No. 2018-15 “Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract.” These amendments align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contact with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). The accounting for the service element of a hosting arrangement that is a service contract is not affected by these amendments. The guidance is effective for public business entities for annual periods, including interim periods within those annual periods, beginning after December 15, 2019. Early adoption is permitted. The Company is assessing ASU 2018-15 and the impact on its accounting and disclosures.
Disclosure Requirements for Fair Value Measurement: In August 2018, the FASB issued ASU No. 2018-13 “Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement.” These amendments modify the disclosure requirements in Topic 820 as follows:
Removals: the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy; the policy for timing of transfers between levels; and the valuation processes for Level 3 fair value measurements.
Modifications: for investments in certain entities that calculate net asset value, an entity is required to disclose the timing of liquidation of an investee’s assets and the date when restrictions from redemption might lapse only if the investee has communicated the timing to the entity or announced the timing publicly; and the amendments clarify that the measurement uncertainty disclosure is to communicate information about the uncertainty in measurement as of the reporting date.
Additions: the changes in unrealized gains and losses for the period included in other comprehensive income for recurring Level 3 fair value measurements held at the end of the reporting period; and the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements.
The guidance is effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The amendments on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements, and the narrative description of measurement uncertainty should all be applied prospectively for only the most recent interim or annual period presented in the initial year of adoption. All other amendments should be applied retrospectively to all periods presented upon their effective date. Early adoption is permitted. An entity is permitted to early adopt any removed or modified disclosures upon issuance of ASU No. 2018-13 and delay adoption of the additional disclosures until their effective date. The Company is assessing ASU 2018-13 and the impact on its disclosures.

9


Premium Amortization: In March 2017, the FASB issued ASU No. 2017-08 “Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities.” These amendments shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. The guidance is effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted, including adoption in an interim period. If an entity early adopts in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments should be applied on a modified retrospective basis, with a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. The Company adopted ASU 2017-08 on January 1, 2019 and recognized a cumulative-effect adjustment to retained earnings of $0.30 million.
Simplifying the Test for Goodwill Impairment: In January 2017, the FASB issued ASU No. 2017-04 “Intangibles - Goodwill and Other (Topic 350) - Simplifying the Test for Goodwill Impairment.” These amendments eliminate Step 2 from the goodwill impairment test. The amendments also eliminate the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The guidance is effective for annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. ASU 2017-04 should be adopted on a prospective basis. The Company has assessed ASU 2017-04 and does not expect it to have a material impact on its accounting and disclosures.
Measurement of Credit Losses on Financial Instruments: In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments-Credit Losses (Topic 326) - Measurement of Credit Losses on Financial Instruments.” The provisions of ASU 2016-13 were issued to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments that are not accounted for at fair value through net income, including loans held for investment, held-to-maturity debt securities, trade and other receivables, net investment in leases and other commitments to extend credit held by a reporting entity at each reporting date. ASU 2016-13 requires that financial assets measured at amortized cost be presented at the net amount expected to be collected, through an allowance for credit losses that is deducted from the amortized cost basis. The amendments in ASU 2016-13 eliminate the probable incurred loss recognition in current GAAP and reflect an entity’s current estimate of all expected credit losses. The measurement of expected credit losses is based upon historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the financial assets.
For purchased financial assets with a more-than-insignificant amount of credit deterioration since origination (“PCD assets”) that are measured at amortized cost, the initial allowance for credit losses is added to the purchase price rather than being reported as a credit loss expense. Subsequent changes in the allowance for credit losses on PCD assets are recognized through the statement of income as a credit loss expense.
Credit losses relating to available-for-sale debt securities will be recorded through an allowance for credit losses rather than as a direct write-down to the security.
ASU 2016-13 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company has a cross-functional team working through an implementation plan which includes assessment and documentation of processes, internal controls and data as well as model development. The Company is also in the process of implementing a third-party software solution to assist in the application of the new standard. The impact of adopting ASU 2016-13 cannot be reasonably estimated at this point.

10


Note 3 — Investment Securities Available-For-Sale
The following table shows investment securities available-for-sale.
(Dollars in thousands)
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Fair Value
March 31, 2019
 
 

 
 

 
 

 
 

U.S. Treasury and Federal agencies securities
 
$
537,895

 
$
737

 
$
(3,226
)
 
$
535,406

U.S. States and political subdivisions securities
 
88,501

 
518

 
(263
)
 
88,756

Mortgage-backed securities — Federal agencies
 
332,342

 
1,520

 
(3,921
)
 
329,941

Corporate debt securities
 
47,860

 
312

 
(166
)
 
48,006

Foreign government and other securities
 
700

 

 

 
700

Total debt securities available-for-sale
 
$
1,007,298

 
$
3,087

 
$
(7,576
)
 
$
1,002,809

 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

 
 

U.S. Treasury and Federal agencies securities
 
$
537,913

 
$
196

 
$
(6,886
)
 
$
531,223

U.S. States and political subdivisions securities
 
95,346

 
172

 
(936
)
 
94,582

Mortgage-backed securities — Federal agencies
 
324,390

 
718

 
(6,875
)
 
318,233

Corporate debt securities
 
45,843

 

 
(451
)
 
45,392

Foreign government and other securities
 
700

 

 
(1
)
 
699

Total debt securities available-for-sale
 
$
1,004,192

 
$
1,086

 
$
(15,149
)
 
$
990,129

At March 31, 2019 and December 31, 2018, the residential mortgage-backed securities held by the Company consisted primarily of GNMA, FNMA and FHLMC pass-through certificates which are guaranteed by those respective agencies of the United States government (Government Sponsored Enterprise, GSEs).
The following table shows the contractual maturities of investments in debt securities available-for-sale at March 31, 2019. Expected maturities will differ from contractual maturities, because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
(Dollars in thousands)
 
Amortized Cost
 
Fair Value
Due in one year or less
 
$
141,236

 
$
140,922

Due after one year through five years
 
526,676

 
524,765

Due after five years through ten years
 
7,044

 
7,181

Due after ten years
 

 

Mortgage-backed securities
 
332,342

 
329,941

Total debt securities available-for-sale
 
$
1,007,298

 
$
1,002,809


11


The following table summarizes gross unrealized losses and fair value by investment category and age. At March 31, 2019, the Company's available-for-sale securities portfolio consisted of 620 securities, 322 of which were in an unrealized loss position.
 
 
Less than 12 Months
 
12 months or Longer
 
Total
(Dollars in thousands) 
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
March 31, 2019
 
 

 
 

 
 

 
 

 
 

 
 

U.S. Treasury and Federal agencies securities
 
$

 
$

 
$
417,740

 
$
(3,226
)
 
$
417,740

 
$
(3,226
)
U.S. States and political subdivisions securities
 
1,367

 
(1
)
 
32,560

 
(262
)
 
33,927

 
(263
)
Mortgage-backed securities - Federal agencies
 
26,788

 
(73
)
 
192,836

 
(3,848
)
 
219,624

 
(3,921
)
Corporate debt securities
 
4,962

 

 
18,007

 
(166
)
 
22,969

 
(166
)
Foreign government and other securities
 
700

 

 

 

 
700

 

Total debt securities available-for-sale
 
$
33,817

 
$
(74
)
 
$
661,143

 
$
(7,502
)
 
$
694,960

 
$
(7,576
)
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

 
 

 
 

 
 

U.S. Treasury and Federal agencies securities
 
$
55,491

 
$
(177
)
 
$
424,269

 
$
(6,709
)
 
$
479,760

 
$
(6,886
)
U.S. States and political subdivisions securities
 
21,059

 
(61
)
 
45,365

 
(875
)
 
66,424

 
(936
)
Mortgage-backed securities - Federal agencies
 
65,554

 
(511
)
 
198,221

 
(6,364
)
 
263,775

 
(6,875
)
Corporate debt securities
 
21,496

 
(143
)
 
23,896

 
(308
)
 
45,392

 
(451
)
Foreign government and other securities
 
699

 
(1
)
 

 

 
699

 
(1
)
Total debt securities available-for-sale
 
$
164,299

 
$
(893
)
 
$
691,751

 
$
(14,256
)
 
$
856,050

 
$
(15,149
)
The initial indication of potential other-than-temporary-impairment (OTTI) for debt securities is a decline in fair value below amortized cost. Quarterly, the impaired securities are analyzed on a qualitative and quantitative basis in determining OTTI. Declines in the fair value of debt securities available-for-sale below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of impairment related to other factors is recognized in other comprehensive income. In estimating OTTI losses, the Company considers among other things, (i) the length of time and the extent to which fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) whether it is more likely than not that the Company will not have to sell any such securities before a recovery of cost.
At March 31, 2019, the Company does not have the intent to sell any of the debt securities available-for-sale in the table above and believes that it is more likely than not, that it will not have to sell any such securities before an anticipated recovery of cost. Primarily the unrealized losses on debt securities are due to increases in market rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover on all debt securities as they approach their maturity date or re-pricing date or if market yields for such investments decline. The Company does not believe any of the securities are impaired due to reasons of credit quality.
The following table shows the gross realized gains and losses from the available-for-sale debt securities portfolio. Realized gains and losses of all securities are computed using the specific identification cost basis.
 
 
Three Months Ended 
 March 31,
(Dollars in thousands)
 
2019
 
2018
Gross realized gains
 
$

 
$
2

Gross realized losses
 

 
(347
)
OTTI losses
 

 

Net realized gains (losses)
 
$

 
$
(345
)
At March 31, 2019 and December 31, 2018, investment securities available-for-sale with carrying values of $257.94 million and $242.31 million, respectively, were pledged as collateral for security repurchase agreements and for other purposes.
Note 4 — Loan and Lease Financings
The loan and lease portfolio includes direct financing leases, which are included in commercial and agricultural, auto and light truck, medium and heavy duty truck, aircraft, and construction equipment on the Consolidated Statements of Financial Condition.

12


The following table shows the the components of the investment in direct finance leases at March 31, 2019 and December 31, 2018.
(Dollars in thousands)
 
March 31,
2019
 
December 31,
2018
Direct finance leases:
 
 

 
 

Minimum lease payments
 
$
249,069

 
$
257,398

Estimated unguaranteed residual values
 
41

 
41

Less: Unearned income
 
(45,420
)
 
(46,709
)
Net investment in lease financing
 
$
203,690

 
$
210,730

To mitigate this risk of loss, the Company seeks to diversify both the type of equipment leased and the industries in which the lessees participate. In addition, a portion of our leases are terminal rental adjustment clause or “TRAC” leases where the lessee effectively guarantees the full residual value through a rental adjustment at the end of term or those where partial value is guaranteed (“split-TRAC”), which has a limited residual risk. Under a split-TRAC structure, the limited residual risk would be satisfied first by the net sale proceeds of the leased asset. The lessee’s at-risk portion, or top risk, is satisfied last and is subject to repayment as additional rent, if the TRAC amount is not satisfied by the net sale proceeds.
The following table shows direct financing minimum lease payments receivable for the next five years 2019 through 2023 and thereafter.
(Dollars in thousands)
 
 
2019
 
$
39,791

2020
 
46,697

2021
 
39,067

2022
 
36,643

2023
 
31,450

Thereafter
 
55,421

Total
 
$
249,069

Interest income recognized from direct financing lease payments for the three months ended March 31, 2019 and 2018 was $2.78 million and $2.57 million, respectively.
The Company evaluates loans and leases for credit quality at least annually but more frequently if certain circumstances occur (such as material new information which becomes available and indicates a potential change in credit risk). The Company uses two methods to assess credit risk: loan or lease credit quality grades and credit risk classifications. The purpose of the loan or lease credit quality grade is to document the degree of risk associated with individual credits as well as inform management of the degree of risk in the portfolio taken as a whole. Credit risk classifications are used to categorize loans by degree of risk and to designate individual or committee approval authorities for higher risk credits at the time of origination. Credit risk classifications include categories for: Acceptable, Marginal, Special Attention, Special Risk, Restricted by Policy, Regulated and Prohibited by Law.
All loans and leases, except residential real estate and home equity loans and consumer loans, are assigned credit quality grades on a scale from 1 to 12 with grade 1 representing superior credit quality. The criteria used to assign grades to extensions of credit that exhibit potential problems or well-defined weaknesses are primarily based upon the degree of risk and the likelihood of orderly repayment, and their effect on the Company’s safety and soundness. Loans or leases graded 7 or weaker are considered “special attention” credits and, as such, relationships in excess of $100,000 are reviewed quarterly as part of management’s evaluation of the appropriateness of the reserve for loan and lease losses. Grade 7 credits are defined as “watch” and contain greater than average credit risk and are monitored to limit the exposure to increased risk; grade 8 credits are “special mention” and, following regulatory guidelines, are defined as having potential weaknesses that deserve management’s close attention. Credits that exhibit well-defined weaknesses and a distinct possibility of loss are considered “classified” and are graded 9 through 12 corresponding to the regulatory definitions of “substandard” (grades 9 and 10) and the more severe “doubtful” (grade 11) and “loss” (grade 12).

13


The following table shows the credit quality grades of the recorded investment in loans and leases, segregated by class.
 
 
Credit Quality Grades
(Dollars in thousands) 
 
1-6
 
7-12
 
Total
March 31, 2019
 
 

 
 

 
 

Commercial and agricultural
 
$
1,117,440

 
$
28,591

 
$
1,146,031

Auto and light truck
 
534,407

 
19,671

 
554,078

Medium and heavy duty truck
 
284,208

 
1,423

 
285,631

Aircraft
 
802,373

 
28,064

 
830,437

Construction equipment
 
623,140

 
17,895

 
641,035

Commercial real estate
 
799,662

 
18,797

 
818,459

Total
 
$
4,161,230

 
$
114,441

 
$
4,275,671

 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

Commercial and agricultural
 
$
1,043,019

 
$
30,186

 
$
1,073,205

Auto and light truck
 
528,174

 
31,813

 
559,987

Medium and heavy duty truck
 
281,834

 
1,710

 
283,544

Aircraft
 
768,442

 
34,669

 
803,111

Construction equipment
 
625,579

 
19,660

 
645,239

Commercial real estate
 
787,376

 
22,510

 
809,886

Total
 
$
4,034,424

 
$
140,548

 
$
4,174,972

For residential real estate and home equity and consumer loans, credit quality is based on the aging status of the loan and by payment activity. The following table shows the recorded investment in residential real estate and home equity and consumer loans by performing or nonperforming status. Nonperforming loans are those loans which are on nonaccrual status or are 90 days or more past due.
(Dollars in thousands) 
 
Performing
 
Nonperforming
 
Total
March 31, 2019
 
 

 
 

 
 

Residential real estate and home equity
 
$
512,927

 
$
1,792

 
$
514,719

Consumer
 
135,578

 
219

 
135,797

Total
 
$
648,505

 
$
2,011

 
$
650,516

 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

Residential real estate and home equity
 
$
521,846

 
$
2,009

 
$
523,855

Consumer
 
136,423

 
214

 
136,637

Total
 
$
658,269

 
$
2,223

 
$
660,492


14


The following table shows the recorded investment of loans and leases, segregated by class, with delinquency aging and nonaccrual status.
(Dollars in thousands) 
 
Current
 
30-59 Days Past Due
 
60-89 Days Past Due
 
90 Days or More Past Due and Accruing
 
Total
Accruing 
Loans
 
Nonaccrual
 
Total
Financing
Receivables
March 31, 2019
 
 

 
 

 
 

 
 

 
 

 
 

 
 

Commercial and agricultural
 
$
1,142,979

 
$
84

 
$

 
$

 
$
1,143,063

 
$
2,968

 
$
1,146,031

Auto and light truck
 
548,752

 
1,024

 
148

 

 
549,924

 
4,154

 
554,078

Medium and heavy duty truck
 
285,539

 
23

 

 

 
285,562

 
69

 
285,631

Aircraft
 
818,494

 
9,106

 
1,585

 

 
829,185

 
1,252

 
830,437

Construction equipment
 
639,039

 
580

 

 

 
639,619

 
1,416

 
641,035

Commercial real estate
 
816,251

 
277

 

 

 
816,528

 
1,931

 
818,459

Residential real estate and home equity
 
511,627

 
819

 
481

 
151

 
513,078

 
1,641

 
514,719

Consumer
 
134,808

 
629

 
141

 
28

 
135,606

 
191

 
135,797

Total
 
$
4,897,489

 
$
12,542

 
$
2,355

 
$
179

 
$
4,912,565

 
$
13,622

 
$
4,926,187

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

 
 

 
 

 
 

 
 

Commercial and agricultural
 
$
1,070,530

 
$
22

 
$

 
$

 
$
1,070,552

 
$
2,653

 
$
1,073,205

Auto and light truck
 
544,022

 
3,154

 
1,437

 

 
548,613

 
11,374

 
559,987

Medium and heavy duty truck
 
283,284

 
154

 

 

 
283,438

 
106

 
283,544

Aircraft
 
790,233

 
4,149

 
1,168

 

 
795,550

 
7,561

 
803,111

Construction equipment
 
641,270

 
1,643

 

 

 
642,913

 
2,326

 
645,239

Commercial real estate
 
807,793

 
109

 

 

 
807,902

 
1,984

 
809,886

Residential real estate and home equity
 
520,124

 
1,267

 
455

 
295

 
522,141

 
1,714

 
523,855

Consumer
 
135,591

 
682

 
150

 
73

 
136,496

 
141

 
136,637

Total
 
$
4,792,847

 
$
11,180

 
$
3,210

 
$
368

 
$
4,807,605

 
$
27,859

 
$
4,835,464


15


The following table shows impaired loans and leases, segregated by class, and the corresponding reserve for impaired loan and lease losses.
(Dollars in thousands) 
 
Recorded Investment
 
Unpaid Principal Balance
 
Related Reserve
March 31, 2019
 
 

 
 

 
 

With no related reserve recorded:
 
 

 
 

 
 

Commercial and agricultural
 
$
2,269

 
$
2,269

 
$

Auto and light truck
 
590

 
590

 

Medium and heavy duty truck
 

 

 

Aircraft
 
1,251

 
1,251

 

Construction equipment
 
471

 
471

 

Commercial real estate
 
1,117

 
1,117

 

Residential real estate and home equity
 

 

 

Consumer
 

 

 

Total with no related reserve recorded
 
5,698

 
5,698

 

With a reserve recorded:
 
 

 
 

 
 

Commercial and agricultural
 
504

 
504

 
42

Auto and light truck
 
3,365

 
3,365

 
488

Medium and heavy duty truck
 

 

 

Aircraft
 

 

 

Construction equipment
 
922

 
922

 
149

Commercial real estate
 
727

 
727

 
20

Residential real estate and home equity
 
342

 
344

 
124

Consumer
 

 

 

Total with a reserve recorded
 
5,860

 
5,862

 
823

Total impaired loans
 
$
11,558

 
$
11,560

 
$
823

 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

With no related reserve recorded:
 
 

 
 

 
 

Commercial and agricultural
 
$
2,471

 
$
2,471

 
$

Auto and light truck
 
7,504

 
7,504

 

Medium and heavy duty truck
 
106

 
106

 

Aircraft
 
556

 
556

 

Construction equipment
 
905

 
905

 

Commercial real estate
 
1,131

 
1,131

 

Residential real estate and home equity
 

 

 

Consumer
 

 

 

Total with no related reserve recorded
 
12,673

 
12,673

 

With a reserve recorded:
 
 

 
 

 
 

Commercial and agricultural
 

 

 

Auto and light truck
 
3,840

 
3,840

 
372

Medium and heavy duty truck
 

 

 

Aircraft
 
7,004

 
7,004

 
1,255

Construction equipment
 
1,340

 
1,340

 
279

Commercial real estate
 
759

 
759

 
51

Residential real estate and home equity
 
344

 
346

 
126

Consumer
 

 

 

Total with a reserve recorded
 
13,287

 
13,289

 
2,083

Total impaired loans
 
$
25,960

 
$
25,962

 
$
2,083


16


The following table shows average recorded investment and interest income recognized on impaired loans and leases, segregated by class.
 
 
Three Months Ended March 31,
 
 
2019
 
2018
(Dollars in thousands) 
 
Average
Recorded
Investment
 
Interest
Income
 
Average
Recorded
Investment
 
Interest
Income
Commercial and agricultural
 
$
2,821

 
$

 
$
2,843

 
$

Auto and light truck
 
5,003

 

 
7,827

 

Medium and heavy duty truck
 
54

 

 
347

 

Aircraft
 
5,445

 

 
3,069

 

Construction equipment
 
1,929

 

 
1,330

 

Commercial real estate
 
1,859

 

 
3,696

 

Residential real estate and home equity
 
343

 
5

 
350

 
4

Consumer
 

 

 

 

Total
 
$
17,454

 
$
5

 
$
19,462

 
$
4

 
There were no loan and lease modifications classified as a troubled debt restructuring (TDR) during the three months ended March 31, 2019 and 2018. The classification between nonperforming and performing is determined at the time of modification. Modification programs focus on extending maturity dates or modifying payment patterns with most TDRs experiencing a combination of concessions. Modifications do not result in the contractual forgiveness of principal or interest. There were no modifications during the three months ended March 31, 2019 and 2018 that resulted in an interest rate reduction below market rate. Consequently, the financial impact of the modification was immaterial.
There were no TDRs which had payment defaults within the twelve months following modification during the three months ended March 31, 2019 and 2018. Default occurs when a loan or lease is 90 days or more past due under the modified terms or transferred to nonaccrual.
The following table shows the recorded investment of loans and leases classified as troubled debt restructurings as of March 31, 2019 and December 31, 2018.
(Dollars in thousands)
 
March 31,
2019
 
December 31,
2018
Performing TDRs
 
$
342

 
$
344

Nonperforming TDRs
 
229

 
316

Total TDRs
 
$
571

 
$
660

 
Note 5 — Reserve for Loan and Lease Losses
The reserve for loan and lease loss methodology has been consistently applied for several years, with enhancements instituted periodically. Reserve ratios are reviewed quarterly and revised periodically to reflect recent loss history and to incorporate current risks and trends which may not be recognized in historical data. As the historical charge-off analysis is updated, the Company reviews the look-back periods for each business loan portfolio. Furthermore, a thorough analysis of charge-offs, non-performing asset levels, special attention outstandings and delinquency is performed in order to review portfolio trends and other factors, including specific industry risks and economic conditions, which may have an impact on the reserves and reserve ratios applied to various portfolios. The Company adjusts the calculated historical based ratio as a result of the analysis of environmental factors, principally economic risk and concentration risk. Key economic factors affecting the portfolios are growth in gross domestic product, unemployment rates, housing market trends, commodity prices, inflation and global economic and political issues. Concentration risk is impacted primarily by geographic concentration in Northern Indiana and Southwestern Lower Michigan in the business banking and commercial real estate portfolios and by collateral concentration in the specialty finance portfolios and exposure to foreign markets by geographic risk.

17


The reserve for loan and lease losses is maintained at a level believed to be appropriate by the Company to absorb probable losses inherent in the loan and lease portfolio. The determination of the reserve requires significant judgment reflecting the Company’s best estimate of probable loan and lease losses related to specifically identified impaired loans and leases as well as probable losses in the remainder of the various loan and lease portfolios. For purposes of determining the reserve, the Company has segmented loans and leases into classes based on the associated risk within these segments. The Company has determined that eight classes exist within the loan and lease portfolio. The methodology for assessing the appropriateness of the reserve consists of several key elements, which include: specific reserves for impaired loans, formula reserves for each business lending division portfolio including percentage allocations for special attention loans and leases not deemed impaired, and reserves for pooled homogeneous loans and leases. The Company’s evaluation is based upon a continuing review of these portfolios, estimates of customer performance, collateral values and dispositions, and assessments of economic and geopolitical events, all of which are subject to judgment and will change.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The following table shows the changes in the reserve for loan and lease losses, segregated by class, for the three months ended March 31, 2019 and 2018.
(Dollars in thousands)
 
Commercial and
agricultural loans
 
Auto and
light truck
 
Medium and
heavy duty truck
 
Aircraft
 
Construction
equipment
 
Commercial
real estate
 
Residential
real estate
and home
equity
 
Consumer
loans
 
Total
March 31, 2019
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Balance, beginning of period
 
$
17,063

 
$
14,689

 
$
4,303

 
$
33,047

 
$
10,922

 
$
15,705

 
$
3,425

 
$
1,315

 
$
100,469

Charge-offs
 
79

 
409

 

 
3,000

 
195

 

 
21

 
250

 
3,954

Recoveries
 
34

 
9

 

 
185

 
104

 
9

 
3

 
75

 
419

Net charge-offs (recoveries)
 
45

 
400

 

 
2,815

 
91

 
(9
)
 
18

 
175

 
3,535

Provision (recovery of provision)
 
1,289

 
(30
)
 
106

 
3,208

 
52

 
120

 
(21
)
 
194

 
4,918

Balance, end of period
 
$
18,307

 
$
14,259

 
$
4,409

 
$
33,440

 
$
10,883

 
$
15,834

 
$
3,386

 
$
1,334

 
$
101,852

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
March 31, 2018
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Balance, beginning of period
 
$
16,228

 
$
10,103

 
$
4,844

 
$
34,619

 
$
9,343

 
$
14,792

 
$
3,666

 
$
1,288

 
$
94,883

Charge-offs
 
25

 
316

 

 
29

 
5

 
7

 
11

 
163

 
556

Recoveries
 
49

 
6

 

 
44

 
19

 
21

 
6

 
73

 
218

Net charge-offs (recoveries)
 
(24
)
 
310

 

 
(15
)
 
(14
)
 
(14
)
 
5

 
90

 
338

Provision (recovery of provision)
 
1,357

 
1,017

 
(351
)
 
202

 
1,560

 
(36
)
 
(96
)
 
133

 
3,786

Balance, end of period
 
$
17,609

 
$
10,810

 
$
4,493

 
$
34,836

 
$
10,917

 
$
14,770

 
$
3,565

 
$
1,331

 
$
98,331


18


The following table shows the reserve for loan and lease losses and recorded investment in loans and leases, segregated by class, separated between individually and collectively evaluated for impairment as of March 31, 2019 and December 31, 2018.
(Dollars in thousands)
 
Commercial and
agricultural loans
 
Auto and
light truck
 
Medium and
heavy duty truck
 
Aircraft
 
Construction
equipment
 
Commercial
real estate
 
Residential
real estate
and home
equity
 
Consumer
loans
 
Total
March 31, 2019
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Reserve for loan and lease losses
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Ending balance, individually evaluated for impairment
 
$
42

 
$
488

 
$

 
$

 
$
149

 
$
20

 
$
124

 
$

 
$
823

Ending balance, collectively evaluated for impairment
 
18,265

 
13,771

 
4,409

 
33,440

 
10,734

 
15,814

 
3,262

 
1,334

 
101,029

Total reserve for loan and lease losses
 
$
18,307

 
$
14,259

 
$
4,409

 
$
33,440

 
$
10,883

 
$
15,834

 
$
3,386

 
$
1,334

 
$
101,852

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Recorded investment in loans
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Ending balance, individually evaluated for impairment
 
$
2,773

 
$
3,955

 
$

 
$
1,251

 
$
1,393

 
$
1,844

 
$
342

 
$

 
$
11,558

Ending balance, collectively evaluated for impairment
 
1,143,258

 
550,123

 
285,631

 
829,186

 
639,642

 
816,615

 
514,377

 
135,797

 
4,914,629

Total recorded investment in loans
 
$
1,146,031

 
$
554,078

 
$
285,631

 
$
830,437

 
$
641,035

 
$
818,459

 
$
514,719

 
$
135,797

 
$
4,926,187

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Reserve for loan and lease losses
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Ending balance, individually evaluated for impairment
 
$

 
$
372

 
$

 
$
1,255

 
$
279

 
$
51

 
$
126

 
$

 
$
2,083

Ending balance, collectively evaluated for impairment
 
17,063

 
14,317

 
4,303

 
31,792

 
10,643

 
15,654

 
3,299

 
1,315

 
98,386

Total reserve for loan and lease losses
 
$
17,063

 
$
14,689

 
$
4,303

 
$
33,047

 
$
10,922

 
$
15,705

 
$
3,425

 
$
1,315

 
$
100,469

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Recorded investment in loans
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Ending balance, individually evaluated for impairment
 
$
2,471

 
$
11,344

 
$
106

 
$
7,560

 
$
2,245

 
$
1,890

 
$
344

 
$

 
$
25,960

Ending balance, collectively evaluated for impairment
 
1,070,734

 
548,643

 
283,438

 
795,551

 
642,994

 
807,996

 
523,511

 
136,637

 
4,809,504

Total recorded investment in loans
 
$
1,073,205

 
$
559,987

 
$
283,544

 
$
803,111

 
$
645,239

 
$
809,886

 
$
523,855

 
$
136,637

 
$
4,835,464

Note 6 — Operating Leases
As a lessor, the Company finances various types of construction equipment, medium and heavy duty trucks, automobiles and other equipment under leases classified as operating leases.
The following table shows the summary of the gross investment in operating lease equipment and accumulated depreciation.
(Dollars in thousands)
 
March 31,
2019
 
December 31,
2018
Operating leases:
 
 

 
 

Gross investment in operating lease financing
 
$
198,984

 
$
199,954

Accumulated depreciation
 
(67,390
)
 
(65,514
)
Net investment in operating lease financing
 
$
131,594

 
$
134,440

The following table shows minimum future lease rental payments due from clients on operating lease equipment at March 31, 2019.
(Dollars in thousands)
 
 
2019
 
$
23,462

2020
 
33,623

2021
 
19,570

2022
 
11,578

2023
 
6,037

Thereafter
 
2,774

Total
 
$
97,044

Income related to operating lease equipment rental for the three months ended March 31, 2019 and 2018 was $7.98 million and $7.76 million, respectively. Depreciation expense related to operating leased equipment for the three months ended March 31, 2019 and 2018 was $6.52 million and $6.43 million, respectively.

19


Income related to reimbursements from lessees for personal property tax on operating leased equipment for the three months ended March 31, 2019 was $0.24 million. Expense related to personal property tax payments on operating leased equipment for the three months ended March 31, 2019 was $0.24 million.
Note 7 — Mortgage Servicing Rights
The Company recognizes the rights to service residential mortgage loans for others as separate assets, whether the servicing rights are acquired through a separate purchase or through the sale of originated loans with servicing rights retained. The Company allocates a portion of the total proceeds of a mortgage loan to servicing rights based on the relative fair value. The unpaid principal balance of residential mortgage loans serviced for third parties was $735.50 million and $734.30 million at March 31, 2019 and December 31, 2018, respectively.
Mortgage servicing rights (MSRs) are evaluated for impairment at each reporting date. For purposes of impairment measurement, MSRs are stratified based on the predominant risk characteristics of the underlying servicing, principally by loan type. If temporary impairment exists within a tranche, a valuation allowance is established through a charge to income equal to the amount by which the carrying value exceeds the fair value. If it is later determined all or a portion of the temporary impairment no longer exists for a particular tranche, the valuation allowance is reduced through a recovery of income.
The following table shows changes in the carrying value of MSRs and the associated valuation allowance.
 
 
Three Months Ended 
 March 31,
(Dollars in thousands)
 
2019
 
2018
Mortgage servicing rights:
 
 

 
 

Balance at beginning of period
 
$
4,283

 
$
4,349

Additions
 
197

 
243

Amortization
 
(233
)
 
(236
)
Sales
 

 

Carrying value before valuation allowance at end of period
 
4,247

 
4,356

Valuation allowance:
 
 

 
 

Balance at beginning of period
 

 

Impairment recoveries
 

 

Balance at end of period
 
$

 
$

Net carrying value of mortgage servicing rights at end of period
 
$
4,247

 
$
4,356

Fair value of mortgage servicing rights at end of period
 
$
6,677

 
$
7,389

 
At March 31, 2019 and 2018, the fair value of MSRs exceeded the carrying value reported in the Consolidated Statements of Financial Condition by $2.43 million and $3.03 million, respectively. This difference represents increases in the fair value of certain MSRs that could not be recorded above cost basis.
Mortgage loan contractual servicing fees, including late fees and ancillary income, were $0.62 million and $0.66 million for the three months ended March 31, 2019 and 2018, respectively. Mortgage loan contractual servicing fees are included in Mortgage Banking on the Consolidated Statements of Income.
Note 8 — Commitments and Financial Instruments with Off-Balance-Sheet Risk
Lease Commitments — The Company and its subsidiaries are obligated under operating leases for certain office premises and equipment.
The following table shows operating lease right of use assets and operating lease liabilities as of March 31, 2019.
(Dollars in thousands)
Statement of Financial Condition classification
March 31,
2019
Operating lease right of use assets
Accrued income and other assets
$
10,409

Operating lease liabilities
Accrued expenses and other liabilities
$
10,801


20


The following table shows the components of operating leases expense for the three months ended March 31, 2019.
(Dollars in thousands)
Statement of Income classification
 
Three Months Ended 
 March 31, 2019
Operating lease cost
Net occupancy expense
 
$
878

Short-term lease cost
Net occupancy expense
 
3

Variable lease cost
Net occupancy expense
 

Total operating lease cost
 
 
$
881

Gross rental expense for the three months ended March 31, 2018 was $0.94 million.
The following table shows future minimum rental commitments for all noncancellable operating leases for the next five years and thereafter.
(Dollars in thousands)
 
 
2019
 
$
2,479

2020
 
3,581

2021
 
2,391

2022
 
1,133

2023
 
425

Thereafter
 
1,706

Total lease payments
 
11,715

Less: imputed interest
 
(914
)
Present value of operating lease liabilities
 
$
10,801

The following table shows the weighted average remaining operating lease term, the weighted average discount rate and supplemental Consolidated Statement of Cash Flows information for operating leases at March 31, 2019.
(Dollars in thousands)
March 31,
2019
Weighted average remaining lease term
4.89 years

Weighted average discount rate
3.02
%
Cash paid for amounts included in the measurement of lease liabilities:
 
Operating cash flows from operating leases
$
948

During the three months ended March 31, 2019, the Company recognized a net gain on the sale of an office building in the amount of $1.32 million. The Company commenced an operating lease with the buyer of the building to lease a portion of it for office space resulting in a new right of use asset and operating lease liability.
There are no new significant leases that have not yet commenced as of March 31, 2019.
Financial Instruments with Off-Balance-Sheet Risk — 1st Source and its subsidiaries are parties to financial instruments with off-balance-sheet risk in the normal course of business. These off-balance-sheet financial instruments include commitments to originate and sell loans and standby letters of credit. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Statements of Financial Condition.
The following table shows financial instruments whose contract amounts represent credit risk.
(Dollars in thousands)
 
March 31, 2019
 
December 31, 2018
Amounts of commitments:
 
 
 
 
Loan commitments to extend credit
 
$
1,068,340

 
$
1,095,053

Standby letters of credit
 
$
29,830

 
$
31,133

Commercial and similar letters of credit
 
$
2,427

 
$
2,500

The exposure to credit loss in the event of nonperformance by the other party to the financial instruments for loan commitments and standby letters of credit is represented by the dollar amount of those instruments. The Company uses the same credit policies and collateral requirements in making commitments and conditional obligations as it does for on-balance-sheet instruments.

21


The Bank grants mortgage loan commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan commitments is managed by entering into contracts for future deliveries of loans. Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
Standby letters of credit are conditional commitments that guarantee the performance of a client to a third party. The credit risk involved in and collateral obtained when issuing standby letters of credit is essentially the same as that involved in extending loan commitments to clients. Standby letters of credit generally have terms ranging from six months to one year.
Commercial letters of credit are issued specifically to facilitate commerce and typically result in the commitment being drawn on when the underlying transaction is consummated between the customer and the third party. Commercial letters of credit generally have terms ranging from three months to six months.
Note 9 — Derivative Financial Instruments
Commitments to originate residential mortgage loans held for sale and forward commitments to sell residential mortgage loans are considered derivative instruments. See Note 8 for further information.
The Company has certain interest rate derivative positions that are not designated as hedging instruments. Derivative assets and liabilities are recorded at fair value on the Consolidated Statements of Financial Condition and do not take into account the effects of master netting agreements. Master netting agreements allow the Company to settle all derivative contracts held with a single counterparty on a net basis, and to offset net derivative positions with related collateral, where applicable. These derivative positions relate to transactions in which the Company enters into an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution. In connection with each transaction, the Company agrees to pay interest to the client on a notional amount at a variable interest rate and receive interest from the client on the same notional amount at a fixed interest rate. At the same time, the Company agrees to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows the client to effectively convert a variable rate loan to a fixed rate. Because the terms of the swaps with the customers and the other financial institutions offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact the Company’s results of operations.
The following table shows the amounts of non-hedging derivative financial instruments.
 
 
 
 
Asset derivatives
 
Liability derivatives
(Dollars in thousands)
 
Notional or contractual amount
 
Statement of Financial Condition classification
 
Fair value
 
Statement of Financial Condition classification
 
Fair value
March 31, 2019
 
 

 
 
 
 

 
 
 
 

Interest rate swap contracts
 
$
908,503

 
Other assets
 
$
10,375

 
Other liabilities
 
$
10,558

Loan commitments
 
11,671

 
Mortgages held for sale
 
189

 
N/A
 

Forward contracts - mortgage loan
 
16,334

 
N/A
 

 
Mortgages held for sale
 
125

Total
 
$
936,508

 
 
 
$
10,564

 
 
 
$
10,683

 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 
 
 

 
 
 
 

Interest rate swap contracts
 
$
855,848

 
Other assets
 
$
7,124

 
Other liabilities
 
$
7,250

Loan commitments
 
5,871

 
Mortgages held for sale
 
112

 
N/A
 

Forward contracts - mortgage loan
 
14,087

 
N/A
 

 
Mortgages held for sale
 
135

Total
 
$
875,806

 
 
 
$
7,236

 
 
 
$
7,385


22


The following table shows the amounts included in the Statements of Income for non-hedging derivative financial instruments.
 
 
 
 
Gain (loss)
 
 
 
 
Three Months Ended 
 March 31,
(Dollars in thousands)
 
Statement of Income classification
 
2019
 
2018
Interest rate swap contracts
 
Other expense
 
$
(57
)
 
$
(1
)
Interest rate swap contracts
 
Other income
 
279

 
333

Loan commitments
 
Mortgage banking
 
77

 
(4
)
Forward contracts - mortgage loan
 
Mortgage banking
 
10

 
3

Total
 
 
 
$
309

 
$
331

 
The following table shows the offsetting of financial assets and derivative assets.
 
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Statement of Financial Condition
 
 
(Dollars in thousands)
 
Gross Amounts of Recognized Assets
 
Gross Amounts Offset in the Statement of Financial Condition
 
Net Amounts of Assets Presented in the Statement of Financial Condition
 
Financial Instruments
 
Cash Collateral Received
 
Net Amount
March 31, 2019
 
 

 
 

 
 

 
 

 
 

 
 

Interest rate swaps
 
$
10,375

 
$

 
$
10,375

 
$

 
$
90

 
$
10,285

 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

 
 

 
 

 
 

Interest rate swaps
 
$
7,128

 
$
4

 
$
7,124

 
$
177

 
$
610

 
$
6,337

 
The following table shows the offsetting of financial liabilities and derivative liabilities.
 
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Statement of Financial Condition
 
 
(Dollars in thousands)
 
Gross Amounts of Recognized Liabilities
 
Gross Amounts Offset in the Statement of Financial Condition
 
Net Amounts of Liabilities Presented in the Statement of Financial Condition
 
Financial Instruments
 
Cash Collateral Pledged
 
Net Amount
March 31, 2019
 
 

 
 

 
 

 
 

 
 

 
 

Interest rate swaps
 
$
10,558

 
$

 
$
10,558

 
$
9,761

 
$

 
$
797

Repurchase agreements
 
112,172

 

 
112,172

 
112,172

 

 

Total
 
$
122,730

 
$

 
$
122,730

 
$
121,933

 
$

 
$
797

 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

 
 

 
 

 
 

Interest rate swaps
 
$
7,254

 
$
4

 
$
7,250

 
$
1,700

 
$

 
$
5,550

Repurchase agreements
 
103,627

 

 
103,627

 
103,627

 

 

Total
 
$
110,881

 
$
4

 
$
110,877

 
$
105,327

 
$

 
$
5,550

If a default in performance of any obligation of a repurchase agreement occurs, each party will set-off property held in respect of transactions against obligations owing in respect of any other transactions. At March 31, 2019 and December 31, 2018, repurchase agreements had a remaining contractual maturity of $109.89 million and $102.34 million in overnight and $2.28 million and $1.29 million in up to 30 days, respectively and were collateralized by U.S. Treasury and Federal agencies securities.
Note 10 — Variable Interest Entities
A variable interest entity (VIE) is a partnership, limited liability company, trust or other legal entity that meets any one of the following criteria:
The entity does not have sufficient equity to conduct its activities without additional subordinated financial support from another party.
The entity’s investors lack the power to direct the activities that most significantly affect the entity’s economic performance.
The entity’s at-risk holders do not have the obligation to absorb the losses or the right to receive residual returns.

23


The voting rights of some investors are not proportional to their economic interests in the entity, and substantially all of the entity’s activities involve, or are conducted on behalf of, investors with disproportionately few voting rights.
The Company is involved in various entities that are considered to be VIEs. The Company’s investments in VIEs are primarily related to investments promoting affordable housing, community development and renewable energy sources. Some of these tax-advantaged investments support the Company’s regulatory compliance with the Community Reinvestment Act. The Company’s investments in these entities generate a return primarily through the realization of federal and state income tax credits, and other tax benefits, such as tax deductions from operating losses of the investments, over specified time periods. These tax credits are recognized as a reduction of tax expense or, for investments qualifying as investment tax credits, as a reduction to the related investment asset. The Company recognized federal income tax credits related to its affordable housing and community development tax-advantaged investments in tax expense of $0.35 million and $0.32 million, for the three months ended March 31, 2019 and 2018, respectively. The Company also recognized $1.60 million and $8.15 million of investment tax credits for the three months ended March 31, 2019 and 2018, respectively.
The Company is not required to consolidate VIEs in which it has concluded it does not have a controlling financial interest, and thus is not the primary beneficiary. In such cases, the Company does not have both the power to direct the entities’ most significant activities and the obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIEs. As a limited partner in these operating partnerships, we are allocated credits and deductions associated with the underlying properties. The Company has determined that it is not the primary beneficiary of these investments because the general partners have the power to direct activities that most significantly influence the economic performance of their respective partnerships.
The Company’s investments in these unconsolidated VIEs are carried in Other Assets on the Consolidated Statements of Financial Condition. The Company’s unfunded capital and other commitments related to these unconsolidated VIEs are generally carried in Other Liabilities on the Consolidated Statements of Financial Condition. The Company’s maximum exposure to loss from these unconsolidated VIEs include the investment recorded on the Company’s Consolidated Statements of Financial Condition, net of unfunded capital commitments, and previously recorded tax credits which remain subject to recapture by taxing authorities based on compliance features required to be met at the project level. While the Company believes potential losses from these investments are remote, the maximum exposure was determined by assuming a scenario where the community-based business, housing projects and renewable energy projects completely fail and do not meet certain taxing authority compliance requirements resulting in recapture of the related tax credits.
The following table provides a summary of investments in affordable housing, community development and renewable energy VIEs that the Company has not consolidated.
(Dollars in thousands)
March 31, 2019
December 31, 2018
Investment carrying amount
$
12,999

$
15,083

Unfunded capital and other commitments
4,692

6,449

Maximum exposure to loss
40,199

40,705

The Company is required to consolidate VIEs in which it has concluded it has significant involvement in and the ability to direct the activities that impact the entity’s economic performance. The Company is the managing general partner of entities to which it shares interest in tax-advantaged investments with third parties. At March 31, 2019 and December 31, 2018, approximately $21.72 million and $8.38 million of the Company’s assets and $18.75 million and $6.70 million of its liabilities included on the Consolidated Statements of Financial Condition were related to tax-advantaged investment VIEs which the Company has consolidated, respectively. The assets of the consolidated VIEs are reported in Other Assets, the liabilities are reported in Other Liabilities and the non-controlling interest is reported in Equity on the Consolidated Statements of Financial Condition. The assets of a particular VIE are the primary source of funds to settle its obligations. The creditors of the VIE do not have recourse to the general credit of the Company. The Company’s exposure to the consolidated VIE is generally limited to the carrying value of its variable interest plus any related tax credits previously recognized.
Additionally, the Company sponsors one trust, 1st Source Master Trust (Capital Trust) of which 100% of the common equity is owned by the Company. The Capital Trust was formed in 2007 for the purpose of issuing corporation-obligated mandatorily redeemable capital securities (the capital securities) to third-party investors and investing the proceeds from the sale of the capital securities solely in junior subordinated debenture securities of the Company (the subordinated notes). The subordinated notes held by the Capital Trust are the sole assets of the Capital Trust. The Capital Trust qualifies as a variable interest entity for which the Company is not the primary beneficiary and therefore reported in the financial statements as an unconsolidated subsidiary. The junior subordinated debentures are reflected as subordinated notes in the Statements of Financial Condition with the corresponding interest distributions reflected as Interest Expense in the Statements of Income. The common shares issued by the Capital Trust are included in Other Assets in the Statements of Financial Condition.

24


Distributions on the capital securities issued by the Capital Trust are payable quarterly at a rate per annum equal to the interest rate being earned by the Capital Trust on the subordinated notes held by the Capital Trust. The capital securities are subject to mandatory redemption, in whole or in part, upon repayment of the subordinated notes. The Company has entered into agreements which, taken collectively, fully and unconditionally guarantee the capital securities subject to the terms of each of the guarantees. The capital securities held by the Capital Trust qualify as Tier 1 capital under Federal Reserve Board guidelines.
The following table shows subordinated notes at March 31, 2019.
(Dollars in thousands)
 
Amount of Subordinated Notes
 
Interest Rate
 
Maturity Date
June 2007 issuance (1)
 
$
41,238

 
7.22
%
 
6/15/2037
August 2007 issuance (2)
 
17,526

 
4.27
%
 
9/15/2037
Total
 
$
58,764

 
 

 
 
 
(1) Fixed rate through life of debt.
(2) 3-Month LIBOR +1.48% through remaining life of debt.

Note 11 — Earnings Per Share
Earnings per common share is computed using the two-class method. Basic earnings per common share is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during the applicable period, excluding outstanding participating securities. Participating securities include non-vested restricted stock awards. Non-vested restricted stock awards are considered participating securities to the extent the holders of these securities receive non-forfeitable dividends at the same rate as holders of common stock. Diluted earnings per common share is computed using the weighted-average number of shares determined for the basic earnings per common share computation plus the dilutive effect of stock compensation using the treasury stock method.
Stock options, where the exercise price was greater than the average market price of the common shares, were excluded from the computation of diluted earnings per common share because the result would have been antidilutive. There were no stock options outstanding as of March 31, 2019 and 2018.
The following table presents a reconciliation of the number of shares used in the calculation of basic and diluted earnings per common share.
 
 
Three Months Ended 
 March 31,
(Dollars in thousands - except per share amounts)
 
2019
 
2018
Distributed earnings allocated to common stock
 
$
6,966

 
$
5,704

Undistributed earnings allocated to common stock
 
15,102

 
13,278

Net earnings allocated to common stock
 
22,068

 
18,982

Net earnings allocated to participating securities
 
128

 
134

Net income allocated to common stock and participating securities
 
$
22,196

 
$
19,116

 
 
 
 
 
Weighted average shares outstanding for basic earnings per common share
 
25,759,186

 
25,950,386

Dilutive effect of stock compensation
 

 

Weighted average shares outstanding for diluted earnings per common share
 
25,759,186

 
25,950,386

 
 
 
 
 
Basic earnings per common share
 
$
0.86

 
$
0.73

Diluted earnings per common share
 
$
0.86

 
$
0.73

 
Note 12 — Stock Based Compensation
As of March 31, 2019, the Company had four active stock-based employee compensation plans, which are more fully described in Note 16 of the Consolidated Financial Statements in 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2018. These plans include three executive stock award plans, the Executive Incentive Plan, the Restricted Stock Award Plan, the Strategic Deployment Incentive Plan; and the Employee Stock Purchase Plan. The 2011 Stock Option Plan was approved by the shareholders on April 21, 2011 but the Company had not made any grants through March 31, 2019.

25


Stock-based compensation expense for all stock-based compensation awards granted is based on the grant-date fair value. For all awards except stock option awards, the grant date fair value is either the fair market value per share or book value per share (corresponding to the type of stock awarded) as of the grant date. For stock option awards, the grant date fair value is estimated using the Black-Scholes option pricing model. For all awards the Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award, for which the Company uses the related vesting term.
Total fair value of options vested and expensed was zero for the three months ended March 31, 2019 and 2018. As of March 31, 2019 and 2018 there were no outstanding stock options. There were no stock options exercised during the three months ended March 31, 2019 and 2018. All shares issued in connection with stock option exercises are issued from available treasury stock.
As of March 31, 2019, there was $6.56 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 3.39 years.
Note 13 — Accumulated Other Comprehensive Income (Loss)
The following table presents reclassifications out of accumulated other comprehensive income (loss) related to unrealized gains and losses on available-for-sale securities.
 
 
Three Months Ended March 31,
 
Affected Line Item in the Statements of Income
(Dollars in thousands)
 
2019
 
2018
 
Realized losses included in net income
 
$

 
$
(345
)
 
Losses on investment securities available-for-sale
 
 

 
(345
)
 
Income before income taxes
Tax effect
 

 
83

 
Income tax expense
Net of tax
 
$

 
$
(262
)
 
Net income
 
Note 14 — Income Taxes
The total amount of unrecognized tax benefits that would affect the effective tax rate if recognized was zero at March 31, 2019 and December 31, 2018. Interest and penalties are recognized through the income tax provision. For the three months ended March 31, 2019 and 2018, the Company recognized $0.00 million and $0.01 million in interest or penalties, respectively. There was no accrued interest and penalties at March 31, 2019 and December 31, 2018.
Tax years that remain open and subject to audit include the federal 2015-2018 years and the Indiana 2015-2018 years. The Company does not anticipate a significant change in the amount of uncertain tax positions within the next 12 months.
Note 15 — Fair Value Measurements
The Company records certain assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are also utilized to determine the initial value of certain assets and liabilities, to perform impairment assessments, and for disclosure purposes. The Company uses quoted market prices and observable inputs to the maximum extent possible when measuring fair value. In the absence of quoted market prices, various valuation techniques are utilized to measure fair value. When possible, observable market data for identical or similar financial instruments is used in the valuation. When market data is not available, fair value is determined using valuation models that incorporate management’s estimates of the assumptions a market participant would use in pricing the asset or liability.
Fair value measurements are classified within one of three levels based on the observability of the inputs used to determine fair value, as follows:
Level 1 — The valuation is based on quoted prices in active markets for identical instruments.
Level 2 — The valuation is based on observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3 — The valuation is based on unobservable inputs that are supported by minimal or no market activity and that are significant to the fair value of the instrument. Level 3 valuations are typically performed using pricing models, discounted cash flow methodologies, or similar techniques that incorporate management’s own estimates of assumptions that market participants would use in pricing the instrument, or valuations that require significant management judgment or estimation.

26


A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.
The Company elected fair value accounting for mortgages held for sale. The Company believes the election for mortgages held for sale (which are economically hedged with free-standing derivatives) will reduce certain timing differences and better match changes in the value of these assets with changes in the value of derivatives used as economic hedges for these assets. At March 31, 2019 and December 31, 2018, all mortgages held for sale were carried at fair value.
The following table shows the differences between the fair value carrying amount of mortgages held for sale measured at fair value and the aggregate unpaid principal amount the Company is contractually entitled to receive at maturity.
(Dollars in thousands)
 
Fair value carrying
amount
 
Aggregate
unpaid principal
 
Excess of fair value carrying amount over (under) unpaid principal
 
 
March 31, 2019
 
 

 
 

 
 

 
 
Mortgages held for sale reported at fair value
 
$
9,210

 
$
8,970

 
$
240

 
(1)
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

 
 
Mortgages held for sale reported at fair value
 
$
11,290

 
$
11,076

 
$
214

 
(1)
 
(1)
The excess of fair value carrying amount over (under) unpaid principal is included in mortgage banking income and includes changes in fair value at and subsequent to funding and gains and losses on the related loan commitment prior to funding.
Financial Instruments on Recurring Basis:
The following is a description of the valuation methodologies used for financial instruments measured at fair value on a recurring basis:
Investment securities available-for-sale are valued primarily by a third party pricing agent. Prices supplied by the independent pricing agent, as well as their pricing methodologies and assumptions, are reviewed by the Company for reasonableness and to ensure such prices are aligned with market levels. In general, the Company’s investment securities do not possess a complex structure that could introduce greater valuation risk. The portfolio mainly consists of traditional investments including U.S. Treasury and Federal agencies securities, Federal agency mortgage pass-through securities, and general obligation and revenue municipal bonds. Pricing for such instruments is fairly generic and is easily obtained. On a quarterly basis, prices supplied by the pricing agent are validated by comparison to prices obtained from other third party sources for a material portion of the portfolio.
The valuation policy and procedures for Level 3 fair value measurements of available-for-sale debt securities are decided through collaboration between management of the Corporate Accounting and Funds Management departments. The changes in fair value measurement for Level 3 securities are analyzed on a periodic basis under a collaborative framework with the aforementioned departments. The methodology and variables used for input are derived from the combination of observable and unobservable inputs. The unobservable inputs are determined through internal assumptions that may vary from period to period due to external factors, such as market movement and credit rating adjustments.
Both the market and income valuation approaches are implemented using the following types of inputs:
U.S. treasuries are priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.
Government-sponsored agency debt securities and corporate bonds are primarily priced using available market information through processes such as benchmark curves, market valuations of like securities, sector groupings and matrix pricing.
Other government-sponsored agency securities, mortgage-backed securities and some of the actively traded REMICs and CMOs, are primarily priced using available market information including benchmark yields, prepayment speeds, spreads and volatility of similar securities.
State and political subdivisions are largely grouped by characteristics, i.e., geographical data and source of revenue in trade dissemination systems. Since some securities are not traded daily and due to other grouping limitations, active market quotes are often obtained using benchmarking for like securities. Local direct placement municipal securities, with very little market activity, are priced using an appropriate market yield curve, which includes a credit spread assumption.

27


Mortgages held for sale and the related loan commitments and forward contracts (hedges) are valued using a market value approach and utilizing an appropriate current market yield and a loan commitment closing rate based on historical analysis.
Interest rate swap positions, both assets and liabilities, are valued by a third-party pricing agent using an income approach and utilizing models that use as their basis readily observable market parameters. This valuation process considers various factors including interest rate yield curves, time value and volatility factors. Validation of third party agent valuations is accomplished by comparing those values to the Company’s swap counterparty valuations. Management believes an adjustment is required to “mid-market” valuations for derivatives tied to its performing loan portfolio to recognize the imprecision and related exposure inherent in the process of estimating expected credit losses as well as velocity of deterioration evident with systemic risks embedded in these portfolios. Any change in the mid-market derivative valuation adjustment will be recognized immediately through the Consolidated Statements of Income.
The following table shows the balance of assets and liabilities measured at fair value on a recurring basis.
(Dollars in thousands)
 
Level 1
 
Level 2
 
Level 3
 
Total
March 31, 2019
 
 

 
 

 
 

 
 

Assets:
 
 

 
 

 
 

 
 

Investment securities available-for-sale:
 
 

 
 

 
 

 
 

U.S. Treasury and Federal agencies securities
 
$
33,895

 
$
501,511

 
$

 
$
535,406

U.S. States and political subdivisions securities
 

 
83,692

 
5,064

 
88,756

Mortgage-backed securities — Federal agencies
 

 
329,941

 

 
329,941

Corporate debt securities
 

 
48,006

 

 
48,006

Foreign government and other securities
 

 
700

 

 
700

Total debt securities available-for-sale
 
33,895


963,850


5,064


1,002,809

Mortgages held for sale
 

 
9,210

 

 
9,210

Accrued income and other assets (interest rate swap agreements)
 

 
10,375

 

 
10,375

Total
 
$
33,895

 
$
983,435

 
$
5,064

 
$
1,022,394

 
 
 
 
 
 
 
 
 
Liabilities:
 
 

 
 

 
 

 
 

Accrued expenses and other liabilities (interest rate swap agreements)
 
$

 
$
10,558

 
$

 
$
10,558

Total
 
$

 
$
10,558

 
$

 
$
10,558

 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

 
 

Assets:
 
 

 
 

 
 

 
 

Investment securities available-for-sale:
 
 

 
 

 
 

 
 

U.S. Treasury and Federal agencies securities
 
$
33,746

 
$
497,477

 
$

 
$
531,223

U.S. States and political subdivisions securities
 

 
93,557

 
1,025

 
94,582

Mortgage-backed securities — Federal agencies
 

 
318,233

 

 
318,233

Corporate debt securities
 

 
45,392

 

 
45,392

Foreign government and other securities
 

 
699

 

 
699

Total debt securities available-for-sale
 
33,746


955,358


1,025


990,129

Mortgages held for sale
 

 
11,290

 

 
11,290

Accrued income and other assets (interest rate swap agreements)
 

 
7,124

 

 
7,124

Total
 
$
33,746

 
$
973,772

 
$
1,025

 
$
1,008,543

 
 
 
 
 
 
 
 
 
Liabilities:
 
 

 
 

 
 

 
 

Accrued expenses and other liabilities (interest rate swap agreements)
 
$

 
$
7,250

 
$

 
$
7,250

Total
 
$

 
$
7,250

 
$

 
$
7,250


28


The following table shows changes in Level 3 assets measured at fair value on a recurring basis for the quarter ended March 31, 2019 and 2018.
(Dollars in thousands)
 
U.S. States and
political
subdivisions
securities
 
Foreign government and other securities
 
Investment securities available-for-sale
Beginning balance January 1, 2019
 
$
1,025

 
$

 
$
1,025

Total gains or losses (realized/unrealized):
 
 

 
 
 
 
Included in earnings
 

 

 

Included in other comprehensive income
 
19

 

 
19

Purchases
 
4,100

 

 
4,100

Issuances
 

 

 

Sales
 

 

 

Settlements
 

 

 

Maturities
 
(80
)
 

 
(80
)
Transfers into Level 3
 

 

 

Transfers out of Level 3
 

 

 

Ending balance March 31, 2019
 
$
5,064

 
$

 
$
5,064

 
 
 
 
 
 
 
Beginning balance January 1, 2018
 
$
2,155

 
$
710

 
$
2,865

Total gains or losses (realized/unrealized):
 
 

 
 
 
 
Included in earnings
 

 

 

Included in other comprehensive income
 

 
(2
)
 
(2
)
Purchases
 

 

 

Issuances
 

 

 

Sales
 

 

 

Settlements
 

 

 

Maturities
 

 

 

Transfers into Level 3
 

 

 

Transfers out of Level 3
 

 

 

Ending balance March 31, 2018
 
$
2,155

 
$
708

 
$
2,863

There were no gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at March 31, 2019 or 2018. No transfers between levels occurred during the three months ended March 31, 2019 or 2018.
The following table shows the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a recurring basis.
(Dollars in thousands)
 
Fair Value
 
Valuation Methodology
 
Unobservable Inputs
 
Range of Inputs
March 31, 2019
 
 

 
 
 
 
 
 
Debt securities available-for sale
 
 

 
 
 
 
 
 
Direct placement municipal securities
 
$
5,064

 
Discounted cash flows
 
Credit spread assumption
 
2.51% - 2.94%
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 
 
 
 
 
Debt securities available-for sale
 
 

 
 
 
 
 
 
Direct placement municipal securities
 
$
1,025

 
Discounted cash flows
 
Credit spread assumption
 
0.17% - 3.02%
 
The sensitivity to changes in the unobservable inputs and their impact on the fair value measurement can be significant. The significant unobservable input for direct placement municipal securities are the credit spread assumptions used to determine the fair value measure. An increase (decrease) in the estimated spread assumption of the market will decrease (increase) the fair value measure of the securities.
Financial Instruments on Non-recurring Basis:
The Company may be required, from time to time, to measure certain other financial assets at fair value on a non-recurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower of cost or market accounting or impairment charges of individual assets.

29


The Credit Policy Committee (CPC), a management committee, is responsible for overseeing the valuation processes and procedures for Level 3 measurements of impaired loans, other real estate and repossessions. The CPC reviews these assets on a quarterly basis to determine the accuracy of the observable inputs, generally third party appraisals, auction values, values derived from trade publications and data submitted by the borrower, and the appropriateness of the unobservable inputs, generally discounts due to current market conditions and collection issues. The CPC establishes discounts based on asset type and valuation source; deviations from the standard are documented. The discounts are reviewed periodically, annually at a minimum, to determine they remain appropriate. Consideration is given to current trends in market values for the asset categories and gains and losses on sales of similar assets. The Loan and Funds Management Committee of the Board of Directors is responsible for overseeing the CPC.
Discounts vary depending on the nature of the assets and the source of value. Aircraft are generally valued using quarterly trade publications adjusted for engine time, condition, maintenance programs, discounted by 10%. Likewise, autos are valued using current auction values, discounted by 10%; medium and heavy duty trucks are valued using trade publications and auction values, discounted by 15%. Construction equipment is generally valued using trade publications and auction values, discounted by 20%. Real estate is valued based on appraisals or evaluations, discounted by 20% with higher discounts for property in poor condition or property with characteristics which may make it more difficult to market. Commercial loans subject to borrowing base certificates are generally discounted by 20% for receivables and 40% - 75% for inventory with higher discounts when monthly borrowing base certificates are not required or received.
Impaired loans and related write-downs are based on the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are reviewed quarterly and estimated using customized discounting criteria, appraisals and dealer and trade magazine quotes which are used in a market valuation approach. In accordance with fair value measurements, only impaired loans for which a reserve for loan loss has been established based on the fair value of collateral require classification in the fair value hierarchy. As a result, only a portion of the Company’s impaired loans are classified in the fair value hierarchy.
The Company has established MSRs valuation policies and procedures based on industry standards and to ensure valuation methodologies are consistent and verifiable. MSRs and related adjustments to fair value result from application of lower of cost or fair value accounting. For purposes of impairment, MSRs are stratified based on the predominant risk characteristics of the underlying servicing, principally by loan type. The fair value of each tranche of the servicing portfolio is estimated by calculating the present value of estimated future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates, servicing costs, and other economic factors. Prepayment rates and discount rates are derived through a third party pricing agent. Changes in the most significant inputs, including prepayment rates and discount rates, are compared to the changes in the fair value measurements and appropriate resolution is made. A fair value analysis is also obtained from an independent third party agent and compared to the internal valuation for reasonableness. MSRs do not trade in an active, open market with readily observable prices and though sales of MSRs do occur, precise terms and conditions typically are not readily available and the characteristics of the Company’s servicing portfolio may differ from those of any servicing portfolios that do trade.
Other real estate is based on the fair value of the underlying collateral less expected selling costs. Collateral values are estimated primarily using appraisals and reflect a market value approach. Fair values are reviewed quarterly, and new appraisals are obtained annually. Repossessions are similarly valued.
For assets measured at fair value on a nonrecurring basis the following represents impairment charges (recoveries) recognized on these assets during the quarter ended March 31, 2019: impaired loans - $3.00 million; mortgage servicing rights - $0.00 million; repossessions - $1.10 million; and other real estate - $0.00 million.

30


The following table shows the carrying value of assets measured at fair value on a non-recurring basis.
(Dollars in thousands)
 
Level 1
 
Level 2
 
Level 3
 
Total
March 31, 2019
 
 

 
 

 
 

 
 

Impaired loans - collateral based
 
$

 
$

 
$
1,578

 
$
1,578

Accrued income and other assets (mortgage servicing rights)
 

 

 
4,247

 
4,247

Accrued income and other assets (repossessions)
 

 

 
10,411

 
10,411

Accrued income and other assets (other real estate)
 

 

 
417

 
417

Total
 
$

 
$

 
$
16,653

 
$
16,653

 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

 
 

Impaired loans - collateral based
 
$

 
$

 
$
7,306

 
$
7,306

Accrued income and other assets (mortgage servicing rights)
 

 

 
4,283

 
4,283

Accrued income and other assets (repossessions)
 

 

 
6,666

 
6,666

Accrued income and other assets (other real estate)
 

 

 
299

 
299

Total
 
$

 
$

 
$
18,554

 
$
18,554

The following table below shows the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a non-recurring basis.
(Dollars in thousands)
 
Carrying Value
 
Fair Value
 
Valuation Methodology
 
Unobservable Inputs
 
Range of Inputs
March 31, 2019
 
 

 
 

 
 
 
 
 
 
Impaired loans
 
$
1,578

 
$
1,578

 
Collateral based measurements including appraisals, trade publications, and auction values
 
Discount for lack of marketability and current conditions
 
20% - 100%
 
 
 
 
 
 
 
 
 
 
 
Mortgage servicing rights
 
4,247

 
6,677

 
Discounted cash flows
 
Constant prepayment rate (CPR)
 
9.1% - 25.9%
 
 
 

 
 

 
 
 
Discount rate
 
9.8% - 12.6%
 
 
 
 
 
 
 
 
 
 
 
Repossessions
 
10,411

 
10,883

 
Appraisals, trade publications and auction values
 
Discount for lack of marketability
 
0% - 6%
 
 
 
 
 
 
 
 
 
 
 
Other real estate
 
417

 
424

 
Appraisals
 
Discount for lack of marketability
 
0% - 9%
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 
 
 
 
 
Impaired loans
 
$
7,306

 
$
7,306

 
Collateral based measurements including appraisals, trade publications, and auction values
 
Discount for lack of marketability and current conditions
 
20% - 35%
 
 
 
 
 
 
 
 
 
 
 
Mortgage servicing rights
 
4,283

 
7,238

 
Discounted cash flows
 
Constant prepayment rate (CPR)
 
7.2% - 24.8%
 
 
 

 
 

 
 
 
Discount rate
 
10.3 % - 13.1%
 
 
 
 
 
 
 
 
 
 
 
Repossessions
 
6,666

 
6,991

 
Appraisals, trade publications and auction values
 
Discount for lack of marketability
 
4% - 6%
 
 
 
 
 
 
 
 
 
 
 
Other real estate
 
299

 
305

 
Appraisals
 
Discount for lack of marketability
 
0% - 10%
GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring or non-recurring basis.

31


The following table shows the fair values of the Company’s financial instruments.
(Dollars in thousands)
 
Carrying or Contract Value
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
March 31, 2019
 
 

 
 

 
 

 
 

 
 

Assets:
 
 

 
 

 
 

 
 

 
 

Cash and due from banks
 
$
64,619

 
$
64,619

 
$
64,619

 
$

 
$

Federal funds sold and interest bearing deposits with other banks
 
3,062

 
3,062

 
3,062

 

 

Investment securities, available-for-sale
 
1,002,809

 
1,002,809

 
33,895

 
963,850

 
5,064

Other investments
 
28,404

 
28,404

 
28,404

 

 

Mortgages held for sale
 
9,210

 
9,210

 

 
9,210

 

Loans and leases, net of reserve for loan and lease losses
 
4,824,335

 
4,802,938

 

 

 
4,802,938

Mortgage servicing rights
 
4,247

 
6,677

 

 

 
6,677

Accrued interest receivable
 
21,576

 
21,576

 

 
21,576

 

Interest rate swaps
 
10,375

 
10,375

 

 
10,375

 

Liabilities:
 
 

 
 

 
 

 
 

 
 

Deposits
 
$
5,124,091

 
$
5,121,098

 
$
3,559,051

 
$
1,562,047

 
$

Short-term borrowings
 
255,388

 
255,388

 
148,284

 
107,104

 

Long-term debt and mandatorily redeemable securities
 
71,439

 
69,724

 

 
69,724

 

Subordinated notes
 
58,764

 
55,484

 

 
55,484

 

Accrued interest payable
 
11,377

 
11,377

 

 
11,377

 

Interest rate swaps
 
10,558

 
10,558

 

 
10,558

 

Off-balance-sheet instruments *
 

 
247

 

 
247

 

 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

 
 

 
 

Assets:
 
 

 
 

 
 

 
 

 
 

Cash and due from banks
 
$
94,907

 
$
94,907

 
$
94,907

 
$

 
$

Federal funds sold and interest bearing deposits with other banks
 
4,172

 
4,172

 
4,172

 

 

Investment securities, available-for-sale
 
990,129

 
990,129

 
33,746

 
955,358

 
1,025

Other investments
 
28,404

 
28,404

 
28,404

 

 

Mortgages held for sale
 
11,290

 
11,290

 

 
11,290

 

Loans and leases, net of reserve for loan and lease losses
 
4,734,995

 
4,689,267

 

 

 
4,689,267

Mortgage servicing rights
 
4,283

 
7,238

 

 

 
7,238

Accrued interest receivable
 
18,880

 
18,880

 

 
18,880

 

Interest rate swaps
 
7,124

 
7,124

 

 
7,124

 

Liabilities:
 
 

 
 

 
 

 
 

 
 

Deposits
 
$
5,122,322

 
$
5,111,711

 
$
3,654,556

 
$
1,457,155

 
$

Short-term borrowings
 
199,344

 
199,344

 
113,734

 
85,610

 

Long-term debt and mandatorily redeemable securities
 
71,123

 
68,751

 

 
68,751

 

Subordinated notes
 
58,764

 
45,874

 

 
45,874

 

Accrued interest payable
 
8,950

 
8,950

 

 
8,950

 

Interest rate swaps
 
7,250

 
7,250

 

 
7,250

 

Off-balance-sheet instruments *
 

 
259

 

 
259

 

 
* Represents estimated cash outflows required to currently settle the obligations at current market rates.
These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. These estimates are subjective in nature and require considerable judgment to interpret market data. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange, nor are they intended to represent the fair value of the Company as a whole. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The fair value estimates presented herein are based on pertinent information available to management as of the respective balance sheet date. Although the Company is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.

32


Other significant assets, such as premises and equipment, other assets, and liabilities not defined as financial instruments, are not included in the above disclosures. Also, the fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.
ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following management’s discussion and analysis is presented to provide information concerning 1st Source Corporation and its subsidiaries’ (collectively referred to as “the Company”, “we”, and “our”) financial condition as of March 31, 2019, as compared to December 31, 2018, and the results of operations for the three months ended March 31, 2019 and 2018. This discussion and analysis should be read in conjunction with our consolidated financial statements and the financial and statistical data appearing elsewhere in this report and our 2018 Annual Report.
Except for historical information contained herein, the matters discussed in this document express “forward-looking statements.” Generally, the words “believe,” “contemplate,” “seek,” “plan,” “possible,” “assume,” “expect,” “intend,” “targeted,” “continue,” “remain,” “estimate,” “anticipate,” “project,” “will,” “should,” “indicate,” “would,” “may” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Those statements, including statements, projections, estimates or assumptions concerning future events or performance, and other statements that are other than statements of historical fact, are subject to material risks and uncertainties. We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made. We may make other written or oral forward-looking statements from time to time. Readers are advised that various important factors could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected in such forward-looking statements. Such factors include, but are not limited to, changes in law, regulations or GAAP; our competitive position within the markets we serve; increasing consolidation within the banking industry; unforeseen changes in interest rates; unforeseen changes in loan prepayment assumptions; unforeseen downturns in or major events affecting the local, regional or national economies or the industries in which we have credit concentrations; and other matters discussed in our filings with the SEC, including our Annual Report on Form 10-K  for 2018, which filings are available from the SEC. We undertake no obligation to publicly update or revise any forward-looking statements.
FINANCIAL CONDITION
Our total assets at March 31, 2019 were $6.38 billion, an increase of $85.34 million or 1.36% from December 31, 2018. Total investment securities, available-for-sale were $1.00 billion, an increase of $12.68 million or 1.28% from December 31, 2018. Federal funds sold and interest bearing deposits with other banks were $3.06 million, a decrease of $1.11 million or 26.61% from December 31, 2018.
Total loans and leases were $4.93 billion, an increase of $90.72 million or 1.88% from December 31, 2018. Our foreign loan and lease outstandings, all denominated in U.S. dollars were $221.33 million and $224.44 million as of March 31, 2019 and December 31, 2018, respectively. Foreign loans and leases are in aircraft financing. Loan and lease outstandings to borrowers in Brazil and Mexico were $86.17 million and $128.31 million as of March 31, 2019, respectively, compared to $83.90 million and $127.16 million as of December 31, 2018, respectively. As of March 31, 2019 and December 31, 2018 there was not a significant concentration in any other country. Solar loan and lease outstandings were $111.07 million as of March 31, 2019, an increase of $15.08 million or 15.70% from the $96.00 million at December 31, 2018. Solar loan and lease outstandings are included in commercial and agricultural loans. Equipment owned under operating leases was $131.59 million, a decrease of $2.85 million, or 2.12% compared to December 31, 2018.
Total deposits were $5.12 billion, an increase of $1.77 million or 0.03% from the end of 2018. Short-term borrowings were $255.39 million, an increase of $56.04 million or 28.11% from December 31, 2018. Long-term debt and mandatorily redeemable securities were $71.44 million, an increase of $0.32 million or 0.44% from December 31, 2018.

33


The following table shows accrued income and other assets.
(Dollars in thousands)
 
March 31,
2019
 
December 31,
2018
Accrued income and other assets:
 
 

 
 

Bank owned life insurance cash surrender value
 
$
67,939

 
$
67,434

Operating lease right of use assets
 
10,409

 

Accrued interest receivable
 
21,576

 
18,880

Mortgage servicing rights
 
4,247

 
4,283

Other real estate
 
417

 
299

Repossessions
 
10,411

 
6,666

All other assets
 
64,705

 
61,709

Total accrued income and other assets
 
$
179,704

 
$
159,271

 
CAPITAL
As of March 31, 2019, total shareholders’ equity was $778.42 million, up $16.34 million, or 2.14% from the $762.08 million at December 31, 2018. In addition to net income of $22.20 million, other significant changes in shareholders’ equity during the first three months of 2019 included $7.26 million of common stock acquired for treasury and $6.98 million of dividends paid. The accumulated other comprehensive loss component of shareholders’ equity totaled $3.41 million at March 31, 2019, compared to $10.68 million at December 31, 2018. Our equity-to-assets ratio was 12.20% as of March 31, 2019, compared to 12.11% at December 31, 2018. Book value per common share rose to $30.33 at March 31, 2019, from $29.56 at December 31, 2018.
We declared and paid cash dividends per common share of $0.27 during the first quarter of 2019. The trailing four quarters dividend payout ratio, representing cash dividends per common share divided by diluted earnings per common share, was 30.79%. The dividend payout is continually reviewed by management and the Board of Directors subject to the Company’s capital and dividend policy.
The banking regulators have established guidelines for leverage capital requirements, expressed in terms of Tier 1 or core capital as a percentage of average assets, to measure the soundness of a financial institution. In addition, banking regulators have established risk-based capital guidelines for U.S. banking organizations.
The actual capital amounts and ratios of 1st Source Corporation and 1st Source Bank as of March 31, 2019, are presented in the table below.
 
 
Actual
 
Minimum Capital Adequacy
 
Minimum Capital Adequacy with Capital Buffer
 
To Be Well Capitalized Under Prompt Corrective Action Provisions
(Dollars in thousands)
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
Total Capital (to Risk-Weighted Assets):
 
 

 
 

 
 

 
 

 
 
 
 
 
 

 
 

1st Source Corporation
 
$
833,742

 
14.58
%
 
$
457,587

 
8.00
%
 
$
600,583

 
10.50
%
 
$
571,984

 
10.00
%
1st Source Bank
 
758,438

 
13.25

 
457,766

 
8.00

 
600,817

 
10.50

 
572,207

 
10.00

Tier 1 Capital (to Risk-Weighted Assets):
 
 

 
 

 
 

 
 

 
 
 
 
 
 

 
 

1st Source Corporation
 
761,832

 
13.32

 
343,190

 
6.00

 
486,186

 
8.50

 
457,587

 
8.00

1st Source Bank
 
686,501

 
12.00

 
343,324

 
6.00

 
486,376

 
8.50

 
457,766

 
8.00

Common Equity Tier 1 Capital (to Risk-Weighted Assets):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
1st Source Corporation
 
702,153

 
12.28

 
257,393

 
4.50

 
400,389

 
7.00

 
371,790

 
6.50

1st Source Bank
 
683,822

 
11.95

 
257,493

 
4.50

 
400,545

 
7.00

 
371,935

 
6.50

Tier 1 Capital (to Average Assets):
 
 

 
 

 
 

 
 

 
 
 
 
 
 

 
 

1st Source Corporation
 
761,832

 
12.23

 
249,130

 
4.00

 
N/A

 
N/A

 
311,412

 
5.00

1st Source Bank
 
686,501

 
11.03

 
249,006

 
4.00

 
N/A

 
N/A

 
311,257

 
5.00

LIQUIDITY AND INTEREST RATE SENSITIVITY
Effective liquidity management ensures that the cash flow requirements of depositors and borrowers, as well as our operating cash needs are met. Funds are available from a number of sources, including the securities portfolio, the core deposit base, access to the national brokered certificates of deposit market, national listing service certificates of deposit, Federal Home Loan Bank (FHLB) borrowings, Federal Reserve Bank (FRB) borrowings, and the capability to package loans for sale.

34


We have borrowing sources available to supplement deposits and meet our funding needs. 1st Source Bank has established relationships with several banks to provide short term borrowings in the form of federal funds purchased. At March 31, 2019, we had $37.00 million of borrowings in the federal funds market. We could borrow $228.00 million in additional funds for a short time from these banks on a collective basis. As of March 31, 2019, we had $146.27 million outstanding in FHLB advances and could borrow an additional $401.43 million contingent on the FHLB activity-based stock ownership requirement. We also had no outstandings with the FRB and could borrow $758.73 million as of March 31, 2019.
Our loan to asset ratio was 77.22% at March 31, 2019 compared to 76.83% at December 31, 2018 and 77.52% at March 31, 2018. Cash and cash equivalents totaled $67.68 million at March 31, 2019 compared to $99.08 million at December 31, 2018 and $51.15 million at March 31, 2018. At March 31, 2019, the Statement of Financial Condition was rate sensitive by $384.03 million more assets than liabilities scheduled to reprice within one year, or approximately 1.15%. Management believes that the present funding sources provide adequate liquidity to meet our cash flow needs.
Under Indiana law governing the collateralization of public fund deposits, the Indiana Board of Depositories determines which financial institutions are required to pledge collateral based on the strength of their financial ratings. We have been informed that no collateral is required for our public fund deposits. However, the Board of Depositories could alter this requirement in the future and adversely impact our liquidity. Our potential liquidity exposure if we must pledge collateral is approximately $650 million.
RESULTS OF OPERATIONS
Net income for the three month period ended March 31, 2019 was $22.20 million, compared to $19.12 million for the same period in 2018. Diluted net income per common share was $0.86 for the three month period ended March 31, 2019, compared to $0.73 for the same period in 2018. Return on average common shareholders’ equity was 11.61% for the three months ended March 31, 2019, compared to 10.67% in 2018. The return on total average assets was 1.43% for the three months ended March 31, 2019, compared to 1.31% in 2018.
Net income increased for the three months ended March 31, 2019 compared to the first three months of 2018. Net interest income increased which was offset by an increase in the provision for loan and lease losses. Details of the changes in the various components of net income are discussed further below.

35


NET INTEREST INCOME
The following tables provide an analysis of net interest income and illustrates the interest income earned and interest expense charged for each major component of interest earning assets and interest bearing liabilities. Yields/rates are computed on a tax-equivalent basis, using a 21% rate. Nonaccrual loans and leases are included in the average loan and lease balance outstanding.
DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS’ EQUITY
INTEREST RATES AND INTEREST DIFFERENTIAL
 
 
 
Three Months Ended
 
 
 
March 31, 2019
 
December 31, 2018
 
March 31, 2018
(Dollars in thousands)
Average
Balance
 
Interest Income/Expense
 
Yield/
Rate
 
Average
Balance
 
Interest Income/Expense
 
Yield/
Rate
 
Average
Balance
 
Interest Income/Expense
 
Yield/
Rate
ASSETS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Investment securities available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Taxable
$
909,422

 
$
5,515

 
2.46
%
 
$
895,204

 
$
5,363

 
2.38
%
 
$
813,144

 
$
4,608

 
2.30
%
Tax exempt(1)
78,171

 
472

 
2.45
%
 
81,652

 
516

 
2.51
%
 
103,835

 
655

 
2.56
%
Mortgages held for sale
8,826

 
101

 
4.64
%
 
9,018

 
107

 
4.71
%
 
7,719

 
80

 
4.20
%
Loans and leases, net of unearned discount(1)
4,858,183

 
62,677

 
5.23
%
 
4,835,995

 
62,270

 
5.11
%
 
4,588,782

 
53,699

 
4.75
%
Other investments
42,095

 
438

 
4.22
%
 
51,607

 
452

 
3.47
%
 
39,299

 
408

 
4.21
%
Total earning assets(1)
5,896,697

 
69,203

 
4.76
%
 
5,873,476

 
68,708

 
4.64
%
 
5,552,779

 
59,450

 
4.34
%
Cash and due from banks
63,886

 
 
 
 
 
67,437

 
 
 
 

 
61,395

 
 

 
 

Reserve for loan and lease losses
(101,697
)
 
 
 
 
 
(99,182
)
 
 
 
 

 
(95,707
)
 
 

 
 

Other assets
431,500

 
 
 
 
 
428,813

 
 
 
 

 
421,107

 
 

 
 

Total assets
$
6,290,386

 
 
 
 
 
$
6,270,544

 
 
 
 

 
$
5,939,574

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
 
 
 

 
 
 
 

 
 

 
 

 
 

Interest-bearing deposits
$
3,934,921

 
$
11,470

 
1.18
%
 
$
3,932,453

 
$
10,345

 
1.04
%
 
$
3,702,882

 
$
6,562

 
0.72
%
Short-term borrowings
251,379

 
931

 
1.50
%
 
241,979

 
718

 
1.18
%
 
322,257

 
776

 
0.98
%
Subordinated notes
58,764

 
928

 
6.40
%
 
58,764

 
916

 
6.18
%
 
58,764

 
883

 
6.09
%
Long-term debt and mandatorily redeemable securities
70,481

 
744

 
4.28
%
 
70,871

 
695

 
3.89
%
 
70,311

 
485

 
2.80
%
Total interest-bearing liabilities
4,315,545

 
14,073

 
1.32
%
 
4,304,067

 
12,674

 
1.17
%
 
4,154,214

 
8,706

 
0.85
%
Noninterest-bearing deposits
1,124,441

 
 

 
 

 
1,155,495

 
 

 
 

 
1,005,557

 
 

 
 

Other liabilities
73,183

 
 

 
 

 
51,762

 
 

 
 

 
53,561

 
 

 
 

Shareholders’ equity
775,657

 
 

 
 

 
758,450

 
 

 
 

 
726,242

 
 

 
 

   Noncontrolling interests
1,560

 
 
 
 
 
770

 
 
 
 
 

 
 
 
 
Total liabilities and equity
$
6,290,386

 
 

 
 

 
$
6,270,544

 
 

 
 

 
$
5,939,574

 
 

 
 

Less: Fully tax-equivalent adjustments
 
 
(182
)
 
 
 
 
 
(191
)
 
 
 
 
 
(212
)
 
 
Net interest income/margin (GAAP-derived)(1)
 

 
$
54,948

 
3.78
%
 
 

 
$
55,843

 
3.77
%
 
 

 
$
50,532

 
3.69
%
Fully tax-equivalent adjustments
 
 
182

 
 
 
 
 
191

 
 
 
 
 
212

 
 
Net interest income/margin - FTE(1)
 

 
$
55,130

 
3.79
%
 
 

 
$
56,034

 
3.78
%
 
 

 
$
50,744

 
3.71
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1) See “Reconciliation of Non-GAAP Financial Measures” at the end of this section for additional information on this performance measure/ratio.
Quarter Ended March 31, 2019 compared to the Quarter Ended March 31, 2018
The taxable-equivalent net interest income for the three months ended March 31, 2019 was $55.13 million, an increase of 8.64% over the same period in 2018. The net interest margin on a fully taxable-equivalent basis was 3.79% for the three months ended March 31, 2019, compared to 3.71% for the three months ended March 31, 2018.
During the three month period ended March 31, 2019, average earning assets increased $343.92 million or 6.19% over the comparable period in 2018. Average interest-bearing liabilities increased $161.33 million or 3.88%. The yield on average earning assets increased 42 basis points to 4.76% from 4.34% primarily due to higher rates on loans and leases and taxable investment securities available-for-sale. Total cost of average interest-bearing liabilities increased 47 basis points to 1.32% from 0.85% as a result of the rising interest rate environment during 2018. The result to the net interest margin, or the ratio of net interest income to average earning assets, was an increase of 9 basis points.

36


The largest contributor to the improved yield on average earning assets for the three months ended March 31, 2019, compared to the three months ended March 31, 2018, was an increase in yields on net loans and leases of 48 basis points primarily due to market conditions as a result of 2018 Federal interest rate increases. The improved yield on net loans and leases was also negatively impacted by 2 basis points due to net interest recoveries of $0.08 million in the first quarter of 2019 vs. net interest recoveries of $0.15 million in the first quarter of 2018. Average net loans and leases increased $269.40 million or 5.87% with the largest increases occurring within the commercial and agricultural and commercial real estate portfolios as a result of market demand. Total average investment securities increased $70.61 million or 7.70%. Average mortgages held for sale increased $1.11 million or 14.34%. Average other investments, which include federal funds sold, time deposits with other banks, Federal Reserve Bank excess balances, Federal Reserve Bank and Federal Home Loan Bank (FHLB) stock and commercial paper increased $2.80 million or 7.11% from the first quarter of 2018.
Average interest-bearing deposits increased $232.04 million or 6.27% for the first quarter of 2019 over the same period in 2018 primarily due to organic customer growth and higher rates to support increased loan and lease demand. The effective rate paid on average interest-bearing deposits grew 46 basis points to 1.18% from 0.72%. The increase in the average cost of interest-bearing deposits was primarily the result of higher rates, competitive pressure on rates, and a shift in the deposit mix from the first quarter of 2018.
Average short-term borrowings decreased $70.88 million or 21.99% for the first quarter of 2019 compared to the same period in 2018. Interest paid on short-term borrowings increased 52 basis points due to 2018 Federal interest rate increases. Interest paid on subordinated notes increased 31 basis points during the first quarter of 2019 from the same period a year ago due to a variable rate on one traunche. Average long-term debt and mandatorily redeemable securities balances were relatively flat. Interest paid on long-term debt and mandatorily redeemable securities increased 148 basis points during the first quarter of 2019 from the same period in 2018 primarily due to higher rates on mandatorily redeemable securities.
 
 
 
 
 
 
 
 
 
 
 
 
Reconciliation of Non-GAAP Financial Measures
The accounting and reporting policies of 1st Source conform to generally accepted accounting principles (“GAAP”) in the United States and prevailing practices in the banking industry. However, certain non-GAAP performance measures are used by management to evaluate and measure the Company’s performance. These include taxable-equivalent net interest income (including its individual components) and net interest margin (including its individual components). Management believes that these measures provide users of the Company’s financial information a more meaningful view of the performance of the interest-earning assets and interest-bearing liabilities.
Management reviews yields on certain asset categories and the net interest margin of the Company and its banking subsidiaries on a fully taxable-equivalent (“FTE”) basis. In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measure ensures comparability of net interest income arising from both taxable and tax-exempt sources.
 
 
Three Months Ended
(Dollars in thousands)
March 31,
2019
December 31,
2018
March 31,
2018
Calculation of Net Interest Margin
 
 
 
(A)
Interest income (GAAP)
$
69,021

$
68,517

$
59,238

 
Fully tax-equivalent adjustments:
 
 
 
(B)
- Loans and leases
95

94

88

(C)
- Tax-exempt investment securities
87

97

124

(D)
Interest income - FTE (A+B+C)
69,203

68,708

59,450

(E)
Interest expense (GAAP)
14,073

12,674

8,706

(F)
Net interest income (GAAP) (A–E)
54,948

55,843

50,532

(G)
Net interest income - FTE (D–E)
55,130

56,034

50,744

(H)
Annualization factor
4.056

3.967

4.056

(I)
Total earning assets
$
5,896,697

$
5,873,476

$
5,552,779

 
Net interest margin (GAAP-derived) (F*H)/I
3.78
%
3.77
%
3.69
%
 
Net interest margin - FTE (G*H)/I
3.79
%
3.78
%
3.71
%
PROVISION AND RESERVE FOR LOAN AND LEASE LOSSES 
The provision for loan and lease losses for the three month period ended March 31, 2019 was $4.92 million compared to a provision for loan and lease losses in the three month period ended March 31, 2018 of $3.79 million. Net charge-offs of $3.54 million were recorded for the first quarter 2019, compared to net charge-offs of $0.34 million for the same quarter a year ago.

37


The increase in the amount of the provision for the most recent quarter was principally driven by one large charge-off of $3 million and loan growth. Loan growth during the first quarter of 2019 was $90.72 million. A large syndicated aircraft account was placed in nonaccrual status during the second quarter of 2018 and significant charge-offs were recognized during 2018 and the first quarter of 2019. The remaining balance is less than $1 million, payment of which is anticipated to come from a final settlement of escrowed funds.
We continue to evaluate risks which may impact our loan portfolios. We believe geopolitical events have the potential to negatively impact the U.S. economy. Current concerns include slower growth projections for world economies and the sharp decline in global trade growth exacerbated by tariff disputes, particularly between China and the U.S. Political uncertainty continues in Latin America, with ongoing corruption scandals, fueling U.S. border concerns. Mexico’s economy is slowing and Brazil continues to require further structural reforms. Concerns continue to be heightened globally due to actual and potential terrorist attacks.
Another area of concern continues to be our aircraft portfolio where we have a collateral concentration and $221 million in foreign exposure. The aircraft industry was among the sectors affected most by the sluggish economy. Currently, the U.S. economy remains strong but the global economy is showing signs of weakness. The majority of our foreign exposure is in Mexico and Brazil. Brazil is beginning to show slow and steady recovery as it emerges from its worst recession in twenty-five years. However, the country continues to be plagued by corruption scandals and violence. Mexico’s economy is currently stronger but is exhibiting weakness which could lead to further deterioration. We continue to monitor individual customer performance and assess risks in the portfolio as a whole.
On March 31, 2019, 30 day and over loan and lease delinquencies as a percentage of loan and lease outstandings were 0.31%, relatively unchanged from 0.27% on March 31, 2018. The reserve for loan and lease losses as a percentage of loans and leases outstanding at the end of the period was 2.07% compared to 2.10% one year ago. The decrease in the reserve as a percent of loans and leases outstanding was primarily due to charging off a significant exposure and lower special attention loan outstanding balances. A summary of loan and lease loss experience during the three months ended March 31, 2019 and 2018 is located in Note 5 of the Consolidated Financial Statements.
A loan or lease is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or lease agreement. We evaluate loans and leases exceeding $100,000 for impairment and establish a specific reserve as a component of the reserve for loan and lease losses when it is probable all amounts due will not be collected pursuant to the contractual terms of the loan or lease and the recorded investment in the loan or lease exceeds its fair value. A summary of impaired loans as of March 31, 2019 and December 31, 2018 is reflected in Note 4 of the Consolidated Financial Statements.
NONPERFORMING ASSETS 
The following table shows nonperforming assets.
(Dollars in thousands)
 
March 31,
2019
 
December 31,
2018
 
March 31,
2018
Loans and leases past due 90 days or more
 
$
178

 
$
366

 
$
123

Nonaccrual loans and leases
 
13,622

 
27,859

 
25,360

Other real estate
 
417

 
299

 
1,184

Repossessions
 
10,411

 
6,666

 
9,432

Equipment owned under operating leases
 
64

 
126

 
2

Total nonperforming assets
 
$
24,692

 
$
35,316

 
$
36,101

 
Nonperforming assets as a percentage of loans and leases were 0.49% at March 31, 2019, 0.71% at December 31, 2018, and 0.74% at March 31, 2018. Nonperforming assets totaled $24.69 million at March 31, 2019, a decrease of 30.08% from the $35.32 million reported at December 31, 2018, and a 31.60% decrease from the $36.10 million reported at March 31, 2018. The decrease in nonperforming assets during the first three months of 2019 was related to lower nonaccrual loans and leases offset by an increase in repossessions. The decrease in nonperforming assets at March 31, 2019 from March 31, 2018 occurred primarily in nonaccrual loans and leases and lower other real estate offset by an increase in repossessions.
The decrease in nonaccrual loans and leases at March 31, 2019 from December 31, 2018 occurred primarily in the aircraft and auto and light truck portfolios. The decrease in nonaccrual loans and leases at March 31, 2019 from March 31, 2018 occurred primarily in the auto and light truck, aircraft, and commercial real estate portfolios. A summary of nonaccrual loans and leases and past due aging for the period ended March 31, 2019 and December 31, 2018 is located in Note 4 of the Consolidated Financial Statements.
Other real estate is the result of foreclosing on real estate in the local market for which we have a current appraisal and are well secured. Other real estate decreased over the past year due to sales of existing properties outpacing current foreclosures.

38


Repossessions consisted mainly of aircraft and auto and light trucks. At the time of repossession, the recorded amount of the loan or lease is written down to the fair value of the equipment or vehicle by a charge to the reserve for loan and lease losses or other income, if a positive adjustment, unless the equipment is in the process of immediate sale. Any subsequent fair value write-downs or write-ups, to the extent of previous write-downs, are included in noninterest expense.
The following table shows a summary of other real estate and repossessions.
(Dollars in thousands)
 
March 31,
2019
 
December 31,
2018
 
March 31,
2018
Commercial and agricultural
 
$
22

 
$

 
$

Auto and light truck
 
5,293

 
440

 
167

Medium and heavy duty truck
 

 
15

 

Aircraft
 
4,400

 
6,209

 
8,735

Construction equipment
 
603

 

 
530

Commercial real estate
 

 

 
482

Residential real estate and home equity
 
417

 
299

 
702

Consumer
 
93

 
2

 

Total
 
$
10,828

 
$
6,965

 
$
10,616

 
For financial statement purposes, nonaccrual loans and leases are included in loan and lease outstandings, whereas repossessions and other real estate are included in other assets.
NONINTEREST INCOME
The following table shows the details of noninterest income.
 
 
 
Three Months Ended 
 March 31,
(Dollars in thousands)
 
 
2019
 
2018
 
$ Change
 
% Change
Noninterest income:
 
 
 

 
 

 
 
 
 
Trust and wealth advisory
 
 
$
4,858

 
$
5,188

 
(330
)
 
(6.36
)%
Service charges on deposit accounts
 
 
2,498

 
2,484

 
14

 
0.56
 %
Debit card
 
 
3,220

 
3,103

 
117

 
3.77
 %
Mortgage banking
 
 
936

 
884

 
52

 
5.88
 %
Insurance commissions
 
 
2,174

 
1,958

 
216

 
11.03
 %
Equipment rental
 
 
7,982

 
7,755

 
227

 
2.93
 %
Losses on investment securities available-for-sale
 
 

 
(345
)
 
345

 
NM

Other
 
 
2,456

 
2,780

 
(324
)
 
(11.65
)%
Total noninterest income
 
 
$
24,124

 
$
23,807

 
317

 
1.33
 %
NM = Not Meaningful
Trust and wealth advisory fees (which include investment management fees, estate administration fees, mutual fund fees, annuity fees, and fiduciary fees) decreased during the three months ended March 31, 2019 compared with the same period a year ago. Trust and wealth advisory fees are largely based on the number and size of client relationships and the market value of assets under management. The market value of trust assets under management at March 31, 2019, December 31, 2018, and March 31, 2018 was $4.18 billion, $3.94 billion, and $4.62 billion, respectively. The decrease in trust and wealth advisory fees compared to one year ago is primarily due to a reduction in the market value of trust assets under management due to stock market movements.
Service charges on deposit accounts were flat for the three months ended March 31, 2019 over the comparable period in 2018.
Debit card income improved in the three months ended March 31, 2019 over the same period a year ago. The majority of the improvement in debit card income was the result of an increased volume of debit card transactions in 2019.
Mortgage banking income increased in the three months ended March 31, 2019 as compared to the same period in 2018. The increase was primarily caused by a higher volume of loans originated for the secondary market during the first quarter of 2019.
Insurance commissions were higher during the three months ended March 31, 2019 over the same period a year ago. The increase in insurance commissions was primarily due to an increased book of business and higher contingent commissions received.

39


Equipment rental income grew for the three months ended March 31, 2019 over the comparable period in 2018. The increase was the result of the average equipment rental portfolio growing 4% over the same period a year ago due to improving market conditions for equipment finance mainly in specialty vehicles and solar financing. The growth in equipment rental income was offset by a similar increase in depreciation on equipment owned under operating leases.
Losses on investment securities available-for-sale decreased during the three months ended March 31, 2019 compared the same period in 2018 primarily from repositioning the portfolio during the first quarter of 2018 in response to tax reform.
Other income decreased for the three months ended March 31, 2019 over the comparable period in 2018. The decrease was primarily a result of reduced gains on partnership investments offset by personal property tax reimbursements on leased equipment from lessees that are reported gross as required by the new leasing standard effective January 1, 2019. These personal property tax reimbursements were offset by a similar increase in other expense resulting from the payment of personal property taxes to the taxing jurisdictions.
NONINTEREST EXPENSE
The following table shows the details of noninterest expense.
 
 
Three Months Ended 
 March 31,
(Dollars in thousands)
 
2019
 
2018
 
$ Change
 
% Change
Noninterest expense:
 
 

 
 

 
 
 
 
Salaries and employee benefits
 
$
23,495

 
$
22,531

 
964

 
4.28
 %
Net occupancy
 
2,772

 
2,866

 
(94
)
 
(3.28
)%
Furniture and equipment
 
6,024

 
5,455

 
569

 
10.43
 %
Depreciation – leased equipment
 
6,524

 
6,428

 
96

 
1.49
 %
Professional fees
 
1,598

 
2,017

 
(419
)
 
(20.77
)%
Supplies and communication
 
1,493

 
1,553

 
(60
)
 
(3.86
)%
FDIC and other insurance
 
645

 
698

 
(53
)
 
(7.59
)%
Business development and marketing
 
949

 
1,533

 
(584
)
 
(38.10
)%
Loan and lease collection and repossession
 
1,361

 
951

 
410

 
43.11
 %
Other
 
343

 
1,525

 
(1,182
)
 
(77.51
)%
Total noninterest expense
 
$
45,204

 
$
45,557

 
(353
)
 
(0.77
)%
Salaries and employee benefits increased during the three months ended March 31, 2019 compared to the same period in 2018. The increase was mainly the result of higher base salaries as a result of normal merit increases, increased company contributions to employee retirement accounts and a rise in group insurance claims offset by a decrease in incentive compensation.
Net occupancy expense decreased during the three months ended March 31, 2019 compared to the same period a year ago. The decrease for 2019 was primarily attributable to reduced snow removal costs and lower premises repairs compared to 2018.
Furniture and equipment expense, including depreciation, increased during the three months ended March 31, 2019 compared to the same period a year ago. Furniture and equipment expense was higher in 2019 mainly due to software maintenance costs and increased equipment depreciation.
Depreciation on leased equipment increased slightly for the three months ended March 31, 2019 compared to the same period in 2018. Depreciation on leased equipment correlates with the growth in equipment rental income.
Professional fees decreased during the first quarter of 2019 compared to the same period a year ago. The decrease was mainly due to reduced utilization of consulting services related to a customer relationship management project and information technology projects during the first quarter of 2018 offset by an increase in legal fees.
Supplies and communication decreased slightly during the first quarter of 2019 compared to the same period a year ago. The decrease resulted primarily from lower data communication line charges and decreased telephone service and equipment costs.
FDIC and other insurance was lower during the three months ended March 31, 2019 compared to the same period in 2018. The decrease in 2019 was mainly due to lower assessments for FDIC insurance offset by increased general insurance costs.
Business development and marketing expense decreased during the first quarter of 2019 compared to the same period a year ago. The reduction was primarily the result of fewer marketing promotions.
Loan and lease collection and repossession expense increased during the three months ended March 31, 2019 compared to the same period in 2018. The higher expense was mainly due to increased valuation adjustments on repossessed assets.

40


Other expenses were lower during the three months ended March 31, 2019 compared to the same period in 2018. The decrease was primarily related to higher gains on the sale of fixed assets and a trust loss in 2018. Additionally, other expense during the first quarter included personal property taxes on leased equipment of $0.24 million that are reported gross as required by the new leasing standard effective January 1, 2019. These personal property taxes on leased equipment were offset by a similar increase in other income from the reimbursement of personal property taxes by lessees.
INCOME TAXES
The provision for income taxes for the three month period ended March 31, 2019 was $6.75 million, compared to $5.88 million for the same period in 2018. The effective tax rate was 23.33% and 23.52% for the first quarter ended March 31, 2019 and 2018, respectively.
ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes in market risks faced by 1st Source since December 31, 2018. For information regarding our market risk, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2018.
ITEM 4.
CONTROLS AND PROCEDURES
As of the end of the period covered by this report an evaluation was carried out, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, at March 31, 2019, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by 1st Source in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and are designed to ensure that information required to be disclosed in those reports is accumulated and communicated to management as appropriate to allow timely decisions regarding required disclosure.
In addition, there were no changes in our internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the first fiscal quarter of 2019 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.



PART II.  OTHER INFORMATION
ITEM 1.         Legal Proceedings.
1st Source and its subsidiaries are involved in various legal proceedings incidental to the conduct of our businesses. Management does not expect that the outcome of any such proceedings will have a material adverse effect on our consolidated financial position or results of operations.
ITEM 1A.      Risk Factors.
There have been no material changes in risks faced by 1st Source since December 31, 2018. For information regarding our risk factors, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2018.

41


ITEM 2.         Unregistered Sales of Equity Securities and Use of Proceeds
ISSUER PURCHASES OF EQUITY SECURITIES
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 (or Approximate Dollar Value) of Shares that may yet be Purchased Under the Plans or Programs
January 01 - 31, 2019
 

 
$

 

 
1,185,161

February 01 - 28, 2019
 
59,935

 
47.59

 
59,935

 
1,125,226

March 01 - 31, 2019
 
94,225

 
46.76

 
94,225

 
1,031,001

 
* 1st Source maintains a stock repurchase plan that was authorized by the Board of Directors on July 24, 2014. Under the terms of the plan, 1st Source may repurchase up to 2,000,000 shares of its common stock from time to time to mitigate the potential dilutive effects of stock-based incentive plans and other potential uses of common stock for corporate purposes. Since the inception of the plan, 1st Source has repurchased a total of 968,999 shares.
ITEM 3.         Defaults Upon Senior Securities.
None
ITEM 4.         Mine Safety Disclosures.
None
ITEM 5.         Other Information.
None
ITEM 6.         Exhibits
The following exhibits are filed with this report:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.INS
 
XBRL Instance Document
 
 
 
101.SCH
 
XBRL Taxonomy Extension Schema Document
 
 
 
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
 
101.LAB
 
XBRL Taxonomy Extension Labels Linkbase Document
 
 
 
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document
 
 
 
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document

42


SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


 
 
1st Source Corporation
 
 
 
 
 
 
 
 
 
DATE
April 18, 2019
 
/s/ CHRISTOPHER J. MURPHY III
 
 
Christopher J. Murphy III
Chairman of the Board and CEO
 
 
 
 
 
 
DATE
April 18, 2019
 
/s/ ANDREA G. SHORT
 
 
Andrea G. Short
Treasurer and Chief Financial Officer
Principal Accounting Officer


43