form10-q.htm
 





UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended   June 30, 2007
 
OR
 
      o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from __________________   to ________________
 
Commission file number 0-6233
 
(Exact name of registrant as specified in its charter)
 
INDIANA
 
35-1068133
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)

100 North Michigan Street
South Bend, Indiana
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.

 
Yes
X
 
No
   

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

 
Large accelerated filer
   
Accelerated filer
X
 
Non-accelerated filer
   

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 
Yes
   
No
X
 

Number of shares of common stock outstanding as of July 19, 2007  –  24,416,999  shares

 

 


 

-1-



 
TABLE OF CONTENTS
 

PART I.  FINANCIAL INFORMATION
 
   
Page
Item 1.
 
 
3
 
4
 
5
 
6
 
7
Item 2.
13
Item 3.
24
Item 4.
24
     
PART II.  OTHER INFORMATION
 
     
Item 1.
25
Item 1A.
25
Item 2.
25
Item 3.
25
Item 4.
26
Item 5.
26
Item 6.
26
     
27
     
EXHIBITS
 
   Exhibit 31.1
   Exhibit 31.2
   Exhibit 32.1
   Exhibit 32.2
 
 



 
 
       
 
 
       
(Unaudited - Dollars in thousands)
 
 
       
   
June 30,
   
December 31,
 
   
2007
   
2006
 
ASSETS
 
 
   
 
 
Cash and due from banks
  $
97,691
    $
118,131
 
Federal funds sold and
               
interest bearing deposits with other banks
   
196,232
     
64,979
 
Investment securities available-for-sale
               
(amortized cost of $797,840 and $709,091
               
at June 30, 2007 and December 31, 2006, respectively)
   
794,604
     
708,672
 
Mortgages held for sale
   
25,599
     
50,159
 
Loans and leases - net of unearned discount:
               
Commercial and agricultural loans
   
567,932
     
478,310
 
Auto, light truck and environmental equipment
   
350,254
     
317,604
 
Medium and heavy duty truck
   
329,103
     
341,744
 
Aircraft financing
   
535,362
     
498,914
 
Construction equipment financing
   
362,654
     
305,976
 
Loans secured by real estate
   
834,153
     
632,283
 
Consumer loans
   
154,712
     
127,706
 
Total loans and leases
   
3,134,170
     
2,702,537
 
Reserve for loan and lease losses
    (62,682 )     (58,802 )
Net loans and leases
   
3,071,488
     
2,643,735
 
Equipment owned under operating leases, net
   
79,082
     
76,310
 
Net premises and equipment
   
50,847
     
37,326
 
Goodwill and intangible assets
   
91,196
     
19,418
 
Accrued income and other assets
   
97,911
     
88,585
 
Total assets
  $
4,504,650
    $
3,807,315
 
                 
LIABILITIES
               
Deposits:
               
Noninterest bearing
  $
380,681
    $
339,866
 
Interest bearing
   
3,204,760
     
2,708,418
 
Total deposits
   
3,585,441
     
3,048,284
 
                 
Federal funds purchased and securities
               
sold under agreements to repurchase
   
241,578
     
195,262
 
Other short-term borrowings
   
22,874
     
27,456
 
Long-term debt and mandatorily redeemable securities
   
44,199
     
43,761
 
Subordinated notes
   
100,260
     
59,022
 
Accrued expenses and other liabilities
   
84,772
     
64,626
 
Total liabilities
   
4,079,124
     
3,438,411
 
                 
SHAREHOLDERS' EQUITY
               
Preferred stock; no par value
               
Authorized 10,000,000 shares; none issued or outstanding
   
-
     
-
 
Common stock; no par value
               
Authorized 40,000,000 shares; issued 25,918,510 at June 30, 2007
               
   and 23,781,518 at December 31, 2006, less unearned shares
               
     (275,004 at June 30, 2007 and 262,986 at December 31, 2006)
   
342,840
     
289,163
 
Retained earnings
   
110,220
     
99,572
 
Cost of common stock in treasury (1,226,507 shares at June 30, 2007, and
               
1,022,435 shares at December 31, 2006)
    (25,524 )     (19,571 )
Accumulated other comprehensive loss
    (2,010 )     (260 )
Total shareholders' equity
   
425,526
     
368,904
 
Total liabilities and shareholders' equity
  $
4,504,650
    $
3,807,315
 
 
               
The accompanying notes are a part of the consolidated financial statements.
               
                 
 
 

 

 

 
 
         
 
       
CONSOLIDATED STATEMENTS OF INCOME
 
 
         
 
       
(Unaudited - Dollars in thousands, except per share amounts)
 
 
         
 
       
   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2007
   
2006
   
2007
   
2006
 
Interest income:
 
 
   
 
   
 
   
 
 
Loans and leases
  $
53,078
    $
44,421
    $
101,352
    $
85,309
 
Investment securities, taxable
   
5,991
     
4,797
     
11,721
     
8,722
 
Investment securities, tax-exempt
   
1,721
     
1,292
     
3,138
     
2,559
 
Other
   
1,542
     
271
     
2,074
     
587
 
Total interest income
   
62,332
     
50,781
     
118,285
     
97,177
 
Interest expense:
                               
Deposits
   
28,795
     
19,283
     
54,065
     
36,316
 
Short-term borrowings
   
2,572
     
2,822
     
5,262
     
5,582
 
Subordinated notes
   
1,296
     
1,080
     
2,390
     
2,130
 
Long-term debt and mandatorily redeemable securities
   
798
     
451
     
1,425
     
905
 
Total interest expense
   
33,461
     
23,636
     
63,142
     
44,933
 
Net interest income
   
28,871
     
27,145
     
55,143
     
52,244
 
Provision for (recovery of) loan and lease losses
   
1,247
      (1,671 )    
624
      (1,971 )
Net interest income after
                               
provision for (recovery of) loan and lease losses
   
27,624
     
28,816
     
54,519
     
54,215
 
Noninterest income:
                               
Trust fees
   
3,871
     
3,658
     
7,514
     
7,049
 
Service charges on deposit accounts
   
5,226
     
4,917
     
9,796
     
9,303
 
Mortgage banking income
   
1,059
     
3,105
     
1,630
     
4,862
 
Insurance commissions
   
938
     
932
     
2,576
     
2,614
 
Equipment rental income
   
5,287
     
4,658
     
10,385
     
8,878
 
Other income
   
2,482
     
1,647
     
4,201
     
3,133
 
Investment securities and other investment gains
   
207
     
150
     
454
     
2,233
 
Total noninterest income
   
19,070
     
19,067
     
36,556
     
38,072
 
Noninterest expense:
                               
Salaries and employee benefits
   
18,153
     
16,873
     
35,719
     
32,387
 
Net occupancy expense
   
2,149
     
1,860
     
4,085
     
3,727
 
Furniture and equipment expense
   
3,748
     
2,959
     
6,842
     
6,093
 
Depreciation - leased equipment
   
4,243
     
3,547
     
8,319
     
6,929
 
Supplies and communication
   
1,512
     
1,307
     
2,784
     
2,670
 
Other  expense
   
4,641
     
5,840
     
8,497
     
9,986
 
Total noninterest expense
   
34,446
     
32,386
     
66,246
     
61,792
 
Income before income taxes
   
12,248
     
15,497
     
24,829
     
30,495
 
Income tax expense
   
4,188
     
5,220
     
8,246
     
10,285
 
                                 
Net income
  $
8,060
    $
10,277
    $
16,583
    $
20,210
 
                                 
Per common share:
                               
Basic net income per common share
  $
0.35
    $
0.46
    $
0.73
    $
0.90
 
Diluted net income per common share
  $
0.34
    $
0.45
    $
0.72
    $
0.88
 
Dividends
  $
0.140
    $
0.127
    $
0.28
    $
0.255
 
Basic weighted average common shares outstanding
   
23,127,790
     
22,505,875
     
22,818,015
     
22,576,338
 
Diluted weighted average common shares outstanding
   
23,423,121
     
22,810,923
     
23,113,159
     
22,876,839
 
                                 
 
                               
The accompanying notes are a part of the consolidated financial statements.
                               
                                 
 

 

 

                   
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
                   
(Unaudited - Dollars in thousands, except per share amounts)
   
 
   
 
   
 
 
                               
                           
Net
 
                           
Unrealized
 
                           
Appreciation
 
                     
Cost of
   
(Depreciation)
 
                     
Common
   
of Securities
 
         
Common
   
Retained
   
Stock
   
Available-
 
 
 
Total
   
Stock
   
Earnings
   
in Treasury
   
For-Sale
 
Balance at January 1, 2006
  $
345,576
    $
221,579
    $
139,601
    $ (12,364 )   $ (3,240 )
Comprehensive Income, net of tax:
                                       
Net Income
   
20,210
     
-
     
20,210
     
-
     
-
 
Change in unrealized appreciation
                                       
of available-for-sale securities, net of tax
    (961 )    
-
     
-
     
-
      (961 )
Total Comprehensive Income
   
19,249
     
-
     
-
     
-
     
-
 
Issuance of 66,296 common shares
                                       
under stock based compensation awards,
                                       
including related tax effects
   
636
     
-
     
292
     
344
     
-
 
Cost of 292,099 shares of common
                                       
stock acquired for treasury
    (7,385 )    
-
     
-
      (7,385 )    
-
 
Cash dividend ($0.255 per share)
    (5,764 )    
-
      (5,764 )    
-
     
-
 
Balance at June 30, 2006
  $
352,312
    $
221,579
    $
154,339
    $ (19,405 )   $ (4,201 )
                                         
Balance at January 1, 2007
  $
368,904
    $
289,163
    $
99,572
    $ (19,571 )   $ (260 )
Comprehensive Income, net of tax:
                                       
Net Income
   
16,583
     
-
     
16,583
     
-
     
-
 
Change in unrealized appreciation
                                       
of available-for-sale securities, net of tax
    (1,750 )    
-
     
-
     
-
      (1,750 )
Total Comprehensive Income
   
14,833
     
-
     
-
     
-
     
-
 
Issuance of 40,088 common shares
                                       
under stock based compensation awards,
                                       
including related tax effects
   
538
     
-
     
381
     
157
     
-
 
Cost of 233,806 shares of common
                                       
stock acquired for treasury
    (6,110 )    
-
     
-
      (6,110 )    
-
 
Cash dividend ($0.28 per share)
    (6,316 )    
-
      (6,316 )    
-
     
-
 
Issuance of 2,124,974 shares of common
                                       
stock for FINA Bancorp purchase
   
53,677
     
53,677
                         
Balance at June 30, 2007
  $
425,526
    $
342,840
    $
110,220
    $ (25,524 )   $ (2,010 )
                                         
The accompanying notes are a part of the consolidated financial statements.
                                 
 
 




           
CONSOLIDATED STATEMENTS OF CASH FLOWS
           
(Unaudited - Dollars in thousands)
           
   
Six Months Ended June 30,
 
   
2007
   
2006
 
Operating activities:
           
Net income
  $
16,583
    $
20,210
 
Adjustments to reconcile net income to net cash
               
from/(used in) operating activities:
               
Provision for (recovery of) loan and lease losses
   
624
      (1,971 )
Depreciation of premises and equipment
   
2,518
     
2,527
 
Depreciation of equipment owned and leased to others
   
8,319
     
6,929
 
Amortization of investment security premiums
               
and accretion of discounts, net
   
71
     
392
 
Amortization of mortgage servicing rights
   
638
     
2,972
 
Mortgage servicing asset impairment recoveries
   
-
      (30 )
Change in deferred income taxes
    (2,272 )     (3,917 )
Realized investment securities gains
    (454 )     (2,233 )
Change in mortgages held for sale
   
24,561
      (14,794 )
Change in trading account securities
   
-
      (300 )
Change in interest receivable
    (1,853 )    
309
 
Change in interest payable
   
3,901
     
1,918
 
Change in other assets
   
625
      (1,534 )
Change in other liabilities
   
10,571
     
5,517
 
Other
   
932
      (152 )
Net change in operating activities
   
64,764
     
15,843
 
                 
Investing activities:
               
Cash paid for acquisition, net
    (56,370 )    
-
 
Proceeds from sales of investment securities
   
1,070
     
61,650
 
Proceeds from maturities of investment securities
   
178,157
     
138,658
 
Purchases of investment securities
    (83,099 )     (195,764 )
Net change in short-term investments
   
24,923
     
66,258
 
Net change in loans and leases
    (192,667 )     (149,251 )
Net change  in equipment owned under operating leases
    (11,091 )     (16,326 )
Purchases of premises and equipment
    (13,549 )     (2,312 )
Net change in investing activities
    (152,626 )     (97,087 )
                 
Financing activities:
               
Net change in demand deposits, NOW
               
accounts and savings accounts
    (156,790 )     (210,773 )
Net change in certificates of deposit
   
171,807
     
279,795
 
Net change in short-term borrowings
   
23,549
     
8,253
 
Proceeds from issuance of long-term debt
   
-
     
10,859
 
Proceeds from issuance of trust preferred securities
   
41,238
     
-
 
Payments on long-term debt
    (385 )     (206 )
Net proceeds from issuance of treasury stock
   
539
     
635
 
Acquisition of treasury stock
    (6,110 )     (7,385 )
Cash dividends
    (6,426 )     (5,867 )
Net change in financing activities
   
67,422
     
75,311
 
Net change in cash and cash equivalents
    (20,440 )     (5,934 )
Cash and cash equivalents, beginning of year
   
118,131
     
124,817
 
Cash and cash equivalents, end of period
  $
97,691
    $
118,883
 
                 
Supplemental non-cash activity:
               
Common stock issued for purchase of FNBV
  $
53,677
    $
-
 
                 
The accompanying notes are a part of the consolidated financial statements.
               
 
 

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

Note 1.  Basis of Presentation
 
    The accompanying unaudited consolidated financial statements reflect all adjustments (all of which are normal and recurring in nature) that are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, the results of operations, changes in shareholders’ equity, and cash flows for the periods presented. These unaudited consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and footnote disclosures normally included in financial statements prepared in accordance with U. S. generally accepted accounting principles have been omitted. The Notes to the Consolidated Financial Statements appearing in 1st Source Corporation’s Annual Report on Form 10-K for 2006 (2006 Annual Report), which include descriptions of significant accounting policies, should be read in conjunction with these interim financial statements. The balance sheet at December 31, 2006, has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by U. S. generally accepted accounting principles for complete financial statements.  Certain amounts in the prior period consolidated financial statements have been reclassified to conform with the current year presentation.

Note 2.  Acquisition Activity

FINA Bancorp
 
    On May 31, 2007, we acquired FINA Bancorp (FINA), the parent company of First National Bank, Valparaiso (FNBV), for $134.19 million.  FNBV is a full service bank with 26 banking facilities located in Porter, LaPorte and Starke Counties of Indiana.  Pursuant to the definitive agreement, FINA shareholders were able to choose whether to receive 1st Source common stock and/or cash pursuant to the election procedures described in the definitive agreement.   Under the terms of the transaction, FINA was acquired in exchange for 2,124,974 shares of 1st Source common stock valued at $53.68 million and $80.51 million in cash.  The value of the common stock was $25.26 per share and was calculated as stipulated in the definitive agreement.  We believe that the purchase of FINA is a natural extension of our service area and is consistent with our growth and market expansion initiatives.  We expect to merge FNBV and 1st Source Bank in 2008.
 
    The acquisition was accounted for under the purchase method of accounting, and accordingly, the purchase price has been allocated to the tangible and identified intangible assets purchased and the liabilities assumed based upon the estimated fair values at the date of acquisition.  There are refinements in the process of allocating the purchase price that have not been entirely completed.  Identified intangible assets and purchase accounting fair value adjustments are being amortized under various methods over the expected lives of the corresponding assets and liabilities.  Goodwill will not be amortized, but will be reviewed for impairment on an annual basis.   Currently, identified intangible assets from the acquisition subject to amortization are $8.86 million and total goodwill from the acquisition is $63.07 million.
 
    On the date of acquisition, unaudited financial statements of FINA reflected assets of $619.31 million, which included $240.13 million of loans and $184.47 million of investment securities, $523.04 million of deposits and year-to-date net income of $3.85 million.  In conjunction with the $240.13 million of loans, FINA’s allowance for loan losses at the acquisition date was $2.42 million.  We applied the guidance required under the American Institute of Certified Public Accountants Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (SOP 03-3) and determined that certain loans acquired in the FINA acquisition had evidence of deterioration of credit quality since origination and probable that all contractual required payments wound not be collected on these loans.  We determined that two loans with book value totaling approximately $0.28 million and a fair value of $0.07 were within the guidelines set forth under SOP 03-3.  We recorded these at their fair value and reduced the allowance for loan losses by $0.21 million.  Accordingly, we recorded $2.21 million of allowance for loan losses on loans not subject to SOP 03-3.  During the quarter ended June 30, 2007, we did not increase the allowance for loan losses for loans subject to SOP 03-3.
 
 
-7-


 Pro Forma Condensed Combined Financial Information
 
   The following pro forma condensed combined financial information presents the results of operations had the acquisition been completed as of the beginning of the periods indicated.

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2007
   
2006
   
2007
   
2006
 
Net interest income after (recovery of) provision for loan and lease losses
  $
31,950
    $
33,436
    $
61,908
    $
63,629
 
Noninterest income
   
24,731
     
19,416
     
43,807
     
39,231
 
Noninterest expense
   
40,359
     
37,070
     
75,330
     
71,155
 
Income before income taxes
   
16,322
     
15,782
     
30,385
     
31,705
 
Income tax expense
   
5,864
     
5,214
     
10,305
     
10,522
 
Net income
  $
10,458
    $
10,568
    $
20,080
    $
21,183
 
                                 
                                 
                                 
Per common share:
                               
  Basic net income per common share
  $
0.43
    $
0.43
    $
0.82
    $
0.86
 
  Diluted net income per common share
  $
0.42
    $
0.42
    $
0.81
    $
0.85
 
Basic weighted average common shares outstanding
   
24,552,223
     
24,630,849
     
24,590,784
     
24,701,312
 
Diluted weighted average common shares outstanding
   
24,847,554
     
24,936,312
     
24,885,928
     
25,002,009
 

Included in the above pro forma results are investment securities and other investment gains/(losses) of $3.01 million and ($0.13) million, after-tax, for the three months ended June 30, 2007 and 2006, respectively; and $3.84 million and $1.14 million, after-tax, for the six months ended June 30, 2007 and 2006, respectively.
 
 
Trustcorp Mortgage Company
 
    On May 1, 2007, the business of Trustcorp Mortgage Company was merged with 1st Source Bank; both of which are wholly owned subsidiaries of 1st Source Corporation.  We believe that this will allow us to focus our home mortgage efforts in 1st Source Bank’s retail footprint in Indiana and Michigan and provide a foundation for broadening direct relationships with our clients.  Prior to the acquisition by 1st Source Bank, both 1st Source Bank and Trustcorp Mortgage Company held a strong mortgage origination market share within 1st Source Bank’s traditional 15 county market of Northern Indiana and Southwestern Michigan.  This market will continue to be the focus of 1st Source Bank’s home mortgage business.

Note 3.  Recent Accounting Pronouncements
 
   In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No.  157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements, but it does not require any new fair value measurements.  SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years.  We are currently in the process of evaluating the impact of SFAS No. 157 on our Consolidated Financial Statements.
 
 
-8-

   In February 2007, the Financial Accounting Standards Board (FASB) issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB No. 115” (SFAS No. 159).  This standard permits an entity to choose to measure many financial instruments and certain other items at fair value.  The fair value option permits companies to choose to measure eligible items at fair value at specified election dates.  Companies will report unrealized gains and losses on items for which the fair value option has been elected in earnings after adoption.  SFAS No. 159 requires additional disclosures related to the fair value measurements included in the companies financial statements.  This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007.  Early adoption is permitted; however, we will adopt SFAS No. 159 on January 1, 2008.  We are evaluating the impact of SFAS No. 159 on the consolidated financial statements.
 
    In July 2006, the FASB issued FASB Interpretation No. 48 (FIN No. 48), “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” which clarifies the accounting for uncertainty in tax positions. FIN No. 48 requires that we recognize in our financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN No. 48 are effective as of the beginning of our 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings.  We adopted the provisions FIN No. 48 on January 1, 2007.  Details related to the adoption of FIN No. 48 and the impact on our financial statements are more fully discussed in Note 7 – Uncertainty in Income Taxes.
 
Note 4.  Reserve for Loan and Lease Losses
 
    The reserve for loan and lease losses is maintained at a level believed to be adequate by management to absorb probable losses inherent in the loan and lease portfolio.  The determination of the reserve requires significant judgment reflecting management’s best estimate of probable loan and lease losses related to specifically identified loans and leases as well as probable losses in the remainder of the various loan and lease portfolios.  The methodology for assessing the appropriateness of the reserve consists of several key elements, which include: specific reserves for identified special attention loans and leases (classified loans and leases and internal watch list credits), percentage allocations for special attention loans and leases without specific reserves, formula reserves for each business lending division portfolio, including a higher percentage reserve allocation for special attention loans and leases without a specific reserve, and reserves for pooled homogeneous loans and leases.  Management’s evaluation is based upon a continuing review of these portfolios, estimates of future customer performance, collateral values and dispositions and forecasts of future economic and geopolitical events, all of which are subject to judgment and will change.

Note 5.  Financial Instruments with Off-Balance-Sheet Risk
 
    To meet the financing needs of our customers, 1st Source Corporation and its subsidiaries are parties to financial instruments with off-balance-sheet risk in the normal course of business. These off-balance-sheet financial instruments include commitments to originate, purchase and sell loans and standby letters of credit.  The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition.  Our exposure to credit loss in the event of nonperformance by the other party to the financial instruments for loan commitments and standby letters of credit is represented by the dollar amount of those instruments. We use the same credit policies and collateral requirements in making commitments and conditional obligations as we do for on-balance-sheet instruments.

 
-9-


    1st Source Bank and FNBV, subsidiaries of 1st Source Corporation, grant mortgage loan commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan commitments is managed by entering into contracts for future deliveries of loans.  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.
 
    We issue letters of credit that are conditional commitments that guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.
 
    As of June 30, 2007 and December 31, 2006, 1st Source Bank had commitments outstanding to originate and purchase mortgage loans aggregating $75.35 million and $113.25 million, respectively. Outstanding commitments to sell mortgage loans aggregated $37.50 million at June 30, 2007, and $73.87 million at December 31, 2006. Standby letters of credit totaled $71.44 million and $83.15 million at June 30, 2007, and December 31, 2006, respectively at 1st Source Bank.  At June 30, 2007, standby letters of credit totaled $1.82 million at FBNV.   Standby letters of credit have terms ranging from six months to one year.

Note 6.  Stock-Based Compensation
 
    As of June 30, 2007, we had five stock-based employee compensation plans, which are more fully described in Note K of the Consolidated Financial Statements in 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2006.  These plans include two stock option plans, the Employee Stock Purchase Plan, the Executive Incentive Plan, and the Restricted Stock Award Plan.
 
    Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R), using the modified prospective transition method and, therefore, have not restated results for prior periods. Under this transition method, stock-based compensation expense for the first quarter of 2006 included compensation expense for all stock-based compensation awards granted prior to, but that remained unvested as of, January 1, 2006. Compensation expense was based on the grant date fair value estimated in accordance with the original provision of SFAS No. 123.
 
    Prior to January 1, 2006, we accounted for stock-based compensation under the recognition, measurement and pro forma disclosure provisions of APB No. 25, the original provisions of SFAS No. 123, and SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (SFAS 148). In accordance with APB No. 25, we generally would have recognized compensation expense for stock awards on the grant date and we generally would have recognized compensation expense for stock options only when we granted options with a discounted exercise price or modified the terms of previously issued options, and would have recognized the related compensation expense ratably over the associated service period, which was generally the option vesting term.
 
    Stock-based compensation expense for all stock-based compensation awards granted after January 1, 2006, is based on the grant-date fair value.  For all awards except stock option awards, the grant date fair value is either the fair market value per share or book value per share (corresponding to the type of stock awarded) as of the grant date.  For stock option awards, the grant date fair value is estimated using the Black-Scholes option pricing model.  For all awards we recognize these compensation costs only for those shares expected to vest on a straight-line basis over the requisite service period of the award, for which we use the related vesting term. We estimate forfeiture rates based on historical employee option exercise and employee termination experience. We have identified separate groups of awardees that exhibit similar option exercise behavior and employee termination experience and have considered them as separate groups in the valuation models and expense estimates.

   
 
-10-


    As a result of our January 1, 2006, adoption of SFAS No.123(R), the impact to the Consolidated Financial Statements for the three month period ended June 30, 2006 on income before income taxes and on net income were additions of $0.67 million and $0.41 million, respectively; and for the six month period ended June 30, 2006 on income before income taxes and on net income were additions of $1.82 million and $1.12 million, respectively.  The cumulative effect of the change in accounting was $0.66 million before income taxes and $0.40 million, after income taxes. The impact on both basic and diluted earnings per share for the three months ended June 30, 2006 was $0.02 per share. The impact on both basic and diluted earnings per share for the six months ended June 30, 2006 was $0.05 per share In addition, prior to the adoption of SFAS No. 123(R), we presented the tax benefit of stock option exercises as operating cash flows. Upon the adoption of SFAS No. 123(R), tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options are classified as financing cash flows.
 
    The stock-based compensation expense recognized in the condensed consolidated statement of operations for the six months ended June 30, 2007 and 2006 was based on awards ultimately expected to vest, and accordingly has been adjusted by the amount of estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based partially on historical experience.
 
    The aggregate intrinsic value in the table below represents the total pretax intrinsic value (the difference between 1st Source’s closing stock price on the last trading day of the second quarter of 2007 (June 30, 2007) and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on June 30, 2007, this amount changes based on the fair market value of 1st Source’s stock. Total intrinsic value of options exercised for the six months ended June 30, 2007 was $267 thousand. Total fair value of options vested and expensed was $28 thousand, net of tax, for the six months ended June 30, 2007.
 



 
 
 
   
 
   
 
   
 
 
 
 
June 30, 2007
   
 
   
 
 
 
 
 
   
 
   
Average
       
 
 
 
   
Weighted
   
Remaining
   
Total
 
 
 
 
   
Average
   
Contractual
   
Intrinsic
 
 
 
Number of
   
Grant-date
   
Term
   
Value
 
 
 
Shares
   
Fair Value
   
(in years)
   
(in 000's)
 
 
 
 
   
 
   
 
   
 
 
Options outstanding, beginning of year
   
489,475
    $
26.04
   
 
   
 
 
Granted
   
2,696
     
28.40
   
 
   
 
 
Exercised
    (20,654 )    
15.63
   
 
   
 
 
Forfeited
   
-
     
-
   
 
   
 
 
Options outstanding, June 30, 2007
   
471,517
    $
26.51
     
1.63
    $
559
 
 
                               
                                 
Vested and expected to vest at June 30, 2007
   
471,517
    $
26.51
     
1.63
    $
559
 
Exercisable at June 30, 2007
   
453,237
    $
26.91
     
1.48
    $
398
 
 


    The following weighted-average assumptions were used to estimate the fair value of options granted during the six months ended June 30, 2007:
  
                     Risk-free interest rate              4.10%
                     Expected dividend yield              1.94%
                     Expected volatility factor              30.46%
                     Expected option life              4.67 years


No options were granted during the six months ended June 30, 2006.
 
As of June 30, 2007, there was $1.91 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 5.38 years.
 
The following table summarizes information about stock options outstanding at June 30, 2007:

 
 
Weighted
 
 
 
 
 
Average
Weighted
 
Weighted
Range of
Number
Remaining
Average
Number
Average
Exercise
of shares
Contractual
Exercise
of shares
Exercise
Prices
Outstanding
Life
Price
Exercisable
Price
$12.04 to $17.99
29,508
5.24
$13.38
18,508
$14.18
$18.00 to $26.99
55,587
3.33
21.06
51,003
21.07
$27.00 to $28.40
386,422
1.10
28.30
383,726
28.30

    The fair value of each stock option was estimated on the date of grant using the Black-Scholes option-pricing model with the weighed average assumptions included on the table above. 

Note 7.  Uncertainty in Income Taxes

    We adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007.  As a result of the implementation of FIN No. 48, we recognized no change in the liability for unrecognized tax benefits.
 

-12-

 
    
    The total amount of unrecognized tax benefits at January 1, 2007, was $5.79 million.  Of that amount, $3.33 million would affect the effective tax rate if recognized.  We recognize interest and penalties through the income tax provision.  The total amount of interest and penalties on the date of adoption was $0.87 million.

Tax years that remain open and subject to audit include federal 2003–2006 years and Indiana 2002–2006 years.  Additionally, we have an open tax examination with the Indiana Department of Revenue for the tax years 2002-2004.  Indiana is currently proposing adjustments for certain apportionment issues.  We are appealing these adjustments.

ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
    Except for historical information contained herein, the matters discussed in this document express “forward-looking statements.” Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “will,” “should,” and similar expressions indicate forward-looking statements. Those statements, including statements, projections, estimates or assumptions concerning future events or performance, and other statements that are other than statements of historical fact, are subject to material risks and uncertainties. We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made. We may make other written or oral forward-looking statements from time to time. Readers are advised that various important factors could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected in such forward-looking statements. Such factors include, but are not limited to, changes in law, regulations or U. S. generally accepted accounting principles; our competitive position within the markets we serve; increasing consolidation within the banking industry; unforeseen changes in interest rates; unforeseen changes in loan prepayment assumptions; unforeseen downturns in or major events affecting the local, regional or national economies or the industries in which we have credit concentrations; and other matters discussed in our filings with the SEC, including our Annual Report on Form 10-K  for 2006, which filings are available from the SEC. We undertake no obligation to publicly update or revise any forward-looking statements.

    The following management’s discussion and analysis is presented to provide information concerning our financial condition as of June 30, 2007, as compared to December 31, 2006, and the results of operations for the three and six month periods ended June 30, 2007 and 2006. 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 2006 Annual Report.
 

-13-

 

IMPACT OF FIRST NATIONAL BANK, VALPARAISO ACQUISITION

The following disclosure is not determined in accordance with generally accepted accounting principles (GAAP) and is considered a non-GAAP disclosure.  Management believes that this presentation, while not in accordance with GAAP, provides useful insight as to the impact of the acquisition of First National Bank, Valparaiso on the financial condition from the date of acquisition to June 30, 2007.

We acquired First National Bank, Valparaiso (FNBV) on May 31, 2007 (See Note 2 of the Notes to Consolidated Financial Statements for information concerning this acquisition).  The following table shows (for selected balance sheet items at June 30, 2007) the consolidated balance sheet item, the total for the balance sheet item for FNBV, and the total for the balance sheet item without FNBV.

                       
(Unaudited - Dollars in thousands)
                       
   
1st Source
         
1st Source
   
1st Source
 
   
Consolidated
   
FNBV
   
Without FNBV
   
Consolidated
 
   
June 30,
   
June 30,
   
June 30,
   
December 31,
 
   
2007
   
2007
   
2007
   
2006
 
Investment securities available-for-sale
  $
794,604
    $
92,198
    $
702,406
    $
708,672
 
                                 
Total loans and leases
   
3,134,170
     
238,979
     
2,895,191
     
2,702,537
 
   Reserve for loan and lease losses
    (62,682 )     (2,230 )     (60,452 )     (58,802 )
Net loans and leases
   
3,071,488
     
236,749
     
2,834,739
     
2,643,735
 
                                 
Net premises and equipment
   
50,847
     
14,034
     
36,813
     
37,326
 
                                 
Goodwill and other intangible assets
   
91,196
     
71,928
     
19,268
     
19,418
 
                                 
Deposits:
                               
  Noninterest bearing
   
380,681
     
50,225
     
330,456
     
339,866
 
  Interest bearing
   
3,204,760
     
512,241
     
2,692,519
     
2,708,418
 
Total deposits
   
3,585,441
     
562,466
     
3,022,975
     
3,048,284
 
                                 
Federal funds purchased and securities sold under agreements to repurchase
   
241,578
     
17,497
     
224,081
     
195,262
 
                                 
Total assets
   
4,504,650
     
718,291
     
3,786,359
     
3,807,315
 

 
FINANCIAL CONDITION

Our total assets at June 30, 2007, were $4.50 billion, up $697.34 million or 18.32% from December 31, 2006.  The increase in assets was due to the acquisition of FNBV which had assets, including goodwill, of $718.29 million at June 30, 2007.

Total loans and leases were $3.13 billion at June 30, 2007, an increase of $431.63 million or 15.97% from December 31, 2006.  The acquisition of FNBV contributed $238.98 million toward the increase in total loans and leases at June 30, 2007.

Total deposits at June 30, 2007, were $3.59 billion, up $537.16 million or 17.62% over the comparable figures at the end of 2006.  The increase in deposits was due to the acquisition of FNBV which had total deposits of $562.47 million at June 30, 2007.
 
 
-14-

 

    Nonperforming assets at June 30, 2007, were $15.69 million compared to $17.67 million at December 31, 2006, an improvement of 11.20%.  The most significant decrease was primarily in the aircraft financing, offset by an increase in loans secured by real estate.   At June 30, 2007, nonperforming assets were 0.49% of net loans and leases compared to 0.64% at December 31, 2006.

Other assets were as follows:
 

(Dollars in Thousands)
 
 
 
 
 
 
 
 
 
June 30,
   
December 31,
 
 
 
2007
   
2006
 
Other assets:
 
 
   
 
 
Bank owned life insurance cash surrender value
  $
38,458
    $
36,157
 
Accrued interest receivable
   
19,849
     
17,997
 
Mortgage servicing assets
   
7,881
     
7,572
 
Other real estate
   
2,856
     
800
 
Repossessions
   
2,183
     
975
 
Goodwill
   
81,924
     
18,851
 
Intangible assets
   
9,272
     
567
 
All other assets
   
26,684
     
25,084
 
Total other assets
  $
189,107
    $
108,003
 


 
CAPITAL

As of June 30, 2007, total shareholders' equity was $425.53 million, up $56.62 million or 15.35% from the $368.90 million at December 31, 2006.  Common stock increased by $53.68 million due to the issuance of 2,124,974 1st Source common shares for the acquisition of FINA.  Other significant changes in shareholders’ equity during the first six months of 2007 included net income of $16.58 million, $6.11 million in treasury stock purchases, and $6.32 million of dividends paid.  The accumulated other comprehensive loss component of shareholders’ equity totaled $2.01 million at June 30, 2007, compared to $0.26 million at December 31, 2006.  The increase in accumulated other comprehensive loss was a result of changes in unrealized gain or loss on securities in the available-for-sale portfolio.  Our equity-to-assets ratio was 9.45% as of June 30, 2007, compared to 9.69% at December 31, 2006. Book value per common share rose to $17.43 at June 30, 2007, up from $16.40 at December 31, 2006.

We declared and paid dividends per common share of $0.14 during the second quarter of 2007.  The trailing four quarters dividend payout ratio, representing dividends per share divided by diluted earnings per share, was 36.13%.  The dividend payout is continually reviewed by management and the Board of Directors.

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 and required capital amounts and ratios of 1st Source Corporation, 1st Source Bank and FNBV, as of June 30, 2007, are presented in the table below:
 



                                     
                           
To Be Well
 
                           
Capitalized Under
 
               
Minimum Capital
   
Prompt Corrective
 
   
Actual
   
Adequacy
   
Action Provisions
 
(Dollars in thousands)
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
Total Capital (To Risk-Weighted Assets):
                                   
1st Source Corporation
  $
480,022
      13.46 %   $
285,271
      8.00 %   $
356,588
      10.00 %
1st Source Bank
   
398,755
     
12.06
     
264,412
     
8.00
     
330,515
     
10.00
 
  FNBV
    63,186       22.23       22,735       8.00       28,419       10.00  
Tier 1 Capital (to Risk-Weighted Assets):
                                               
1st Source Corporation
   
433,403
     
12.15
     
142,635
     
4.00
     
213,953
     
6.00
 
1st Source Bank
   
356,254
     
10.78
     
132,206
     
4.00
     
198,309
     
6.00
 
  FNBV
    60,665       21.35       11,367         4.00       17,051       6.00  
Tier 1 Capital (to Average Assets):
                                               
1st Source Corporation
   
433,403
     
11.02
     
157,246
     
4.00
     
196,557
     
5.00
 
1st Source Bank
   
356,254
     
9.36
     
152,245
     
4.00
     
190,307
     
5.00
 
  FNBV
    60,665       11.22       21,624       4.00       27,029       5.00  
 
 

LIQUIDITY AND INTEREST RATE SENSITIVITY
 
    Effective liquidity management ensures that the cash flow requirements of depositors and borrowers, as well as the operating cash needs of 1st Source Corporation, are met.  Funds are available from a number of sources, including the securities portfolio, the core deposit base, Federal Home Loan Bank borrowings, and the capability to package loans for sale.   Our loan to asset ratio was 69.58% at June 30, 2007 compared to 70.98% at December 31, 2006 and 72.47% at June 30, 2006.  Cash and cash equivalents totaled $97.69 million at June 30, 2007 compared to $118.13 million at December 31, 2006 and $118.88 million at June 30, 2006.  At June 30, 2007, the consolidated statement of financial condition was rate sensitive by $656.00 million more liabilities than assets scheduled to reprice within one year, or approximately 0.80%.  Management believes that the present funding sources provide adequate liquidity to meet our cash flow needs.

SUBORDINATED DEBT
 
    During the second quarter of 2007, we completed the private placement issuance of $40 million of trust preferred securities through a newly formed subsidiary trust organized under Delaware law.  The trust preferred securities were issued at $1,000.00 per share and bear a 7.2175 percent per annum fixed rate of interest, payable quarterly.  The securities are redeemable after five years and are due in 2037.  The net proceeds of the issuance were used to fund a portion of the purchase price for FINA.
 
    During the second quarter of 2007, we obtained commitments for two additional fundings of trust preferred securities that may occur over the next five months.  The trust preferred securities are intended to qualify as tier 1 capital.  The two additional fundings of trust preferred securities may occur as follows:  $17 million to be funded on or before August 1, 2007, at a rate to be determined, and $33 million to be funded on or before October 31, 2007, at a rate to be determined.  These subsequent fundings are expected to be utilized primarily for debt restructuring.
 
    Additionally, during the second quarter of 2007, we provided notice to the trustee for the 690,000 shares of floating rate trust preferred securities issued by 1st Source Capital Trust II of our plans to redeem these securities on August 1, 2007.  The redemption price will be $25.00 per preferred security plus accrued dividends to the date of redemption.
 
 
-16-

 


RESULTS OF OPERATIONS
    
    Net income for the three and six month periods ended June 30, 2007, was $8.06 million and $16.58 million respectively, compared to $10.28 million and $20.21 million for the same periods in 2006.  Diluted net income per common share was $0.34 and $0.72 respectively, for the three and six month periods ended June 30, 2007, compared to $0.45 and $0.88 for the same periods in 2006.  Return on average common shareholders' equity was 8.68% for the six months ended June 30, 2007, compared to 11.62% in 2006. The return on total average assets was 0.87% for the six months ended June 30, 2007, compared to 1.18% in 2006.
 
    The decrease in net income for the six months ended June 30, 2007, over the first six months of 2006, was primarily the result of an increase of $2.60 million to our provision for loan and lease losses, a $1.52 million decline in noninterest income and a $4.45 million increase in noninterest expense, which were partially offset by a $2.04 million reduction in income tax expense.  Details of the changes in the various components of net income are further discussed below.

NET INTEREST INCOME
 
    The taxable equivalent net interest income for the three months ended June 30, 2007, was $29.61 million, an increase of 6.49% over the same period in 2006. The net interest margin on a fully taxable equivalent basis was 3.16% for the three months ended June 30, 2007, compared to 3.44% for the three months ended June 30, 2006. The taxable equivalent net interest income for the six month period ended June 30, 2007, was $56.58 million, an increase of 5.69% over 2006, resulting in a net yield of 3.17%, compared to a net yield of 3.36% for the same period in 2006.
 
    Average earning assets increased $506.53 million or 15.60% and $393.75 million or 12.27%, respectively, for the three and six month periods ended June 30, 2007, over the comparable periods in 2006.  Average interest-bearing liabilities increased $497.03 million or 18.42% and $396.39 million or 14.87%, respectively, for the three and six month periods ended June 30, 2007, over the comparable period one year ago.  The acquisition of FNBV increased our average earning assets by $92.20 million and our average interest-bearing liabilities by $84.63 million.  The yield on average earning assets increased 38 basis points to 6.74% for the second quarter of 2007 from 6.36% for the second quarter of 2006.  The yield on average earning assets for the six month period ended June 30, 2007, increased 51 basis points to 6.70% from 6.19% for the six month period ended June 30, 2006. The rate earned on assets continued to experience positive impacts from the increases in short-term market interest rates from a year ago.  Total cost of average interest-bearing liabilities increased 69 basis points to 4.20% for the second quarter of 2007 from 3.51% for the second quarter of 2006. Total cost of average interest-bearing liabilities increased 76 basis points to 4.16% for the six month period ended June 30, 2007 from 3.40% for the six month period ended June 30, 2006.  The cost of interest-bearing liabilities was also affected by short-term market interest rates.  The result to the net interest margin, or the difference between interest income on earning assets and expense on interest-bearing liabilities, was a decrease of 28 basis points and 19 basis points, respectively, for the three and six month periods ended June 30, 2007 from June 30, 2006.

    The largest contributor to the increase in the yield on average earning assets for the first six months of 2007, on a volume-weighted basis, was the $303.60 million or 12.14% increase in net loans and leases as compared to the first six months of 2006.   Average loans and leases grew by $357.22 million or 14.05% during the second quarter of 2007, compared to the second quarter of 2006.  Average loans and leases outstanding increased across our entire portfolio, most notably in construction equipment financing, commercial loans, aircraft financing, loans secured by real estate, and medium and heavy duty truck financing for both the second quarter and year-to-date 2007 as compared to 2006.   The acquisition of FNBV increased our average loans and leases by $39.58 million.  The majority of loans acquired from FNBV were loans secured by real estate.
 
 
-17-

    Total average investment securities increased 12.26% and 8.62%, respectively, for the three- and six- month periods over one year ago.  This increase was mainly due to an increase in federal agency, mortgage-backed, and municipal securities.  Average mortgages held for sale decreased 41.36% and 33.72% respectively, for the three- and six- month periods over the same periods one year ago.  During the second quarter of 2007 production volume decreased approximately 54% as we reduced our mortgage purchase activity with the majority of our production affiliates.  Production volume decreased approximately 43% on a year-over-year basis mainly due to a decrease in demand.  Other investments, which include federal funds sold, time deposits with other banks and commercial paper, increased 4.27 times for the three month period ended June 30, 2007 from same period one year ago, and 2.12 times for the first six months of 2007 as compared to the first six months of 2006 as excess funds were invested.   The acquisition of FNBV added $20.84 million to our average investment securities portfolio, the majority of which was in federal agency and municipal securities.

     Average interest-bearing deposits increased $505.70 million or 21.66% and $415.94 million or 18.14%, respectively, for the second quarter of 2007 and first six months of 2007, over the same periods in 2006. The effective rate paid on average interest-bearing deposits increased 76 basis points to 4.07% for the second quarter of 2007 compared to 3.31% for the second quarter of 2006.  The effective rate paid on average interest-bearing deposits increased 83 basis points to 4.02% for the first six months of 2007 compared to 3.19% for the first six months of 2006.The increase in the average cost of interest-bearing deposits during the second quarter and first six months of 2007 as compared to the second quarter and first six months of 2006 was primarily the result of increases in interest rates offered on deposit products due to increases in market interest rates and increased competition for deposits across all markets.  The acquisition of FNBV increased our average interest-bearing deposits by $81.70 million.

    Short term borrowings decreased $29.60 million or 10.93% and $36.32 million or 12.91%, respectively, for the second quarter of 2007 and the first six months of 2007, compared to the same time periods in 2006.  Interest paid on short-term and trust preferred borrowings increased due to the interest rate increase in adjustable rate borrowings.  Average long-term debt increased $10.05 million or 30.00% during the second quarter of 2007 as compared to the second quarter of 2006.  Average long-term debt increased $11.31 million or 35.07% during the first six months of 2007 as compared to the first six months of 2006.  The majority of the increase in long-term debt was made up of Federal Home Loan Bank borrowings.  Additionally, we issued $40.00 million of trust preferred securities on June 7, 2007, which were to fund a portion of the purchase price for FNBV.
 
    Average demand deposits decreased $20.16 million and $34.54 million, respectively, for the three- and six-month period ended June 30, 2007 as compared to the three- and six- month periods of 2006.  Much of the decline was due to the reclassification of some of our deposit products from noninterest bearing to interest bearing and a decrease in escrow deposit accounts concurrent with the reduction in our mortgage servicing portfolio.  The acquisition of FNBV added $8.31 million to our average demand deposits.
 
    The following table provides an analysis of net interest income and illustrates the interest earned and interest expense charged for each major component of interest earning assets and interest bearing liabilities.  Yields/rates are computed on a tax-equivalent basis, using a 35% rate.  Nonaccrual loans and leases are included in the average loan and lease balance outstanding.
 

 


DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY
 
INTEREST RATES AND INTEREST DIFFERENTIAL
                                                 
(Dollars in thousands)
                                                 
   
Three months ended June 30,
   
Six months ended June 30,
 
         
2007
               
2006
               
2007
               
2006
       
   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
 
         
Interest
               
Interest
               
Interest
               
Interest
       
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
 
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
ASSETS:
                                                                       
Investment securities:
 
 
                                                                   
Taxable
  $
494,114
    $
5,991
      4.86 %   $
453,246
    $
4,797
      4.25 %   $
489,328
    $
11,721
      4.83 %   $
456,013
    $
8,722
      3.86 %
Tax exempt
   
210,090
     
2,364
      4.51 %    
174,071
     
1,855
      4.27 %    
195,556
     
4,382
      4.52 %    
174,547
     
3,682
      4.25 %
Mortgages - held for sale
   
32,047
     
494
      6.18 %    
54,654
     
916
      6.72 %    
35,489
     
1,132
      6.43 %    
53,545
     
1,743
      6.56 %
Net loans and leases
   
2,899,340
     
52,681
      7.29 %    
2,542,118
     
43,604
      6.88 %    
2,803,434
     
100,409
      7.22 %    
2,499,834
     
83,729
      6.75 %
Other investments
   
117,270
     
1,542
      5.27 %    
22,240
     
271
      4.89 %    
79,262
     
2,074
      5.28 %    
25,380
     
587
      4.66 %
                                                                                                 
Total Earning Assets
   
3,752,861
     
63,072
      6.74 %    
3,246,329
     
51,443
      6.36 %    
3,603,069
     
119,718
      6.70 %    
3,209,319
     
98,463
      6.19 %
                                                                                                 
Cash and due from banks
   
79,994
                     
80,058
                     
75,107
                     
80,001