| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended September 30, | | Nine Months Ended September 30, |
(Dollars in thousands) | 2022 | | 2021 | | 2022 | | 2021 |
Direct finance leases: | | | | | | | |
Interest income on lease receivable | $ | 2,402 | | | $ | 1,629 | | | $ | 6,112 | | | $ | 4,880 | |
| | | | | | | |
Operating leases: | | | | | | | |
Income related to lease payments | $ | 2,761 | | | $ | 3,946 | | | $ | 9,718 | | | $ | 12,830 | |
Depreciation expense | 2,233 | | | 3,239 | | | 7,912 | | | 10,562 | |
Income related to reimbursements from lessees for personal property tax on operating leased equipment for the three months ended September 30, 2022 and 2021 was $0.08 million and $0.02 million, respectively and for the nine months ended September 30, 2022 and 2021 was $0.31 million and $0.40 million, respectively. Expense related to personal property tax payments on operating leased equipment for the three months ended September 30, 2022 and 2021 was $0.08 million and $0.02 million, respectively and for the nine months ended September 30, 2022 and 2021 was $0.31 million and $0.40 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 $866.25 million and $883.90 million at September 30, 2022 and December 31, 2021, 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 September 30, | | Nine Months Ended September 30, |
(Dollars in thousands) | | 2022 | | 2021 | | 2022 | | 2021 |
Mortgage servicing rights: | | | | | | | | |
Balance at beginning of period | | $ | 4,443 | | | $ | 4,678 | | | $ | 4,671 | | | $ | 4,616 | |
Additions | | 152 | | | 395 | | | 660 | | | 1,566 | |
Amortization | | (297) | | | (554) | | | (1,033) | | | (1,663) | |
| | | | | | | | |
Carrying value before valuation allowance at end of period | | 4,298 | | | 4,519 | | | 4,298 | | | 4,519 | |
Valuation allowance: | | | | | | | | |
Balance at beginning of period | | — | | | (223) | | | — | | | (812) | |
Impairment recoveries | | — | | | 223 | | | — | | | 812 | |
Balance at end of period | | $ | — | | | $ | — | | | $ | — | | | $ | — | |
Net carrying value of mortgage servicing rights at end of period | | $ | 4,298 | | | $ | 4,519 | | | $ | 4,298 | | | $ | 4,519 | |
Fair value of mortgage servicing rights at end of period | | $ | 7,493 | | | $ | 4,999 | | | $ | 7,493 | | | $ | 4,999 | |
At September 30, 2022 and 2021, the fair value of MSRs exceeded the carrying value reported in the Consolidated Statements of Financial Condition by $3.20 million and $0.48 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 $0.69 million and $0.81 million for the three months ended September 30, 2022 and 2021, respectively. Mortgage loan contractual servicing fees, including late fees and ancillary income, were $2.13 million and $2.40 million for the nine months ended September 30, 2022 and 2021, 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
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 Consolidated Statements of Financial Condition.
The following table shows financial instruments whose contract amounts represent credit risk.
| | | | | | | | | | | | | | |
(Dollars in thousands) | | September 30, 2022 | | December 31, 2021 |
Amounts of commitments: | | | | |
Loan commitments to extend credit | | $ | 1,199,066 | | | $ | 1,148,984 | |
Standby letters of credit | | $ | 18,761 | | | $ | 24,657 | |
Commercial and similar letters of credit | | $ | 400 | | | $ | 8,531 | |
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.
The Company 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 two 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 two 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 |
September 30, 2022 | | | | | | | | | | |
Interest rate swap contracts | | $ | 947,564 | | | Other assets | | $ | 26,918 | | | Other liabilities | | $ | 27,424 | |
Loan commitments | | 1,460 | | | Mortgages held for sale | | 28 | | | N/A | | — | |
Forward contracts - mortgage loan | | 2,250 | | | Mortgages held for sale | | 82 | | | N/A | | — | |
Total | | $ | 951,274 | | | | | $ | 27,028 | | | | | $ | 27,424 | |
| | | | | | | | | | |
December 31, 2021 | | | | | | | | | | |
Interest rate swap contracts | | $ | 1,064,721 | | | Other assets | | $ | 20,735 | | | Other liabilities | | $ | 21,172 | |
Loan commitments | | 15,086 | | | Mortgages held for sale | | 452 | | | N/A | | — | |
Forward contracts - mortgage loan | | 22,000 | | | N/A | | — | | | Mortgages held for sale | | 11 | |
Total | | $ | 1,101,807 | | | | | $ | 21,187 | | | | | $ | 21,183 | |
The following table shows the amounts included in the Consolidated Statements of Income for non-hedging derivative financial instruments.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | Gain (loss) |
| | | | Three Months Ended September 30, | | Nine Months Ended September 30, |
(Dollars in thousands) | | Statement of Income classification | | 2022 | | 2021 | | 2022 | | 2021 |
Interest rate swap contracts | | Other expense | | $ | (252) | | | $ | 101 | | | $ | (69) | | | $ | 420 | |
Interest rate swap contracts | | Other income | | 83 | | | 69 | | | 83 | | | 307 | |
Loan commitments | | Mortgage banking | | (197) | | | (75) | | | (424) | | | (704) | |
Forward contracts - mortgage loan | | Mortgage banking | | 83 | | | 246 | | | 93 | | | 512 | |
Total | | | | $ | (283) | | | $ | 341 | | | $ | (317) | | | $ | 535 | |
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 |
September 30, 2022 | | | | | | | | | | | | |
Interest rate swaps | | $ | 26,918 | | | $ | — | | | $ | 26,918 | | | $ | — | | | $ | 25,735 | | | $ | 1,183 | |
| | | | | | | | | | | | |
December 31, 2021 | | | | | | | | | | | | |
Interest rate swaps | | $ | 24,436 | | | $ | 3,701 | | | $ | 20,735 | | | $ | — | | | $ | — | | | $ | 20,735 | |
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 |
September 30, 2022 | | | | | | | | | | | | |
Interest rate swaps | | $ | 27,424 | | | $ | — | | | $ | 27,424 | | | $ | — | | | $ | — | | | $ | 27,424 | |
Repurchase agreements | | 130,192 | | | — | | | 130,192 | | | 130,192 | | | — | | | — | |
Total | | $ | 157,616 | | | $ | — | | | $ | 157,616 | | | $ | 130,192 | | | $ | — | | | $ | 27,424 | |
| | | | | | | | | | | | |
December 31, 2021 | | | | | | | | | | | | |
Interest rate swaps | | $ | 24,873 | | | $ | 3,701 | | | $ | 21,172 | | | $ | 20,498 | | | $ | — | | | $ | 674 | |
Repurchase agreements | | 194,727 | | | — | | | 194,727 | | | 194,727 | | | — | | | — | |
Total | | $ | 219,600 | | | $ | 3,701 | | | $ | 215,899 | | | $ | 215,225 | | | $ | — | | | $ | 674 | |
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 September 30, 2022 and December 31, 2021, repurchase agreements had a remaining contractual maturity of $126.92 million and $191.47 million in overnight and $3.27 million and $3.26 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.
•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. Tax credits from affordable housing investments and community development investments are recognized as a reduction of tax expense. Investments in renewable energy sources qualify for investment tax credits which are recognized 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 $0.52 million and $0.55 million for the three months ended September 30, 2022 and 2021, respectively and $1.55 million and $1.56 million for the nine months ended September 30, 2022 and 2021, respectively. The Company also recognized $0.00 million and $0.32 million of investment tax credits for the three months ended September 30, 2022 and 2021, respectively and $9.48 million and $3.32 million for the nine months ended September 30, 2022 and 2021, 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, the Company is 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) | September 30, 2022 | | December 31, 2021 |
Investment carrying amount | $ | 55,546 | | | $ | 35,968 | |
Unfunded capital and other commitments | 51,428 | | | 29,670 | |
Maximum exposure to loss | 50,048 | | | 50,319 | |
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 September 30, 2022 and December 31, 2021, approximately $66.91 million and $59.08 million of the Company’s assets and $0.00 million and $0.00 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.
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 September 30, 2022.
| | | | | | | | | | | | | | | | | | | | |
(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 | | | 4.77 | % | | 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 September 30, 2022 and 2021. 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 September 30, | | Nine Months Ended September 30, |
(Dollars in thousands - except per share amounts) | | 2022 | | 2021 | | 2022 | | 2021 |
Distributed earnings allocated to common stock | | $ | 7,890 | | | $ | 7,749 | | | $ | 23,230 | | | $ | 22,681 | |
Undistributed earnings allocated to common stock | | 24,571 | | | 24,472 | | | 65,489 | | | 67,422 | |
Net earnings allocated to common stock | | 32,461 | | | 32,221 | | | 88,719 | | | 90,103 | |
Net earnings allocated to participating securities | | 276 | | | 262 | | | 722 | | | 708 | |
Net income allocated to common stock and participating securities | | $ | 32,737 | | | $ | 32,483 | | | $ | 89,441 | | | $ | 90,811 | |
| | | | | | | | |
Weighted average shares outstanding for basic earnings per common share | | 24,656,736 | | | 24,919,956 | | | 24,697,106 | | | 25,126,703 | |
Dilutive effect of stock compensation | | — | | | — | | | — | | | — | |
Weighted average shares outstanding for diluted earnings per common share | | 24,656,736 | | | 24,919,956 | | | 24,697,106 | | | 25,126,703 | |
| | | | | | | | |
Basic earnings per common share | | $ | 1.32 | | | $ | 1.29 | | | $ | 3.59 | | | $ | 3.59 | |
Diluted earnings per common share | | $ | 1.32 | | | $ | 1.29 | | | $ | 3.59 | | | $ | 3.59 | |
Note 12 — Stock Based Compensation
As of September 30, 2022, 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, 2021. These plans include three executive stock award plans, the Executive Incentive Plan (EIP), the Restricted Stock Award Plan (RSAP), the Strategic Deployment Incentive Plan (SDP); 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 September 30, 2022. 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 nine months ended September 30, 2022 and 2021. As of September 30, 2022 and 2021 there were no outstanding stock options. There were no stock options exercised during the nine months ended September 30, 2022 and 2021. All shares issued in connection with stock option exercises are issued from available treasury stock.
As of September 30, 2022, there was $8.70 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 3.24 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 September 30, | | Nine Months Ended September 30, | | Affected Line Item in the Statements of Income |
(Dollars in thousands) | | 2022 | | 2021 | | 2022 | | 2021 | |
Realized losses included in net income | | $ | — | | | $ | — | | | $ | — | | | $ | (680) | | | Losses on investment securities available-for-sale |
| | — | | | — | | | — | | | (680) | | | Income before income taxes |
Tax effect | | — | | | — | | | — | | | 164 | | | Income tax expense |
Net of tax | | $ | — | | | $ | — | | | $ | — | | | $ | (516) | | | 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 September 30, 2022 and December 31, 2021. Interest and penalties are recognized through the income tax provision. For the three and nine months ended September 30, 2022 and 2021, the Company recognized no interest or penalties. There were no accrued interest and penalties at September 30, 2022 and December 31, 2021.
Tax years that remain open and subject to audit include the federal 2018-2021 years and the Indiana 2018-2021 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.
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 and for its best-efforts forward sales commitments. The Company economically hedges its mortgages held for sale at the time the interest rate locks are issued to the customers. The Company believes the election for mortgages held for sale will reduce certain timing differences and better match changes in the value of these assets with changes in the value of derivatives or best-best efforts forward sales commitments. At September 30, 2022 and December 31, 2021, 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 | | |
September 30, 2022 | | | | | | | | |
Mortgages held for sale reported at fair value | | $ | 3,058 | | | $ | 2,942 | | | $ | 116 | | | (1) |
| | | | | | | | |
December 31, 2021 | | | | | | | | |
Mortgages held for sale reported at fair value | | $ | 13,284 | | | $ | 12,456 | | | $ | 828 | | | (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.
Mortgages held for sale and the related loan commitments and forward contracts (hedges) are valued by a third party pricing agent. Prices supplied by the independent pricing agent, as well as their pricing methodologies, are reviewed by the Company for reasonableness and to ensure such prices are aligned with market values. On a quarterly basis, prices supplied by the pricing agent are validated by comparison to the prices obtained from other third party sources.
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 |
September 30, 2022 | | | | | | | | |
Assets: | | | | | | | | |
Investment securities available-for-sale: | | | | | | | | |
U.S. Treasury and Federal agencies securities | | $ | 570,045 | | | $ | 461,532 | | | $ | — | | | $ | 1,031,577 | |
U.S. States and political subdivisions securities | | — | | | 110,833 | | | 4,398 | | | 115,231 | |
Mortgage-backed securities — Federal agencies | | — | | | 637,690 | | | — | | | 637,690 | |
Corporate debt securities | | — | | | 16,113 | | | — | | | 16,113 | |
Foreign government and other securities | | — | | | 583 | | | — | | | 583 | |
Total debt securities available-for-sale | | 570,045 | | | 1,226,751 | | | 4,398 | | | 1,801,194 | |
| | | | | | | | |
Mortgages held for sale | | — | | | 3,058 | | | — | | | 3,058 | |
Accrued income and other assets (interest rate swap agreements) | | — | | | 26,918 | | | — | | | 26,918 | |
Total | | $ | 570,045 | | | $ | 1,256,727 | | | $ | 4,398 | | | $ | 1,831,170 | |
| | | | | | | | |
Liabilities: | | | | | | | | |
Accrued expenses and other liabilities (interest rate swap agreements) | | $ | — | | | $ | 27,424 | | | $ | — | | | $ | 27,424 | |
Total | | $ | — | | | $ | 27,424 | | | $ | — | | | $ | 27,424 | |
| | | | | | | | |
December 31, 2021 | | | | | | | | |
Assets: | | | | | | | | |
Investment securities available-for-sale: | | | | | | | | |
U.S. Treasury and Federal agencies securities | | $ | 561,950 | | | $ | 522,056 | | | $ | — | | | $ | 1,084,006 | |
U.S. States and political subdivisions securities | | — | | | 93,852 | | | 1,849 | | | 95,701 | |
Mortgage-backed securities — Federal agencies | | — | | | 659,727 | | | — | | | 659,727 | |
Corporate debt securities | | — | | | 23,009 | | | — | | | 23,009 | |
Foreign government and other securities | | — | | | 598 | | | — | | | 598 | |
Total debt securities available-for-sale | | 561,950 | | | 1,299,242 | | | 1,849 | | | 1,863,041 | |
| | | | | | | | |
Mortgages held for sale | | — | | | 13,284 | | | — | | | 13,284 | |
Accrued income and other assets (interest rate swap agreements) | | — | | | 20,735 | | | — | | | 20,735 | |
Total | | $ | 561,950 | | | $ | 1,333,261 | | | $ | 1,849 | | | $ | 1,897,060 | |
| | | | | | | | |
Liabilities: | | | | | | | | |
Accrued expenses and other liabilities (interest rate swap agreements) | | $ | — | | | $ | 21,172 | | | $ | — | | | $ | 21,172 | |
Total | | $ | — | | | $ | 21,172 | | | $ | — | | | $ | 21,172 | |
The following table shows changes in Level 3 assets measured at fair value on a recurring basis for the quarter ended September 30, 2022 and 2021.
| | | | | | | | | | | | |
(Dollars in thousands) | | U.S. States and political subdivisions securities | | | | |
Beginning balance July 1, 2022 | | $ | 4,515 | | | | | |
Total gains or losses (realized/unrealized): | | | | | | |
Included in earnings | | — | | | | | |
Included in other comprehensive income (loss) | | (32) | | | | | |
Purchases | | — | | | | | |
Issuances | | — | | | | | |
Sales | | — | | | | | |
Settlements | | — | | | | | |
Maturities | | (85) | | | | | |
Transfers into Level 3 | | — | | | | | |
Transfers out of Level 3 | | — | | | | | |
Ending balance September 30, 2022 | | $ | 4,398 | | | | | |
| | | | | | |
Beginning balance July 1, 2021 | | $ | 1,921 | | | | | |
Total gains or losses (realized/unrealized): | | | | | | |
Included in earnings | | — | | | | | |
Included in other comprehensive income (loss) | | (7) | | | | | |
Purchases | | — | | | | | |
Issuances | | — | | | | | |
Sales | | — | | | | | |
Settlements | | — | | | | | |
Maturities | | (85) | | | | | |
Transfers into Level 3 | | — | | | | | |
Transfers out of Level 3 | | — | | | | | |
Ending balance September 30, 2021 | | $ | 1,829 | | | | | |
There were no gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at September 30, 2022 or 2021.
The following table shows the valuation methodology and unobservable inputs for Level 3 assets measured at fair value on a recurring basis.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
(Dollars in thousands) | | Fair Value | | Valuation Methodology | | Unobservable Inputs | | Range of Inputs | | Weighted Average |
September 30, 2022 | | | | | | | | | | |
Debt securities available-for sale | | | | | | | | | | |
Direct placement municipal securities | | $ | 4,398 | | | Discounted cash flows | | Credit spread assumption | | 4.17% - 4.97% | | 4.79 | % |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
December 31, 2021 | | | | | | | | | | |
Debt securities available-for sale | | | | | | | | | | |
Direct placement municipal securities | | $ | 1,849 | | | Discounted cash flows | | Credit spread assumption | | 0.04% - 2.31% | | 1.58 | % |
| | | | | | | | | | |
| | | | | | | | | | |
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.
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.
Collateral-dependent 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 an allowance 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 September 30, 2022: collateral-dependent impaired loans - $0.00 million; mortgage servicing rights - $0.00 million; repossessions - $0.00 million; and other real estate - $0.00 million.
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 |
September 30, 2022 | | | | | | | | |
Collateral-dependent impaired loans | | $ | — | | | $ | — | | | $ | 851 | | | $ | 851 | |
Accrued income and other assets (mortgage servicing rights) | | — | | | — | | | 4,298 | | | 4,298 | |
Accrued income and other assets (repossessions) | | — | | | — | | | 26 | | | 26 | |
| | | | | | | | |
Total | | $ | — | | | $ | — | | | $ | 5,175 | | | $ | 5,175 | |
| | | | | | | | |
December 31, 2021 | | | | | | | | |
Collateral-dependent impaired loans | | $ | — | | | $ | — | | | $ | 571 | | | $ | 571 | |
Accrued income and other assets (mortgage servicing rights) | | — | | | — | | | 4,671 | | | 4,671 | |
Accrued income and other assets (repossessions) | | — | | | — | | | 861 | | | 861 | |
| | | | | | | | |
Total | | $ | — | | | $ | — | | | $ | 6,103 | | | $ | 6,103 | |
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 | | Weighted Average |
September 30, 2022 | | | | | | | | | | | | |
Collateral-dependent impaired loans | | $ | 851 | | | $ | 851 | | | Collateral based measurements including appraisals, trade publications, and auction values | | Discount for lack of marketability and current conditions | | 20% - 90% | | 36.2 | % |
| | | | | | | | | | | | |
Mortgage servicing rights | | 4,298 | | | 7,493 | | | Discounted cash flows | | Constant prepayment rate (CPR) | | 7.4% - 10.4% | | 9.6 | % |
| | | | | | | | Discount rate | | 11.9% - 14.7% | | 12.0 | % |
| | | | | | | | | | | | |
Repossessions | | 26 | | | 30 | | | Appraisals, trade publications and auction values | | Discount for lack of marketability | | 0% - 13% | | 13 | % |
| | | | | | | | | | | | |
| | | | | | | | | | | | |
| | | | | | | | | | | | |
December 31, 2021 | | | | | | | | | | | | |
Collateral-dependent impaired loans | | $ | 571 | | | $ | 571 | | | Collateral based measurements including appraisals, trade publications, and auction values | | Discount for lack of marketability and current conditions | | 20% - 90% | | 43.1 | % |
| | | | | | | | | | | | |
Mortgage servicing rights | | 4,671 | | | 5,640 | | | Discounted cash flows | | Constant prepayment rate (CPR) | | 11.8% - 18.5% | | 16.4 | % |
| | | | | | | | Discount rate | | 8.6% - 11.5% | | 8.8 | % |
| | | | | | | | | | | | |
Repossessions | | 861 | | | 942 | | | Appraisals, trade publications and auction values | | Discount for lack of marketability | | 0% - 21% | | 2 | % |
| | | | | | | | | | | | |
| | | | | | | | | | | | |
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.
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 |
September 30, 2022 | | | | | | | | | | |
Assets: | | | | | | | | | | |
Cash and due from banks | | $ | 86,952 | | | $ | 86,952 | | | $ | 86,952 | | | $ | — | | | $ | — | |
Federal funds sold and interest bearing deposits with other banks | | 30,652 | | | 30,652 | | | 30,652 | | | — | | | — | |
Investment securities, available-for-sale | | 1,801,194 | | | 1,801,194 | | | 570,045 | | | 1,226,751 | | | 4,398 | |
Other investments | | 25,538 | | | 25,538 | | | 25,538 | | | — | | | — | |
Mortgages held for sale | | 3,058 | | | 3,058 | | | — | | | 3,058 | | | — | |
Loans and leases, net of allowance for loan and lease losses | | 5,626,342 | | | 5,533,010 | | | — | | | — | | | 5,533,010 | |
Mortgage servicing rights | | 4,298 | | | 7,493 | | | — | | | — | | | 7,493 | |
Accrued interest receivable | | 20,625 | | | 20,625 | | | — | | | 20,625 | | | — | |
Interest rate swaps | | 26,918 | | | 26,918 | | | — | | | 26,918 | | | — | |
Liabilities: | | | | | | | | | | |
Deposits | | $ | 6,621,231 | | | $ | 6,602,827 | | | $ | 5,842,321 | | | $ | 760,506 | | | $ | — | |
Short-term borrowings | | 340,462 | | | 340,462 | | | 143,181 | | | 197,281 | | | — | |
Long-term debt and mandatorily redeemable securities | | 47,587 | | | 46,052 | | | — | | | 46,052 | | | — | |
Subordinated notes | | 58,764 | | | 48,394 | | | — | | | 48,394 | | | — | |
Accrued interest payable | | 3,133 | | | 3,133 | | | — | | | 3,133 | | | — | |
Interest rate swaps | | 27,424 | | | 27,424 | | | — | | | 27,424 | | | — | |
Off-balance-sheet instruments * | | — | | | 120 | | | — | | | 120 | | | — | |
| | | | | | | | | | |
December 31, 2021 | | | | | | | | | | |
Assets: | | | | | | | | | | |
Cash and due from banks | | $ | 54,420 | | | $ | 54,420 | | | $ | 54,420 | | | $ | — | | | $ | — | |
Federal funds sold and interest bearing deposits with other banks | | 470,767 | | | 470,767 | | | 470,767 | | | — | | | — | |
Investment securities, available-for-sale | | 1,863,041 | | | 1,863,041 | | | 561,950 | | | 1,299,242 | | | 1,849 | |
Other investments | | 27,189 | | | 27,189 | | | 27,189 | | | — | | | — | |
Mortgages held for sale | | 13,284 | | | 13,284 | | | — | | | 13,284 | | | — | |
Loans and leases, net of allowance for loan and lease losses | | 5,218,722 | | | 5,269,551 | | | — | | | — | | | 5,269,551 | |
Mortgage servicing rights | | 4,671 | | | 5,640 | | | — | | | — | | | 5,640 | |
Accrued interest receivable | | 17,760 | | | 17,760 | | | — | | | 17,760 | | | — | |
Interest rate swaps | | 20,735 | | | 20,735 | | | — | | | 20,735 | | | — | |
Liabilities: | | | | | | | | | | |
Deposits | | $ | 6,679,065 | | | $ | 6,680,163 | | | $ | 5,794,928 | | | $ | 885,235 | | | $ | — | |
Short-term borrowings | | 200,027 | | | 200,027 | | | 192,801 | | | 7,226 | | | — | |
Long-term debt and mandatorily redeemable securities | | 71,251 | | | 71,305 | | | — | | | 71,305 | | | — | |
Subordinated notes | | 58,764 | | | 58,553 | | | — | | | 58,553 | | | — | |
Accrued interest payable | | 1,885 | | | 1,885 | | | — | | | 1,885 | | | — | |
Interest rate swaps | | 21,172 | | | 21,172 | | | — | | | 21,172 | | | — | |
Off-balance-sheet instruments * | | — | | | 364 | | | — | | | 364 | | | — | |
* 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.
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 September 30, 2022, as compared to December 31, 2021, and the results of operations for the three and nine months ended September 30, 2022 and 2021. 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 2021 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,” “hope,” “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; potential impacts of the COVID-19 pandemic; and other matters discussed in our filings with the SEC, including our Annual Report on Form 10-K for 2021, 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 September 30, 2022 were $8.10 billion, an increase of $1.20 million or 0.01% from December 31, 2021. Total investment securities available-for-sale were $1.80 billion, a decrease of $61.85 million or 3.32% from December 31, 2021. The largest contributor to the decrease in investment securities available-for-sale was negative market value adjustments due to temporary, non-credit-related, net unrealized losses as a result of changes in interest rates, market spreads and market conditions subsequent to purchase. Federal funds sold and interest bearing deposits with other banks were $30.65 million, a decrease of $440.12 million or 93.49% from December 31, 2021. The decrease in federal funds sold and interest bearing deposits with other banks was due to lower interest bearing deposits at the Federal Reserve Bank mainly from funding loan growth.
Total loans and leases were $5.76 billion, an increase of $415.86 million or 7.78% from December 31, 2021. The largest contributors to the increase in loans and leases was growth in the auto and light truck, construction equipment and aircraft portfolios offset by approximately $69 million of Paycheck Protection Program loans forgiven by the SBA during 2022. As of September 30, 2022, total PPP loans were $6.35 million which is net of unearned fees of $0.13 million and located within the commercial and agricultural portfolio. Our foreign loan and lease balances, all denominated in U.S. dollars were $239.80 million and $193.31 million as of September 30, 2022 and December 31, 2021, respectively. Foreign loans and leases are in aircraft financing. Loan and lease balances to borrowers in Brazil and Mexico were $79.29 million and $131.39 million as of September 30, 2022, respectively, compared to $65.24 million and $117.90 million as of December 31, 2021, respectively. As of September 30, 2022 and December 31, 2021 there was not a significant concentration in any other country.
Equipment owned under operating leases was $32.96 million, a decrease of $15.47 million, or 31.94% compared to December 31, 2021. The largest contributor to the decrease in equipment owned under operating leases was reduced leasing volume primarily due to a change in customer preferences and competitive pricing pressure for new business.
Total deposits were $6.62 billion, a decrease of $57.83 million or 0.87% from the end of 2021. The largest contributor to the decrease in total deposits was a decrease in time deposits offset by an increase in interest-bearing public fund deposits. Short-term borrowings were $340.46 million, an increase of $140.44 million or 70.21% from December 31, 2021 due primarily to increased short-term FHLB borrowings largely to support strong loan growth. Long-term debt and mandatorily redeemable securities were $47.59 million, a decrease of $23.66 million or 33.21% from December 31, 2021 due primarily to a decrease in long-term FHLB borrowings. Accrued expenses and other liabilities were $143.08 million, an increase of $25.36 million or 21.55% from December 31, 2021 primarily due to an increase in unfunded partnership commitments and the fair value of interest rate swap contracts with customers.
The following table shows accrued income and other assets. | | | | | | | | | | | | | | |
(Dollars in thousands) | | September 30, 2022 | | December 31, 2021 |
Accrued income and other assets: | | | | |
Bank owned life insurance cash surrender value | | $ | 82,655 | | | $ | 71,466 | |
Operating lease right of use assets | | 20,548 | | | 22,071 | |
Accrued interest receivable | | 20,625 | | | 17,760 | |
Mortgage servicing rights | | 4,298 | | | 4,671 | |
| | | | |
Repossessions | | 26 | | | 861 | |
Partnership investments carrying amount | | 122,453 | | | 95,045 | |
All other assets | | 111,433 | | | 57,595 | |
Total accrued income and other assets | | $ | 362,038 | | | $ | 269,469 | |
The largest contributors to the increase in accrued income and other assets from December 31, 2021 was higher partnership investments carrying amounts, bank owned life insurance cash surrender value, and deferred tax assets related to available-for-sale debt securities included in all other assets above.
CAPITAL
As of September 30, 2022, total shareholders’ equity was $826.06 million, down $90.20 million, or 9.84% from the $916.26 million at December 31, 2021. In addition to net income of $89.44 million, other significant changes in shareholders’ equity during the first nine months of 2022 included $23.30 million of dividends paid and $6.84 million in common stock acquired for treasury. The accumulated other comprehensive loss component of shareholders’ equity increased to $162.28 million at September 30, 2022, compared to $9.86 million at December 31, 2021 due to changes in interest rates, market spreads and market conditions on our available-for-sale investment portfolio. Our shareholders’ equity-to-assets ratio was 10.20% as of September 30, 2022, compared to 11.32% at December 31, 2021. Book value per common share declined to $33.50 at September 30, 2022, from $37.04 at December 31, 2021 primarily due to an increase in accumulated other comprehensive losses.
We declared and paid cash dividends per common share of $0.32 during the third quarter of 2022. The trailing four quarters dividend payout ratio, representing cash dividends per common share divided by diluted earnings per common share, was 26.54%. 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 September 30, 2022, 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 | | $ | 1,111,003 | | | 16.50 | % | | $ | 538,728 | | | 8.00 | % | | $ | 707,080 | | | 10.50 | % | | $ | 673,410 | | | 10.00 | % |
1st Source Bank | | 1,036,300 | | | 15.40 | | | 538,348 | | | 8.00 | | | 706,582 | | | 10.50 | | | 672,935 | | | 10.00 | |
Tier 1 Capital (to Risk-Weighted Assets): | | | | | | | | | | | | | | | | |
1st Source Corporation | | 1,026,126 | | | 15.24 | | | 404,046 | | | 6.00 | | | 572,398 | | | 8.50 | | | 538,728 | | | 8.00 | |
1st Source Bank | | 951,481 | | | 14.14 | | | 403,761 | | | 6.00 | | | 571,995 | | | 8.50 | | | 538,348 | | | 8.00 | |
Common Equity Tier 1 Capital (to Risk-Weighted Assets): | | | | | | | | | | | | | | | | |
1st Source Corporation | | 908,825 | | | 13.50 | | | 303,034 | | | 4.50 | | | 471,387 | | | 7.00 | | | 437,716 | | | 6.50 | |
1st Source Bank | | 891,180 | | | 13.24 | | | 302,821 | | | 4.50 | | | 471,055 | | | 7.00 | | | 437,408 | | | 6.50 | |
Tier 1 Capital (to Average Assets): | | | | | | | | | | | | | | | | |
1st Source Corporation | | 1,026,126 | | | 12.69 | | | 323,538 | | | 4.00 | | | N/A | | N/A | | 404,422 | | | 5.00 | |
1st Source Bank | | 951,481 | | | 11.77 | | | 323,394 | | | 4.00 | | | N/A | | N/A | | 404,242 | | | 5.00 | |
PPP loan balances have been assigned a zero percent risk weight and therefore had no impact on our total risk-weighted assets at September 30, 2022.
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. At September 30, 2022, we had $15.00 million of borrowings in the federal funds market. We could borrow $230.00 million in additional funds for a short time from these banks on a collective basis. As of September 30, 2022, we had $213.09 million outstanding in FHLB advances and could borrow an additional $337.68 million contingent on the FHLB activity-based stock ownership requirement. We also had no outstandings with the FRB and could borrow $468.00 million as of September 30, 2022.
Our loan to asset ratio was 71.16% at September 30, 2022 compared to 66.03% at December 31, 2021 and 67.29% at September 30, 2021. Cash and cash equivalents totaled $117.60 million at September 30, 2022 compared to $525.19 million at December 31, 2021 and $637.28 million at September 30, 2021. The decrease in cash and cash equivalents was primarily due to a reduction in excess liquidity from fewer PPP loan forgiveness proceeds and positive loan growth. At September 30, 2022, the Consolidated Statements of Financial Condition was rate sensitive by $307.87 million more liabilities than assets scheduled to reprice within one year, or approximately 0.91%. 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 $981 million.
RESULTS OF OPERATIONS
Net income available to common shareholders for the three and nine month period ended September 30, 2022 was $32.74 million and $89.44 million, compared to $32.48 million and $90.81 million for the same periods in 2021. Diluted net income per common share was $1.32 and $3.59 for the three and nine month periods ended September 30, 2022, compared to $1.29 and $3.59 earned for the same periods in 2021. Return on average common shareholders’ equity was 13.56% for the nine months ended September 30, 2022, compared to 13.45% in 2021. The return on total average assets was 1.49% for the nine months ended September 30, 2022, compared to 1.60% in 2021.
Net income decreased for the nine months ended September 30, 2022 compared to the first nine months of 2021. The provision for credit losses increased and noninterest income decreased offset by an increase to net interest income and a decrease to noninterest expense. Details of the changes in the various components of net income are discussed further below.
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 | | |
| September 30, 2022 | | June 30, 2022 | | September 30, 2021 |
(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 | $ | 1,816,138 | | | $ | 6,691 | | | 1.46 | % | | $ | 1,805,044 | | | $ | 6,289 | | | 1.40 | % | | $ | 1,451,523 | | | $ | 4,533 | | | 1.24 | % |
Tax exempt(1) | 47,841 | | | 426 | | | 3.53 | % | | 30,930 | | | 195 | | | 2.53 | % | | 30,493 | | | 172 | | | 2.24 | % |
Mortgages held for sale | 4,272 | | | 58 | | | 5.39 | % | | 4,889 | | | 52 | | | 4.27 | % | | 17,750 | | | 120 | | | 2.68 | % |
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Loans and leases, net of unearned discount(1) | 5,627,718 | | | 69,064 | | | 4.87 | % | | 5,467,808 | | | 60,448 | | | 4.43 | % | | 5,427,080 | | | 61,655 | | | 4.51 | % |
Other investments | 119,624 | | | 421 | | | 1.40 | % | | 376,960 | | | 1,168 | | | 1.24 | % | | 477,406 | | | 360 | | | 0.30 | % |
Total earning assets(1) | 7,615,593 | | | 76,660 | | | 3.99 | % | | 7,685,631 | | | 68,152 | | | 3.56 | % | | 7,404,252 | | | 66,840 | | | 3.58 | % |
Cash and due from banks | 74,329 | | | | | | | 90,101 | | | | | | | 76,915 | | | | | |
Allowance for loan and lease losses | (133,989) | | | | | | | (132,020) | | | | | | | (137,206) | | | | | |
Other assets | 463,171 | | | | | | | 448,604 | | | | | | | 452,802 | | | | | |
Total assets | $ | 8,019,104 | | | | | | | $ | 8,092,316 | | | | | | | $ | 7,796,763 | | | | | |
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LIABILITIES AND SHAREHOLDERS’ EQUITY | | | | | | | | | | | | | | | | |
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Interest-bearing deposits | $ | 4,634,092 | | | $ | 6,556 | | | 0.56 | % | | $ | 4,753,331 | | | $ | 3,553 | | | 0.30 | % | | $ | 4,488,169 | | | $ | 2,924 | | | 0.26 | % |
Short-term borrowings: | | | | | | | | | | | | | | | | | |
Securities sold under agreements to repurchase | 159,345 | | | 21 | | | 0.05 | % | | 176,994 | | | 23 | | | 0.05 | % | | 177,720 | | | 24 | | | 0.05 | % |
Other short-term borrowings | 57,609 | | | 359 | | | 2.47 | % | | 5,394 | | | — | | | — | % | | 5,492 | | | 1 | | | 0.07 | % |
Subordinated notes | 58,764 | | | 904 | | | 6.10 | % | | 58,764 | | | 851 | | | 5.81 | % | | 58,764 | | | 816 | | | 5.51 | % |
Long-term debt and mandatorily redeemable securities | 48,399 | | | (296) | | | (2.43) | % | | 54,662 | | | 140 | | | 1.03 | % | | 81,371 | | | 740 | | | 3.61 | % |
Total interest-bearing liabilities | 4,958,209 | | | 7,544 | | | 0.60 | % | | 5,049,145 | | | 4,567 | | | 0.36 | % | | 4,811,516 | | | 4,505 | | | 0.37 | % |
Noninterest-bearing deposits | 2,039,147 | | | | | | | 2,042,462 | | | | | | | 1,913,675 | | | | | |
Other liabilities | 90,336 | | | | | | | 84,995 | | | | | | | 111,337 | | | | | |
Shareholders’ equity | 873,209 | | | | | | | 861,134 | | | | | | | 915,552 | | | | | |
Noncontrolling interests | 58,203 | | | | | | | 54,580 | | | | | | | 44,683 | | | | | |
Total liabilities and equity | $ | 8,019,104 | | | | | | | $ | 8,092,316 | | | | | | | $ | 7,796,763 | | | | | |
Less: Fully tax-equivalent adjustments | | | (182) | | | | | | | (123) | | | | | | | (111) | | | |
Net interest income/margin (GAAP-derived)(1) | | | $ | 68,934 | | | 3.59 | % | | | | $ | 63,462 | | | 3.31 | % | | | | $ | 62,224 | | | 3.33 | % |
Fully tax-equivalent adjustments | | | 182 | | | | | | | 123 | | | | | | | 111 | | | |
Net interest income/margin - FTE(1) | | | $ | 69,116 | | | 3.60 | % | | | | $ | 63,585 | | | 3.32 | % | | | | $ | 62,335 | | | 3.34 | % |
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(1) See “Reconciliation of Non-GAAP Financial Measures” at the end of this section for additional information on this performance measure/ratio. |
Quarter Ended September 30, 2022 compared to the Quarter Ended September 30, 2021
The taxable-equivalent net interest income for the three months ended September 30, 2022 was $69.12 million, an increase of 10.88% over the same period in 2021. The net interest margin on a fully taxable-equivalent basis was 3.60% for the three months ended September 30, 2022, compared to 3.34% for the three months ended September 30, 2021.
During the three month period ended September 30, 2022, average earning assets increased $211.34 million, up 2.85% over the comparable period in 2021. Average interest-bearing liabilities increased $146.69 million or 3.05%. The yield on average earning assets increased 41 basis points to 3.99% from 3.58% primarily due to higher rates on loans and leases, investment securities and 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. Total cost of average interest-bearing liabilities increased 23 basis points to 0.60% from 0.37% as a result of higher rates on interest-bearing deposits and short-term FHLB borrowings offset by lower interest expense on mandatorily redeemable securities. The result to the net interest margin, or the ratio of net interest income to average earning assets, was an increase of 26 basis points.
The largest contributors to the improved yield on average earning assets for the three months ended September 30, 2022 compared to the three months ended September 30, 2021 was an increase in yields on net loans and leases and taxable investment securities. The yield on net loans and leases grew 36 basis points primarily from rising interest rates and higher net interest recoveries of $0.25 million which had a positive three basis points impact. Average net loans and leases increased $200.64 million or 3.70% primarily in the auto and light truck, construction equipment and aircraft portfolios. Average loans and leases net PPP loans increased $451.88 million, up 8.74% compared to the third quarter of 2021. Average investment securities increased $381.96 million or 25.77% which represents investment of excess liquidity with the largest increases in U.S. treasury and federal agency securities and mortgage-backed securities over the same period. Average other investments, primarily held at the Federal Reserve Bank, decreased $357.78 million or 74.94% largely to fund loan growth and deploy excess liquidity into the investment portfolio.
Average interest-bearing deposits increased $145.92 million or 3.25% for the third quarter of 2022 over the same period in 2021 primarily due to public fund deposits and savings account balances. The effective rate paid on average interest-bearing deposits increased 30 basis point to 0.56% from 0.26%. Average noninterest-bearing deposits grew $125.47 million or 6.56% for the third quarter of 2022 over the same period in 2021 primarily due to customers remaining cautious with their funds and spending.
Average short-term borrowings increased $33.74 million or 18.42% for the third quarter of 2022 compared to the same period in 2021 primarily to support strong loan growth during the quarter. Interest paid on short-term borrowings increased 64 basis points due to higher short-term FHLB borrowings. Interest paid on subordinated notes increased 59 basis points during the third quarter of 2022 from the same period a year ago due to a variable rate increase on one tranche. Average long-term debt and mandatorily redeemable securities balances decreased $32.97 million or 40.52%. Interest paid on long-term debt and mandatorily redeemable securities decreased 604 basis points during the third quarter of 2022 from the same period in 2021 primarily due to lower rates on mandatorily redeemable securities from a reduction in book value per share during the quarter. Mandatorily redeemable shares are issued under the terms of one of our executive incentive compensation plans and are settled based on book value per share with changes from the previous reporting date recorded as interest expense.
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| Nine Months Ended |
| September 30, 2022 | | September 30, 2021 |
(Dollars in thousands) | Average Balance | | Interest Income/Expense | | Yield/ Rate | | Average Balance | | Interest Income/Expense | | Yield/ Rate |
ASSETS | | | | | | | | | | | |
Investment securities available-for-sale: | | | | | | | | | | | |
Taxable | $ | 1,826,095 | | | $ | 19,324 | | | 1.41 | % | | $ | 1,317,976 | | | $ | 12,676 | | | 1.29 | % |
Tax exempt(1) | 36,157 | | | 786 | | | 2.91 | % | | 33,792 | | | 578 | | | 2.29 | % |
Mortgages held for sale | 5,967 | | | 177 | | | 3.97 | % | | 13,094 | | | 260 | | | 2.65 | % |
Loans and leases, net of unearned discount(1) | 5,474,401 | | | 184,730 | | | 4.51 | % | | 5,480,229 | | | 176,684 | | | 4.31 | % |
Other investments | 302,844 | | | 1,952 | | | 0.86 | % | | 366,432 | | | 943 | | | 0.34 | % |
Total earning assets(1) | 7,645,464 | | | 206,969 | | | 3.62 | % | | 7,211,523 | | | 191,141 | | | 3.54 | % |
Cash and due from banks | 75,497 | | | | | | | 76,103 | | | | | |
Allowance for loan and lease losses | (131,572) | | | | | | | (140,800) | | | | | |
Other assets | 450,701 | | | | | | | 456,293 | | | | | |
Total assets | $ | 8,040,090 | | | | | | | $ | 7,603,119 | | | | | |
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LIABILITIES AND SHAREHOLDERS’ EQUITY | | | | | | | | | | |
Interest-bearing deposits | $ | 4,658,394 | | | $ | 12,485 | | | 0.36 | % | | $ | 4,403,595 | | | $ | 9,652 | | | 0.29 | % |
Short-term borrowings: | | | | | | | | | | | |
Securities sold under agreements to repurchase | 176,029 | | | 67 | | | 0.05 | % | | 175,869 | | | 87 | | | 0.07 | % |
Other short-term borrowings | 22,983 | | | 360 | | | 2.09 | % | | 6,336 | | | 3 | | | 0.06 | % |
Subordinated notes | 58,764 | | | 2,578 | | | 5.87 | % | | 58,764 | | | 2,448 | | | 5.57 | % |
Long-term debt and mandatorily redeemable securities | 57,597 | | | (948) | | | (2.20) | % | | 81,286 | | | 2,030 | | | 3.34 | % |
Total interest-bearing liabilities | 4,973,767 | | | 14,542 | | | 0.39 | % | | 4,725,850 | | | 14,220 | | | 0.40 | % |
Noninterest-bearing deposits | 2,037,113 | | | | | | | 1,818,271 | | | | | |
Other liabilities | 92,236 | | | | | | | 111,750 | | | | | |
Shareholders’ equity | 881,574 | | | | | | | 902,907 | | | | | |
Noncontrolling interests | 55,400 | | | | | | | 44,341 | | | | | |
Total liabilities and equity | $ | 8,040,090 | | | | | | | $ | 7,603,119 | | | | | |
Less: Fully tax-equivalent adjustments | | | (413) | | | | | | | (350) | | | |
Net interest income/margin (GAAP-derived)(1) | | | $ | 192,014 | | | 3.36 | % | | | | $ | 176,571 | | | 3.27 | % |
Fully tax-equivalent adjustments | | | 413 | | | | | | | 350 | | | |
Net interest income/margin - FTE(1) | | | $ | 192,427 | | | 3.37 | % | | | | $ | 176,921 | | | 3.28 | % |
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(1) See “Reconciliation of Non-GAAP Financial Measures” at the end of this section for additional information on this performance measure/ratio. |
Nine Months Ended September 30, 2022 compared to the Nine Months Ended September 30, 2021
The taxable-equivalent net interest income for the nine months ended September 30, 2022 was $192.43 million, an increase of 8.76% over the same period in 2021. The net interest margin on a fully taxable-equivalent basis was 3.37% for the nine months ended September 30, 2022, compared to 3.28% for the same period in 2021.
During the nine month period ended September 30, 2022, average earning assets increased $433.94 million, up 6.02% over the comparable period in 2021. Average interest-bearing liabilities increased $247.92 million or 5.25%. The yield on average earning assets increased eight basis points to 3.62% from 3.54% primarily due to higher higher rates on loans and leases, investment securities and 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. Total cost of average interest-bearing liabilities decreased one basis point to 0.39% from 0.40% as a result of repricing of time deposits and lower interest expense on mandatorily redeemable securities. The result to the net interest margin, or the ratio of net interest income to average earning assets, was a net nine basis point impact.
The largest contributor to the improved yield on average earning assets for the nine months ended September 30, 2022, compared to the nine months ended September 30, 2021, was an increase in yields on net loans and leases of 20 basis points primarily due to market conditions as a result of Federal Reserve interest rate increases. The yield on net loans and leases was also positively impacted by five basis points due to recognition of unearned fees on PPP loans which have been forgiven by the SBA compared to a positive 12 basis point impact during 2021 offset by PPP loan balances outstanding which earn interest at 1.00%. Average net loans and leases decreased $5.83 million or 0.11% primarily due to average PPP loans of $26.58 million compared to average PPP loans of $357.28 million in 2021 in the commercial and agricultural loan portfolio. Average loans and leases net PPP loans increased $324.88 million, up 6.34%. Average mortgages held for sale decreased $7.13 million or 54.43%. Average investment securities increased $510.48 million or 37.76% which represents investment of excess liquidity with the largest increases in U.S. treasury and federal agency securities and mortgage-backed securities. Average other investments, primarily held at the Federal Reserve Bank, decreased $63.59 million or 17.35%.
Average interest-bearing deposits increased $254.80 million or 5.79% for the first nine months of 2022 over the same period in 2021 primarily due to the increased public fund deposits and higher savings account balances. The effective rate paid on average interest-bearing deposits increased seven basis points to 0.36% from 0.29%. Average noninterest-bearing deposits grew $218.84 million or 12.04% for the first nine months of 2022 over the same period in 2021 primarily due to customers remaining cautious with their funds and spending.
Average short-term borrowings increased $16.81 million or 9.22% for the first nine months of 2022 compared to the same period in 2021. Interest paid on short-term borrowings increased 22 basis points. Interest paid on subordinated notes increased 30 basis points due to a variable rate on one tranche. Average long-term debt and mandatorily redeemable securities balances decreased $23.69 million or 29.14%. Interest paid on long-term debt and mandatorily redeemable securities decreased 554 basis points due to lower rates on mandatorily redeemable securities from a reduction in book value per share during 2022. Mandatorily redeemable shares are issued under the terms of one of our executive incentive compensation plans and are settled based on book value per share with changes from the previous reporting date recorded as interest expense.
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.
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| | Three Months Ended | | Nine Months Ended |
| | September 30, | June 30, | September 30, | | September 30, | September 30, |
(Dollars in thousands) | 2022 | 2022 | 2021 | | 2022 | 2021 |
Calculation of Net Interest Margin | | | | | | |
(A) | Interest income (GAAP) | $ | 76,478 | | $ | 68,029 | | $ | 66,729 | | | $ | 206,556 | | $ | 190,791 | |
| Fully tax-equivalent adjustments: | | | | | | |
(B) | - Loans and leases | 95 | | 85 | | 79 | | | 257 | | 240 | |
(C) | - Tax-exempt investment securities | 87 | | 38 | | 32 | | | 156 | | 110 | |
(D) | Interest income - FTE (A+B+C) | 76,660 | | 68,152 | | 66,840 | | | 206,969 | | 191,141 | |
(E) | Interest expense (GAAP) | 7,544 | | 4,567 | | 4,505 | | | 14,542 | | 14,220 | |
(F) | Net interest income (GAAP) (A–E) | 68,934 | | 63,462 | | 62,224 | | | 192,014 | | 176,571 | |
(G) | Net interest income - FTE (D–E) | 69,116 | | 63,585 | | 62,335 | | | 192,427 | | 176,921 | |
(H) | Annualization factor | 3.967 | | 4.011 | | 3.967 | | | 1.337 | | 1.337 | |
(I) | Total earning assets | $ | 7,615,593 | | $ | 7,685,631 | | $ | 7,404,252 | | | $ | 7,645,464 | | $ | 7,211,523 | |
| Net interest margin (GAAP-derived) (F*H)/I | 3.59 | % | 3.31 | % | 3.33 | % | | 3.36 | % | 3.27 | % |
| Net interest margin - FTE (G*H)/I | 3.60 | % | 3.32 | % | 3.34 | % | | 3.37 | % | 3.28 | % |
PROVISION AND ALLOWANCE FOR CREDIT LOSSES
The provision for credit losses for the three and nine months ended September 30, 2022 was $3.17 million and $7.90 million compared to a recovery of $2.56 million and $3.19 million during the three and nine months ended September 30, 2021. Net charge-offs of $0.30 million or 0.02% of average loans and leases were recorded for the third quarter 2022, compared to net charge-offs of $0.04 million or 0.00% of average loans and leases for the same quarter a year ago. Year-to-date net recoveries of $0.34 million or 0.01% of average loans and leases have been recorded in 2022, compared to net charge-offs of $3.71 million or 0.09% of average loans and leases through September 30, 2021. Net recoveries in 2022 were principally in the aircraft, auto and light truck, and residential real estate portfolios.
The provision for credit losses for the three months ended September 30, 2022 was principally driven by loan growth during the quarter. The prior quarter’s forecast adjustment was maintained as it remains pertinent to the current economic outlook. We remain concerned about the long-term prospects for our bus segment and potential risks in our small business portfolio as financial relief provided by government programs afforded to our lending clients dissipates and the return to normal revenue and employment levels slows. At September 30, 2022, PPP loans totaled $6.35 million and necessitated minimal reserves as the program carries a 100% SBA guarantee and a debt forgiveness component. Impairment reserves for assets individually evaluated were minimally changed this quarter and continue to be a small component of our overall allowance.
We continue to evaluate risks which may impact our loan portfolios. Most notably, the weakened economic outlook exacerbated by the current hostilities in Ukraine and resulting increased uncertainty characterized by persistent inflation and the potential for further disruptions of an already tenuous supply chain. The direct impacts of the pandemic and related economic disruptions which previously dominated our risk analysis, have lessened in the U.S. Concerns remain abroad, particularly in China. Pandemic-related economic disruption remains a concern, particularly the availability of raw materials and extreme price volatility across the supply chain. We remain concerned that geopolitical events and persistently high inflation with weakening growth prospects raise the potential for adverse impacts to the U.S. economy. Increasing interest rates could potentially impact valuations of assets which collateralize our loans. Congressional spending initiatives face multiple challenges and uncompromising partisanship. Additional current concerns include slower growth projections in the U.S. and abroad and the potential for raw material shortages and prolonged interruption in global trade as a result of trade restrictions related to the war in Ukraine and the pandemic-related responses of our trade partners. Political uncertainty continues in Latin America, with governments facing increased pressures from escalating social tensions, persistently high unemployment, and double-digit inflation. Corruption scandals persist, fueling U.S. border concerns. Globally, concerns continue to be heightened due to actual and potential terrorist attacks.
Another area of concern continues to be our aircraft portfolio where we have a collateral concentration and $240 million of foreign exposure, the majority of which is in Mexico and Brazil. We review political and economic data for these countries on a regular basis to assess the impact the environment may have on our customers. Historically, we have experienced volatile and unanticipated losses in both the foreign and domestic segments of our aircraft portfolios. Losses have been primarily attributable to unexpected declines in the value of specific aircraft collateral at a time when the borrower is experiencing financial difficulties. We review and assess aircraft values on an ongoing basis and use a tiered approach to establish advance rates and amortization schedules in an effort to limit collateral exposure. We continue to monitor individual customer performance and assess risks in the portfolio as a whole.
On September 30, 2022, 30 day and over loan and lease delinquency as a percentage of loan and lease balances was 0.09%, compared to 0.20% on September 30, 2021. The allowance for loan and lease losses as a percentage of loans and leases outstanding at the end of the period was 2.36% compared to 2.50% one year ago. The allowance as a percentage of loans and leases outstanding, net of PPP loans, was unchanged at September 30, 2022 compared to 2.42% at December 31, 2021 and 2.58% at September 30, 2021. A summary of loan and lease loss experience during the three and nine months ended September 30, 2022 and 2021 is located in Note 5 of the Consolidated Financial Statements.
NONPERFORMING ASSETS
The following table shows nonperforming assets. | | | | | | | | | | | | | | | | | | | | |
(Dollars in thousands) | | September 30, 2022 | | December 31, 2021 | | September 30, 2021 |
Loans and leases past due 90 days or more | | $ | 165 | | | $ | 249 | | | $ | 96 | |
Nonaccrual loans and leases | | 27,813 | | | 38,706 | | | 43,166 | |
| | | | | | |
Repossessions | | 26 | | | 861 | | | 690 | |
Equipment owned under operating leases | | 1 | | | 1,518 | | | 1,598 | |
Total nonperforming assets | | $ | 28,005 | | | $ | 41,334 | | | $ | 45,550 | |
Nonperforming assets as a percentage of loans and leases were 0.48% at September 30, 2022, 0.77% at December 31, 2021, and 0.84% at September 30, 2021. Excluding PPP loans, nonperforming assets as a percentage of loans and leases were unchanged at September 30, 2022, 0.78% at December 31, 2021, and 0.87% at September 30, 2021. Nonperforming assets totaled $28.01 million at September 30, 2022, a decrease of 32.25% from the $41.33 million reported at December 31, 2021, and a 38.52% decrease from the $45.55 million reported at September 30, 2021. The decrease in nonperforming assets during the first nine months of 2022 was related to continued recovery from the pandemic which has led to lower nonaccrual loans and leases and a decrease in equipment owned under operating leases. The decrease in nonperforming assets at September 30, 2022 from September 30, 2021 was related to a decrease in nonaccrual loans and leases, lower repossessions and decreased equipment owned under operating leases.
The decrease in nonaccrual loans and leases at September 30, 2022 from December 31, 2021 and September 30, 2021 occurred primarily in the bus segment of the auto and light truck portfolio and to a lesser extent in the construction equipment portfolio. A summary of nonaccrual loans and leases and past due aging for the period ended September 30, 2022 and December 31, 2021 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. We currently have no properties held in other real estate assets.
Repossessions consisted of one loan in the auto and light truck portfolio at September 30, 2022. 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 allowance 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 decrease in repossession balances at September 30, 2022 compared to September 30, 2021 was primarily the result of the sale of repossessed buses in the auto and light truck portfolio.
The following table shows a summary of other real estate and repossessions. | | | | | | | | | | | | | | | | | | | | |
(Dollars in thousands) | | September 30, 2022 | | December 31, 2021 | | September 30, 2021 |
Commercial and agricultural | | $ | — | | | $ | — | | | $ | — | |
Solar | | — | | | — | | | — | |
Auto and light truck | | 26 | | | 75 | | | 687 | |
Medium and heavy duty truck | | — | | | — | | | — | |
Aircraft | | — | | | — | | | — | |
Construction equipment | | — | | | 757 | | | — | |
Commercial real estate | | — | | | — | | | — | |
Residential real estate and home equity | | — | | | — | | | — | |
Consumer | | — | | | 29 | | | 3 | |
Total | | $ | 26 | | | $ | 861 | | | $ | 690 | |
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 September 30, | | Nine Months Ended September 30, |
(Dollars in thousands) | | 2022 | | 2021 | | $ Change | | % Change | | 2022 | | 2021 | | $ Change | | % Change |
Noninterest income: | | | | | | | | | | | | | | | | |
Trust and wealth advisory | | $ | 5,498 | | | $ | 5,886 | | | (388) | | | (6.59) | % | | $ | 17,499 | | | $ | 17,833 | | | (334) | | | (1.87) | % |
Service charges on deposit accounts | | 3,240 | | | 2,767 | | | 473 | | | 17.09 | % | | 8,974 | | | 7,722 | | | 1,252 | | | 16.21 | % |
Debit card | | 4,628 | | | 4,570 | | | 58 | | | 1.27 | % | | 13,383 | | | 13,506 | | | (123) | | | (0.91) | % |
Mortgage banking | | 864 | | | 3,149 | | | (2,285) | | | (72.56) | % | | 3,303 | | | 9,909 | | | (6,606) | | | (66.67) | % |
Insurance commissions | | 1,695 | | | 1,862 | | | (167) | | | (8.97) | % | | 5,168 | | | 5,698 | | | (530) | | | (9.30) | % |
Equipment rental | | 2,761 | | | 3,946 | | | (1,185) | | | (30.03) | % | | 9,718 | | | 12,830 | | | (3,112) | | | (24.26) | % |
Losses on investment securities available-for-sale | | — | | | — | | | — | | | NM | | — | | | (680) | | | 680 | | | NM |
Other | | 3,321 | | | 3,317 | | | 4 | | | 0.12 | % | | 9,937 | | | 9,446 | | | 491 | | | 5.20 | % |
Total noninterest income | | $ | 22,007 | | | $ | 25,497 | | | (3,490) | | | (13.69) | % | | $ | 67,982 | | | $ | 76,264 | | | (8,282) | | | (10.86) | % |
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 and nine months ended September 30, 2022 compared with the same periods 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 September 30, 2022, December 31, 2021, and September 30, 2021 was $4.58 billion, $5.33 billion, and $5.09 billion, respectively. The stock and bond market corrections during the first nine months of 2022 have resulted in a decline in the market value of trust assets under management compared to December 31, 2021.
Service charges on deposit accounts increased for the three and nine months ended September 30, 2022 over the comparable periods in 2021. The increase in service charges on deposit accounts primarily reflects a higher volume of consumer nonsufficient fund transactions.
Debit card income increased slightly during the third quarter of 2022 and decreased slightly in the nine months ended September 30, 2022 compared to the same periods a year ago.
Mortgage banking income decreased in the three and nine months ended September 30, 2022 as compared to the same periods in 2021. The reduction for both periods is mainly from reduced mortgage banking origination volumes resulting in lower income from loans sold in the secondary market. Demand for mortgages has continued to decline as higher rates have negatively impacted refinancing volumes. Additionally, we recognized $0.22 million and $0.81 million, respectively in impairment recoveries on our mortgage servicing assets during the three and nine months ended September 30, 2021.
Insurance commissions were lower during the three and nine months ended September 30, 2022 compared to the same periods a year ago. The reduction during 2022 was mainly due to fewer contingent commissions received and a reduction in the book of business.
Equipment rental income decreased for the three and nine months ended September 30, 2022 over the comparable periods in 2021. The decline was the result of a reduction in the construction equipment and auto and light truck portfolios resulting in the average equipment rental portfolio decreasing by 19% over the same periods a year ago due to changing customer preferences and competitive pricing pressures for new business.
There were no sales of investment securities available-for-sale during the three and nine months ended September 30, 2022. During 2021, losses on investment securities available-for-sale were the result of repositioning the portfolio.
Other income was flat for the quarter and increased during the nine months ended September 30, 2022 compared to the comparable periods in 2021. The increase during the nine month period was primarily a result of higher brokerage fees and commissions, a rise in bank owned life insurance policy claims and increased merchant card fees offset by a decrease in customer interest rate swap fees.
NONINTEREST EXPENSE
The following table shows the details of noninterest expense.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended September 30, | | Nine Months Ended September 30, |
(Dollars in thousands) | | 2022 | | 2021 | | $ Change | | % Change | | 2022 | | 2021 | | $ Change | | % Change |
Noninterest expense: | | | | | | | | | | | | | | | | |
Salaries and employee benefits | | $ | 26,386 | | | $ | 26,974 | | | (588) | | | (2.18) | % | | $ | 77,415 | | | $ | 77,680 | | | (265) | | | (0.34) | % |
Net occupancy | | 2,582 | | | 2,654 | | | (72) | | | (2.71) | % | | 7,917 | | | 7,900 | | | 17 | | | 0.22 | % |
Furniture and equipment | | 1,372 | | | 1,494 | | | (122) | | | (8.17) | % | | 4,051 | | | 4,388 | | | (337) | | | (7.68) | % |
Data processing | | 5,802 | | | 4,950 | | | 852 | | | 17.21 | % | | 16,412 | | | 14,851 | | | 1,561 | | | 10.51 | % |
Depreciation – leased equipment | | 2,233 | | | 3,239 | | | (1,006) | | | (31.06) | % | | 7,912 | | | 10,562 | | | (2,650) | | | (25.09) | % |
Professional fees | | 1,539 | | | 1,815 | | | (276) | | | (15.21) | % | | 5,241 | | | 5,574 | | | (333) | | | (5.97) | % |
FDIC and other insurance | | 939 | | | 396 | | | 543 | | | NM | | 2,682 | | | 1,833 | | | 849 | | | 46.32 | % |
Business development and marketing | | 1,415 | | | 4,465 | | | (3,050) | | | (68.31) | % | | 4,352 | | | 6,813 | | | (2,461) | | | (36.12) | % |
| | | | | | | | | | | | | | | | |
Other | | 3,063 | | | 2,077 | | | 986 | | | 47.47 | % | | 10,340 | | | 7,801 | | | 2,539 | | | 32.55 | % |
Total noninterest expense | | $ | 45,331 | | | $ | 48,064 | | | (2,733) | | | (5.69) | % | | $ | 136,322 | | | $ | 137,402 | | | (1,080) | | | (0.79) | % |
NM = Not Meaningful
Salaries and employee benefits decreased during the three and nine months ended September 30, 2022 compared to the same periods in 2021. Lower group insurance claims and a reduction in incentive compensation was offset by higher base salaries as a result of normal merit increases.
Net occupancy expense decreased during the three months ended September 30, 2022 compared to the same period in 2021 and was flat during the nine months ended September 30, 2022 compared to the same period a year ago. The quarterly decrease was primarily due to fewer premises repairs.
Furniture and equipment expense, including depreciation, declined during the three and nine months ended September 30, 2022 compared to the same periods a year ago mainly due to reduced equipment depreciation and rent expenses.
Data processing expense increased during the third quarter and first nine months of 2022 compared to the same periods a year ago due primarily to higher computer processing charges and software maintenance expense for technology projects.
Depreciation on leased equipment decreased for the three and nine months ended September 30, 2022 compared to the same periods in 2021. Depreciation on leased equipment correlates with the decrease in equipment rental income.
Professional fees were lower during the third quarter and first nine months of 2022 compared to the same periods a year ago. Reduced legal expenses were offset by increased professional consulting fees.
FDIC and other insurance was higher during the three and nine months ended September 30, 2022 compared to the same periods in 2021. The increase was mainly due to higher assessments for FDIC premiums from a larger asset base and a one-time $0.38 million recovery of an incurred but not reported insurance reserve recognized during the third quarter of 2021.
Business development and marketing expense was lower during the third quarter and first nine months of 2022 compared to the same periods a year ago. The decrease was mainly due to a charitable contribution of $3.00 million made during the third quarter of 2021 offset by increased business meals, entertainment and travel opportunities tied to fewer COVID-19 restrictions.
Other expenses were higher during the three and nine months ended September 30, 2022 compared to the same periods in 2021. The increase was primarily the result of a rise in the loan loss provision for unfunded loan commitments, an increase in the interest rate swap valuation provision and increased postage and printing costs for customer forms and cards.
INCOME TAXES
The provision for income taxes for the three and nine month period ended September 30, 2022 was $9.70 million and $26.30 million compared to $9.74 million and $27.80 million for the same periods in 2021. The effective tax rate was 22.85% and 23.06% for the quarter ended September 30, 2022 and 2021, respectively and 22.71% and 23.43% for the nine months ended September 30, 2022 and 2021, respectively. The decrease in the year-to-date effective tax rate was due to a slight decrease in the tax provision for state income taxes during the first nine months of 2022 in comparison to the first nine months of 2021.
ITEM 3.