The following management's discussion and analysis is presented to provide information concerning1st Source Corporation and its subsidiaries' (collectively referred to as "the Company", "we", and "our") financial condition as ofJune 30, 2020 , as compared toDecember 31, 2019 , and the results of operations for the three and six months endedJune 30, 2020 and 2019. 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 2019 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; more recently, potential impacts of the COVID-19 pandemic; and other matters discussed in our filings with theSEC , including our Annual Report on Form 10-K for 2019, which filings are available from theSEC . We undertake no obligation to publicly update or revise any forward-looking statements. FINANCIAL CONDITION Our total assets atJune 30, 2020 were$7.37 billion , an increase of$742.37 million or 11.21% fromDecember 31, 2019 . Total investment securities, available-for-sale were$1.06 billion , an increase of$15.21 million or 1.46% fromDecember 31, 2019 . Federal funds sold and interest bearing deposits with other banks were$112.65 million , an increase of$96.50 million or 597.49% fromDecember 31, 2019 . Total loans and leases were$5.69 billion , an increase of$606.80 million or 11.93% fromDecember 31, 2019 . The largest contributor to the increase in loans and leases was PPP loans funded during the second quarter of 2020. PPP loans are discussed in the "COVID-19 Impact" section below. Our foreign loan and lease balances, all denominated inU.S. dollars were$160.41 million and$184.24 million as ofJune 30, 2020 andDecember 31, 2019 , respectively. Foreign loans and leases are in aircraft financing. Loan and lease balances to borrowers inBrazil andMexico were$44.28 million and$109.36 million as ofJune 30, 2020 , respectively, compared to$58.29 million and$111.91 million as ofDecember 31, 2019 , respectively. As ofJune 30, 2020 andDecember 31, 2019 there was not a significant concentration in any other country. Solar loan and lease balances were$248.40 million as ofJune 30, 2020 , an increase of$78.78 million or 46.45% from the$169.62 million atDecember 31, 2019 . Solar loan and lease balances are included in commercial and agricultural loans. Equipment owned under operating leases was$86.18 million , a decrease of$25.50 million , or 22.83% compared toDecember 31, 2019 . The largest contributor to the decrease in equipment owned under operating leases was reduced leasing volume primarily due to a change in customer preferences. Total deposits were$5.99 billion , an increase of$636.13 million or 11.87% from the end of 2019. The largest contributors to the increase in total deposits was PPP loan fundings into business accounts and government stimulus payments. Short-term borrowings were$177.02 million , an increase of$31.13 million or 21.33% fromDecember 31, 2019 . Long-term debt and mandatorily redeemable securities were$81.76 million , an increase of$10.12 million or 14.13% fromDecember 31, 2019 . 3 -------------------------------------------------------------------------------- Table of Contents The following table shows accrued income and other assets. June 30, December 31, (Dollars in thousands) 2020
2019
Accrued income and other assets: Bank owned life insurance cash surrender value$ 69,879 $ 68,774 Operating lease right of use assets 22,744 24,147 Accrued interest receivable 20,976 19,125 Mortgage servicing rights 3,748 4,200 Other real estate 303 522 Repossessions 6,132 8,623 Partnership investments carrying amount 77,147
61,083
All other assets 78,390
41,516
Total accrued income and other assets$ 279,319 $
227,990
The largest contributors to the increase in accrued income and other assets from
CORONAVIRUS (COVID-19) IMPACT The following is a description of the impact the Coronavirus (COVID-19) pandemic is having on our financial condition and results of operations and certain risks to our business that the pandemic creates or exacerbates. Operational Impact As part of our contingency and disaster recovery plans for pandemic outbreaks, we created a dedicated executive COVID-19 response team that is closely monitoring developments and providing guidance for additional precautions and initiatives. We have established separate teams within departments to help ensure that infection will not spread across entire departments. We are encouraging virtual meetings and conference calls in place of in-person meetings, including our annual shareholder meeting which was held virtually this year. Employees with health conditions putting them at higher risk of adverse effects from coronavirus infection are working remotely. Additionally, travel has been restricted. We are promoting social distancing, frequent hand washing, thorough disinfection of all surfaces, and the use of masks or nose and mouth coverings have been mandated in all of our locations. Our banking center lobbies have been closed except for advance appointments only. Banking center drive-ups, ATMs and online/mobile banking services continue to operate. It remains undetermined how long our banking centers will operate at these service levels. Infection rates in the communities we serve vary by region and we will make prudent decisions for the safety of our colleagues and our clients. 4 -------------------------------------------------------------------------------- Table of Contents Loan and lease modifications We began receiving requests from our borrowers for loan and lease deferrals in March. Modifications include the deferral of principal payments or the deferral of principal and interest payments for terms generally 90 - 180 days. Requests are evaluated individually and approved modifications are based on the unique circumstances of each borrower. We are committed to working with our clients to allow time to work through the challenges of this pandemic. At this time, it is uncertain what future impact loan and lease modifications related to COVID-19 difficulties will have on our financial condition, results of operations and reserve for loan and lease losses. The following table shows coronavirus loan and lease modification balances as ofJune 30, 2020 . Recorded Principal Only Principal and Interest
Total COVID-19 Related Investment at Modifications as a % of (Dollars in millions) Deferrals
Deferrals Modifications June 30, 2020 June 30, 2020 Balance Auto and light truck rental $ 170 $ 54 $ 224$ 411 55 % Specialty vehicle(1) 2 73 75 153 49 % Medium and heavy duty truck 87 - 87 284 31 % Aircraft 80 13 93 782 12 % Construction 120 19 139 739 19 % Commercial 129 81 210 2,654 8 % Residential real estate and home equity 2 2 4 532 1 % Consumer - 8 8 137 6 % Total loans 590 250 840 5,692 15 % PPP loans, net of unearned discount(2) - - - 573 - % Total loans less PPP loans $ 590 $ 250 $ 840$ 5,119 16 % (1) Includes motor coaches, shuttle buses, step vans, work trucks and funeral cars. (2) PPP loan balances are located within the Commercial category above. Paycheck Protection Program (PPP) and Liquidity As part of the CARES Act, approved by the President onMarch 27, 2020 and extended onJuly 4, 2020 , theSmall Business Administration (SBA) has been authorized to guarantee loans under the PPP throughAugust 8, 2020 for businesses who meet the necessary eligibility requirements in order to keep their workers on the payroll. We began accepting applications onApril 3, 2020 . PPP loans are fully guaranteed by the SBA and as such do not represent a credit risk. The following table shows PPP loan disbursements as ofJune 30, 2020 . Number of Loans $ of Loans (000's) Average Loan Size Phase One 2,024 $ 520,583$ 257,000 Phase Two 1,326 71,649 54,000 Total 3,350 $ 592,232$ 177,000 As ofJune 30, 2020 , PPP loans were$573.15 million which is net of an unearned discount of$16.43 million and located within the commercial and agricultural portfolio. AtJune 30, 2020 , specialty finance customers had$103.43 million of PPP loans and traditional commercial banking customers had$469.72 million of PPP loans. OnApril 9, 2020 , theFDIC ,Federal Reserve and OCC created the Paycheck Protection Program Liquidity Facility (PPPLF) to bolster the effectiveness of the PPP by providing liquidity to and neutralizing the regulatory capital effects on participating financial institutions. We intend to utilize the liquidity relief offered by the PPPLF to the extent needed and as such do not expect our participation in the PPP to have a negative impact on our liquidity position, capital resources, financial condition or results of operations. As ofJune 30, 2020 , we had not yet utilized the PPPLF. See Part I Financial Information, Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations under the heading "Capital" for more information regarding the COVID-19 impact on share repurchases and dividend activity. Asset impairment Our MSRs have experienced a decrease in their fair value as ofJune 30, 2020 resulting in impairment charges of$0.55 million due to decreased mortgage rates leading to faster prepayment speeds. We will continue to evaluate MSRs at each reporting date to determine whether further valuation allowances are appropriate. 5 -------------------------------------------------------------------------------- Table of Contents We evaluate goodwill for impairment during the fourth quarter of each year, with financial data as ofSeptember 30 . Based on the analysis performed as ofOctober 1, 2019 , we determined that goodwill for our reporting units was not impaired. During the first quarter of 2020, management determined that the deterioration in general economic conditions as a result of the COVID-19 pandemic and responses thereto represented a triggering event prompting an evaluation of goodwill impairment. Based on the analyses performed during the first and second quarters of 2020, we determined that goodwill was not impaired. At this time, we do not believe there exists any impairment to our intangible assets, long-lived assets, right of use assets, or available-for-sale investment securities due to the COVID-19 pandemic. It is uncertain whether prolonged effects of the COVID-19 pandemic will result in future impairment charges related to any of the aforementioned assets. Risks See Part II Other Information, Item 1A, Risk Factors for more information. Reserve for loan and lease losses We have experienced increasing downgrades and defaults as a result of the impact COVID-19 is having on our borrowers as evidenced by increasing special attention and non-performing loan balances. Special attention loan balances increased$46.72 million in the second quarter of 2020 and$67.58 million sinceDecember 31, 2019 and we anticipate further downgrades during the latter half of 2020 and into 2021. Likewise, non-performing loans increased by$36.56 million during the second quarter and$52.96 million since year-end. Second quarter 2020 downgrades were concentrated in auto rental and bus segments within the auto and light truck portfolio as well as a couple of industry specific downgrades in the construction equipment portfolio. We are in communication with our customers to gain a better understanding of our highest risk exposures and probable defaults. This quarter, we sent questionnaires to all of our bus customers in order to better understand their current situations, their customer bases and the likely long-term impact of the economic downturn on their business models, i.e. their ability to withstand reduced revenues for an extended period of time. As a result of the responses and discussions with our customers, we downgraded an additional eleven bus accounts to special attention and placed several of these accounts on nonaccrual status. We anticipate further defaults in our bus lending during the third quarter of 2020. Furthermore, the bus collateral may be difficult to liquidate, particularly in this environment. We believe our auto rental customers will continue to struggle; however, vehicle auctions are well established and are an effective means of liquidating collateral and used vehicle values, to date, have remained strong, so our loss exposure, with the exception of possible fraud, is well managed. Our local market customers have been buoyed in the short-term with funds from the PPP program. Thus far, we have not seen many downgrades or defaults in our commercial lending, but we anticipate this will change particularly as businesses continue to struggle. During the last recession, we also noted a delayed impact on our commercial lending as compared to our specialty finance lending. Our losses year-to-date remain low but we continue to build reserves as we anticipate some of the current and future downgrades and defaults will eventually result in losses. See Part I Financial Information, Note 5 to the Consolidated Financial Statements and Part I Financial Information, Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations under the heading "Provision and Reserve for Loan and Lease Losses" for more information. CAPITAL As ofJune 30, 2020 , total shareholders' equity was$865.00 million , up$36.72 million , or 4.43% from the$828.28 million atDecember 31, 2019 . In addition to net income of$34.92 million , other significant changes in shareholders' equity during the first six months of 2020 included$14.58 million of dividends paid. The accumulated other comprehensive income component of shareholders' equity totaled$19.89 million atJune 30, 2020 , compared to$5.17 million atDecember 31, 2019 . Our shareholders' equity-to-assets ratio was 11.74% as ofJune 30, 2020 , compared to 12.51% atDecember 31, 2019 . Book value per common share rose to$33.85 atJune 30, 2020 , from$32.47 atDecember 31, 2019 . We declared and paid cash dividends per common share of$0.28 during the second quarter of 2020. The trailing four quarters dividend payout ratio, representing cash dividends per common share divided by diluted earnings per common share, was 35.65%. The dividend payout is continually reviewed by management and the Board of Directors subject to the Company's capital and dividend policy. Due to COVID-19, we have temporarily suspended the repurchase of common shares from the open market. Management and the Board of Directors will evaluate future share repurchases and dividend payments based on a careful examination of facts and circumstances at such time and in accordance with 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 forU.S. banking organizations. 6 -------------------------------------------------------------------------------- Table of Contents The actual capital amounts and ratios of1st Source Corporation and1st Source Bank as ofJune 30, 2020 , are presented in the table below. To Be Well Capitalized Minimum Capital Adequacy with Capital Under Prompt Corrective Actual Minimum Capital Adequacy Buffer Action Provisions (Dollars in thousands) AmountRatio AmountRatio AmountRatio AmountRatio Total Capital (to Risk-Weighted Assets):1st Source Corporation $ 934,880 15.58 %$ 479,935 8.00 %$ 629,915 10.50 %$ 599,919 10.00 %1st Source Bank 848,568 14.13 480,442 8.00 630,580 10.50 600,553 10.00 Tier 1 Capital (to Risk-Weighted Assets):1st Source Corporation 859,152 14.32 359,951 6.00 509,931 8.50 479,935 8.001st Source Bank 772,761 12.87 360,332 6.00 510,470 8.50 480,442 8.00 Common Equity Tier 1 Capital (to Risk-Weighted Assets):1st Source Corporation 765,494 12.76 269,964 4.50 419,943 7.00 389,947 6.501st Source Bank 736,103 12.26 270,249 4.50 420,387 7.00 390,359 6.50 Tier 1 Capital (to Average Assets):1st Source Corporation 859,152 12.12 283,609 4.00 N/A N/A 354,511 5.001st Source Bank 772,761 10.90 283,585 4.00 N/A N/A 354,481 5.00 As part of the CARES Act, PPP loan balances have been assigned a zero percent risk weight and therefore had no impact on our total risk-weighted assets atJune 30, 2020 . 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. 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. AtJune 30, 2020 , we had no borrowings in the federal funds market. We could borrow$225.00 million in additional funds for a short time from these banks on a collective basis. As ofJune 30, 2020 , we had$55.48 million outstanding in FHLB advances and could borrow an additional$550.54 million contingent on the FHLB activity-based stock ownership requirement. We also had no outstandings with the FRB and could borrow$449.80 million as ofJune 30, 2020 . Our loan to asset ratio was 77.29% atJune 30, 2020 compared to 76.79% atDecember 31, 2019 and 76.83% atJune 30, 2019 . Cash and cash equivalents totaled$180.24 million atJune 30, 2020 compared to$83.37 million atDecember 31, 2019 and$96.49 million atJune 30, 2019 . The largest contributors to the increase in cash and cash equivalents was higher deposit balances from PPP loan fundings, customer receipts from the government's Economic Impact Payment program and theTreasury Department's and Internal Revenue Service's decision to delay the deadline for tax filings and payments. AtJune 30, 2020 , the Consolidated Statements of Financial Condition was rate sensitive by$303.41 million more assets than liabilities scheduled to reprice within one year, or approximately 1.09%. Management believes that the present funding sources provide adequate liquidity to meet our cash flow needs. UnderIndiana law governing the collateralization of public fund deposits, theIndiana 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, theBoard 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$807 million . RESULTS OF OPERATIONS Net income available to common shareholders for the three and six month periods endedJune 30, 2020 was$18.50 million and$34.92 million , compared to$23.39 million and$45.58 million for the same periods in 2019. Diluted net income per common share was$0.72 and$1.36 for the three and six month periods endedJune 30, 2020 , compared to$0.91 and$1.76 for the same periods in 2019. Return on average common shareholders' equity was 8.23% for the six months endedJune 30, 2020 , compared to 11.75% in 2019. The return on total average assets was 1.02% for the six months endedJune 30, 2020 , compared to 1.44% in 2019. 7
--------------------------------------------------------------------------------
Table of Contents Net income decreased for the six months endedJune 30, 2020 compared to the first six months of 2019. Net interest income decreased and the provision for loan and lease losses increased which was offset by a decrease in noninterest expense. Details of the changes in the various components of net income are discussed further below.
© Edgar Online, source