SRCE

1st Source Corp. 10-Q Summary: Period Ended June 30, 2002

Business Context and Reporting Period

This filing is a Quarterly Report (Form 10-Q) for 1st Source Corporation, a financial institution headquartered in South Bend, Indiana. The report covers the quarterly period ended June 30, 2002, and compares results to the same periods in 2001 and the year-end position of December 31, 2001. The company operates primarily in banking, trust services, and equipment leasing.

Key Financial Metrics

Material Changes vs. Prior Period

• Significant Profit Decline: Net income for the six months ended June 30, 2002, dropped 70% compared to the same period in 2001 ($6.98M vs. $23.09M). This was driven by a sharp increase in the provision for loan losses and noninterest expenses, partially offset by higher net interest income.
• Asset Quality Deterioration: Nonperforming assets increased 40.9% to $61.0 million (2.37% of net loans) from $43.3 million at year-end 2001. Net charge-offs for the six-month period were $22.76 million, compared to $4.07 million in 2001.
• Loan Portfolio Contraction: Total loans decreased 2.9% to $2.46 billion, and total deposits decreased 3.2% to $2.79 billion compared to December 31, 2001.
• Noninterest Income Shift: Loan servicing and sale income decreased 64.3% year-to-date. This decline is largely due to the absence of a $1.0 billion sale of mortgage servicing rights that occurred in Q1 2001, which generated $11.06 million in pre-tax income.
• Expense Growth: Noninterest expenses increased 13.4% year-to-date, driven by higher salaries (due to branch acquisitions in late 2001), increased repossession/collection costs, and amortization of intangible assets.

Outlook, Risks, and Management Commentary

• Economic Headwinds: Management cites a difficult environment caused by the slowdown in technology markets, stock market sell-offs, and a falloff in durable goods manufacturing, all exacerbated by the September 11th events.
• Specific Sector Risks: The company faces substantial loan losses in its niche businesses, specifically aircraft financing and used automobile rental financing. Collateral values for aircraft and used autos have dropped precipitously.
• Future Volatility: Management expects nonperforming assets to fluctuate over the remainder of the year. Large relationships (up to $15 million) in these sectors could significantly impact the nonperforming asset count if they become problem accounts.
• Capital Position: Despite the earnings decline, the company remains well-capitalized. The Tier 1 risk-based capital ratio was 10.94% and total risk-based capital was 12.25%, exceeding regulatory requirements for "well-capitalized" status.
• Accounting Changes: The company adopted FASB No. 142 regarding goodwill, resulting in the cessation of goodwill amortization. Approximately $6.8 million of goodwill was reclassified to "unidentifiable intangible assets" and is now being amortized.

Investor Verification Checklist

• Asset Quality Trends: Verify the trajectory of nonperforming assets and net charge-offs in the upcoming quarters, specifically within the aircraft and auto rental portfolios.
• Collateral Valuation: Assess the adequacy of the reserve for loan losses given the volatility in aircraft and used automobile collateral values.
• Revenue Sustainability: Confirm if the decline in loan servicing and sale income is permanent or if future securitization activities are planned to replace the 2001 one-time gain.
• Expense Management: Monitor if noninterest expenses stabilize following the integration of the 17 branches acquired in late 2001.
• Liquidity Position: Review cash flow statements to ensure operating cash flows remain sufficient to cover the increased provision for loan losses and dividend payments.