1ST SOURCE CORPORATION The following management's discussion and analysis is presented to provide information concerning1st Source Corporation and its subsidiaries' (collectively referred to as "the Company", "we", and "our") financial condition as ofSeptember 30, 2020 , as compared toDecember 31, 2019 , and the results of operations for the three and nine months endedSeptember 30, 2020 and 2019. This discussion and analysis should be read in conjunction with our consolidated financial statements and the financial and statistical data appearing elsewhere in this report and our 2019 Annual Report . Except for historical information contained herein, the matters discussed in this document express "forward-looking statements." Generally, the words "believe," "contemplate," "seek," "plan," "possible," "assume," "expect," "intend," "targeted," "continue," "remain," "estimate," "anticipate," "project," "will," "should," "indicate," "would," "may" and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Those statements, including statements, projections, estimates or assumptions concerning future events or performance, and other statements that are other than statements of historical fact, are subject to material risks and uncertainties. We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made. We may make other written or oral forward-looking statements from time to time. Readers are advised that various important factors could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected in such forward-looking statements. Such factors include, but are not limited to, changes in law, regulations or GAAP; our competitive position within the markets we serve; increasing consolidation within the banking industry; unforeseen changes in interest rates; unforeseen changes in loan prepayment assumptions; unforeseen downturns in or major events affecting the local, regional or national economies or the industries in which we have credit concentrations; more recently, potential impacts of the COVID-19 pandemic; and other matters discussed in our filings with theSEC , including our Annual Report on Form 10-K for 2019, which filings are available from theSEC . We undertake no obligation to publicly update or revise any forward-looking statements. FINANCIAL CONDITION Our total assets atSeptember 30, 2020 were$7.29 billion , an increase of$668.17 million or 10.09% fromDecember 31, 2019 . Total investment securities, available-for-sale were$1.08 billion , an increase of$42.84 million or 4.12% fromDecember 31, 2019 . Federal funds sold and interest bearing deposits with other banks were$91.64 million , an increase of$75.49 million or 467.44% fromDecember 31, 2019 . Total loans and leases were$5.63 billion , an increase of$541.51 million or 10.65% fromDecember 31, 2019 . The largest contributor to the increase in loans and leases was PPP loans funded during the second and third quarters of 2020. PPP loans are discussed in the "COVID-19 Impact" section below. Our foreign loan and lease balances, all denominated inU.S. dollars were$176.62 million and$184.24 million as ofSeptember 30, 2020 andDecember 31, 2019 , respectively. Foreign loans and leases are in aircraft financing. Loan and lease balances to borrowers inBrazil andMexico were$66.46 million and$104.80 million as ofSeptember 30, 2020 , respectively, compared to$58.29 million and$111.91 million as ofDecember 31, 2019 , respectively. As ofSeptember 30, 2020 andDecember 31, 2019 there was not a significant concentration in any other country. Solar loan and lease balances were$263.47 million as ofSeptember 30, 2020 , an increase of$93.85 million or 55.33% from the$169.62 million atDecember 31, 2019 . Solar loan and lease balances are included in commercial and agricultural loans. Equipment owned under operating leases was$79.70 million , a decrease of$31.98 million , or 28.64% compared toDecember 31, 2019 . The largest contributor to the decrease in equipment owned under operating leases was reduced leasing volume primarily due to a change in customer preferences. Total deposits were$5.90 billion , an increase of$539.53 million or 10.07% from the end of 2019. The largest contributors to the increase in total deposits was PPP loan fundings into business accounts and consumer savings levels. Short-term borrowings were$165.57 million , an increase of$19.68 million or 13.49% fromDecember 31, 2019 . Long-term debt and mandatorily redeemable securities were$81.66 million , an increase of$10.02 million or 13.99% fromDecember 31, 2019 . 31 -------------------------------------------------------------------------------- Table of Contents The following table shows accrued income and other assets. September 30, December 31, (Dollars in thousands) 2020
2019
Accrued income and other assets: Bank owned life insurance cash surrender value$ 69,938 $
68,774
Operating lease right of use assets 22,261 24,147 Accrued interest receivable 21,565 19,125 Mortgage servicing rights 3,729 4,200 Other real estate 303 522 Repossessions 4,639 8,623 Partnership investments carrying amount 100,265
61,083
All other assets 78,134
41,516
Total accrued income and other assets$ 300,834 $
227,990
The largest contributors to the increase in accrued income and other assets from
CORONAVIRUS (COVID-19) IMPACT
The following is a description of the impact the Coronavirus (COVID-19) pandemic
is having on our financial condition and results of operations and certain risks
to our business that the pandemic creates or exacerbates.
Operational Impact
Pursuant to our preexisting disaster recovery plan addressing potential pandemic
outbreaks, we created a dedicated executive COVID-19 response team that is
closely monitoring developments and providing guidance for additional
precautions and initiatives. We have divided departments among various locations
to help ensure that infection will not spread across entire departments. We are
encouraging virtual meetings and conference calls in place of in-person
meetings, including our annual shareholder meeting which was held virtually this
year. Employees with health conditions putting them at higher risk of adverse
effects from coronavirus infection are working remotely. Additionally, travel
has been restricted. We are promoting social distancing, frequent hand washing,
thorough disinfection of all surfaces, and the use of masks or nose and mouth
coverings have been mandated in all of our locations. The majority of our
banking center lobbies have been closed except for advance appointments only.
Banking center drive-ups, ATMs and online/mobile banking services continue to
operate. It remains undetermined how long our banking centers will operate at
these service levels. Infection rates in the communities we serve vary by region
and we will make prudent decisions for the safety of our colleagues and our
clients.
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Loan and lease modifications
We began receiving requests from our borrowers for loan and lease deferrals in
March. Modifications include the deferral of principal payments or the deferral
of principal and interest payments for terms generally 90 - 180 days. Requests
are evaluated individually and approved modifications are based on the unique
circumstances of each borrower. We are committed to working with our clients to
allow time to work through the challenges of this pandemic. At this time, it is
uncertain what future impact loan and lease modifications related to COVID-19
difficulties will have on our financial condition, results of operations and
reserve for loan and lease losses. The following table shows coronavirus loan
and lease modification balances in deferment as of June 30, 2020 and September
30, 2020 .
COVID-19 Related Loan and Lease Modifications
(Dollars in millions) June 30, 2020 September 30, 2020
Auto and light truck rental $ 224 $ 22
Specialty vehicle(1) 75 23
Medium and heavy duty truck 87 5
Aircraft 93 13
Construction 139 -
Commercial 210 63
Residential real estate and home equity 4 -
Consumer 8 -
Total loans and leases $ 840 $ 126
(1) Includes buses, step vans and funeral cars.
The following table shows the coronavirus loan and lease modification balances
by deferral type as of
Total Modifications as a %
Additional Recorded Investment of
Principal Only Principal and Total Modifications Modifications at September 30, 2020
(Dollars in millions) Deferrals Interest Deferrals in Deferment
Expected(1) Total Modifications September 30, 2020 Balance
Auto and light truck
rental $ 21 $ 1 $ 22 $ 16 $ 38 $ 379 10 %
Specialty vehicle(2) 11 12 23 23 46 149 31 %
Medium and heavy duty
truck 5 - 5 - 5 271 2 %
Aircraft 13 - 13 6 19 806 2 %
Construction - - - 1 1 724 - %
Commercial 5 58 63 23 86 2,643 3 %
Residential real estate
and home equity - - - - - 520 - %
Consumer - - - - - 135 - %
Total loans and leases 55 71 126 69 195 5,627 3 %
PPP loans, net of unearned
discount(3) - - - - - 581 - %
Total loans and leases
less PPP loans $ 55 $ 71 $ 126 $ 69 $ 195 $ 5,046 4 %
(1) Represents modifications which ended deferment during
As ofSeptember 30, 2020 , COVID-19 related loan modifications for our bus lending were$45.35 million or 50.85% (includes$22.92 million whose modification period ended during September but we expect to grant further extensions) of our total bus loan balances. COVID-19 related loan modifications for the hotel industry were$74.62 million or 47.25% (includes$17.21 million whose modification period ended during September but we expect to grant further extensions) of our total hotel loan balances. Hotel loans are shown within the Commercial category in the charts above and below. 33 -------------------------------------------------------------------------------- Table of Contents With the imposition of travel restrictions as a result of taking steps to slow the spread of COVID-19, our bus clients were immediately impacted resulting in numerous deferral requests. We initially granted three-month deferrals to many of these clients, most of which were principal and interest deferrals. During the second quarter, we sent questionnaires to all of our bus clients in order to gain a better understanding of their situation, their customer base and the likely long-term impact of the economic downturn on their business model, i.e. their ability to withstand reduced revenue for an extended period of time. The problems persisted into the third quarter with most of our bus clients having lost all but a small fraction of their revenue base. During the third quarter, we continued our efforts to differentiate our bus clients based on the underlying risks in their business models and management teams and, to differentiate collateral types, we created tiers from more desirable to less desirable collateral pools and valued the units accordingly, using deeper discount rates against collateral deemed less desirable. Our bus team gathered information on these bus clients, many of which are relatively small relationships and were initially credit scored. We sent out a second round of questionnaires and made personal contacts, asking our clients how they are coping in this unprecedented environment. We tried to assess our client's outlook and their ability to manage through several more months of extreme distress. We gathered information on how they are maintaining their assets and if the units are currently insured. We are diligently working with these clients to try to keep them in business. The government relief programs have not been of much benefit to this sector and the outlook for the next relief package is uncertain. To date, we have extended two rounds of three-month deferrals to many of our bus clients and will continue to agree to a third round of deferrals if we think our clients can support the maintenance and insurance of their units; we will work to collect interest payments where we can. Our intent is to repossess collateral as a last result. If the borrower cannot maintain the assets, we will move to take them back either voluntarily or by legal action. We expect long holding periods until we will be able to sell any repossessed units. So far, we have minimal repossessed bus assets,$638,000 as ofSeptember 30, 2020 , but this number will likely increase. We believe some of the clients for whom we have established specific impairment reserves will eventually require charge-offs but at this time it is difficult to determine which clients. We hope to have more clarity by the end of the 2020. The following table shows the coronavirus loan and lease modification balances. Modification terms generally ranged between three and six months depending on industry. First Modification Second Modification Third Modification (Dollars in millions) Expired In Deferment Total Expired In Deferment(1) Total Expired In Deferment(1) Total Auto and light truck rental$ 255 $ 18$ 273 $ 61 $ 4$ 65 $ - $ 16$ 16 Specialty vehicle(2) 88 - 88 55 16 71 - 30 30 Medium and heavy duty truck 89 - 89 - 5 5 - - - Aircraft 97 - 97 11 19 30 - - - Construction 144 - 144 8 - 8 - 1 1 Commercial 185 55 240 19 25 44 - 6 6 Residential real estate and home equity 7 - 7 2 - 2 - - - Consumer 9 - 9 - - - - - - Total loans and leases$ 874 $ 73$ 947 $ 156 $ 69$ 225 $ - $ 53$ 53
(1) Includes modifications which ended deferment during
Paycheck Protection Program (PPP) and Liquidity As part of the CARES Act, approved by the President onMarch 27, 2020 and extended onJuly 4, 2020 , theSmall Business Administration (SBA) has been authorized to guarantee loans under the PPP throughAugust 8, 2020 for businesses who meet the necessary eligibility requirements in order to keep their workers on the payroll. We began accepting applications onApril 3, 2020 and disbursed the final PPP loan onAugust 25, 2020 . PPP loans are fully guaranteed by the SBA and as such do not represent a credit risk. The following table shows PPP loan disbursements as ofSeptember 30, 2020 . Number of Loans $ of Loans (000's) Average Loan Size Phase One 2,024 $ 520,583 $ 257,000 Phase Two 1,516 76,868 51,000 Total 3,540 $ 597,451 $ 169,000 As ofSeptember 30, 2020 , PPP loans were$580.62 million which is net of an unearned discount of$14.21 million and located within the commercial and agricultural portfolio. AtSeptember 30, 2020 , specialty finance customers had$104.80 million of PPP loans and traditional commercial banking customers had$475.82 million of PPP loans. 34 -------------------------------------------------------------------------------- Table of Contents During the quarter, we began working with our PPP clients to submit loan forgiveness applications to the SBA. OnOctober 8, 2020 , the SBA announced a streamlined loan forgiveness application for loans$50,000 or less. Of the 3,540 PPP loans we originated, 1,972 loans were for$50,000 or less. As of mid-October, we had submitted over$100 million loan forgiveness requests to the SBA. The majority of the requests we have submitted to date remain in process pending SBA review before reimbursement can proceed. OnApril 9, 2020 , theFDIC ,Federal Reserve and OCC created the Paycheck Protection Program Liquidity Facility (PPPLF) to bolster the effectiveness of the PPP by providing liquidity to and neutralizing the regulatory capital effects on participating financial institutions. If needed, we will utilize the liquidity relief offered by the PPPLF and as such do not expect our participation in the PPP to have a negative impact on our liquidity position, capital resources, financial condition or results of operations. As ofSeptember 30, 2020 , we had not yet utilized the PPPLF. See Part I Financial Information, Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations under the heading "Capital" for more information regarding the COVID-19 impact on share repurchases and dividend activity. Asset impairment Our MSRs have experienced a decrease in their fair value as ofSeptember 30, 2020 resulting in year-to-date impairment charges of$0.81 million due to lower mortgage rates leading to faster prepayment speeds. We will continue to evaluate MSRs at each reporting date to determine whether further valuation allowances are appropriate. We evaluate goodwill for impairment during the fourth quarter of each year, with financial data as ofSeptember 30 . Based on the analysis performed as ofOctober 1, 2019 , we determined that goodwill for our reporting units was not impaired. During the first quarter of 2020, management determined that the deterioration in general economic conditions as a result of the COVID-19 pandemic and responses thereto represented a triggering event prompting an evaluation of goodwill impairment. Based on the analyses performed during the first, second and third quarters of 2020, we determined that goodwill was not impaired. At this time, we do not believe there exists any impairment to our intangible assets, long-lived assets, right of use assets, or available-for-sale investment securities due to the COVID-19 pandemic. It is uncertain whether prolonged effects of the COVID-19 pandemic will result in future impairment charges related to any of the aforementioned assets. Risks See Part II Other Information, Item 1A, Risk Factors for more information. Reserve for loan and lease losses We have experienced increasing downgrades and defaults as a result of the impact COVID-19 is having on our borrowers as evidenced by increasing special attention and non-performing loan balances. Special attention loan balances increased$10.91 million in the third quarter of 2020 and$78.49 million sinceDecember 31, 2019 and we anticipate further downgrades during the fourth quarter of 2020 and into 2021. Likewise, non-performing loans increased by$7.62 million during the third quarter and$60.58 million since year-end. Third quarter 2020 downgrades were concentrated in the bus segment within the auto and light truck portfolio as well as a couple of downgrades in the commercial portfolio, one of which was directly impacted by COVID-19 restrictions. We are in communication with our customers to gain a better understanding of our highest risk exposures and probable defaults. As a result of the discussions with our customers, we downgraded an additional 43 bus accounts to special attention and placed several of these accounts on nonaccrual status. We anticipate further defaults in our bus lending during the fourth quarter of 2020. Furthermore, the bus collateral may be difficult to liquidate, particularly in this environment. We believe our auto rental customers will continue to struggle; however, vehicle auctions are well established and are an effective means of liquidating collateral and used vehicle values, to date, have remained strong, so our loss exposure is well managed. Our local market customers have been buoyed in the short-term with funds from the PPP program. Thus far, we have not seen many downgrades or defaults in our commercial lending, but we anticipate this will change particularly as businesses continue to struggle and customers request an additional round of loan modifications. During the last recession, we also noted a delayed impact on our commercial lending as compared to our specialty finance lending. Our losses year-to-date remain moderate but we continue to build reserves as we anticipate some of the current and future downgrades and defaults will eventually result in losses. See Part I Financial Information, Note 5 to the Consolidated Financial Statements and Part I Financial Information, Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations under the heading "Provision and Reserve for Loan and Lease Losses" for more information. 35
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CAPITAL
As of September 30, 2020 , total shareholders' equity was $877.75 million , up
$49.48 million , or 5.97% from the $828.28 million at December 31, 2019 . In
addition to net income of $54.97 million , other significant changes in
shareholders' equity during the first nine months of 2020 included $21.76
million of dividends paid. The accumulated other comprehensive income component
of shareholders' equity totaled $19.66 million at September 30, 2020 , compared
to $5.17 million at December 31, 2019 . Our shareholders' equity-to-assets ratio
was 12.04% as of September 30, 2020 , compared to 12.51% at December 31, 2019 .
Book value per common share rose to $34.35 at September 30, 2020 , from $32.47 at
December 31, 2019 .
We declared and paid cash dividends per common share of $0.28 during the third
quarter of 2020. The trailing four quarters dividend payout ratio, representing
cash dividends per common share divided by diluted earnings per common share,
was 38.00%. The dividend payout is continually reviewed by management and the
Board of Directors subject to the Company's capital and dividend policy. Due to
COVID-19, we had temporarily suspended the repurchase of common shares from the
open market earlier this year. Subject to the Company's capital policy,
management and the Board of Directors may resume share repurchases based on a
careful examination of facts and circumstances at such time.
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, 2020 , are presented in the table below.
To Be Well Capitalized
Minimum Capital Adequacy with Capital Under Prompt Corrective
Actual Minimum Capital Adequacy Buffer Action Provisions
(Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio Amount Ratio
Total Capital (to Risk-Weighted Assets):
1st Source Corporation $ 948,891 15.74 % $ 482,133 8.00 % $ 632,800 10.50 % $ 602,667 10.00 %
1st Source Bank 859,135 14.24 482,677 8.00 633,514 10.50 603,347 10.00
Tier 1 Capital (to Risk-Weighted Assets):
1st Source Corporation 872,755 14.48 361,600 6.00 512,267 8.50 482,133 8.00
1st Source Bank 782,915 12.98 362,008 6.00 512,845 8.50 482,677 8.00
Common Equity Tier 1 Capital (to
Risk-Weighted Assets):
1st Source Corporation 778,494 12.92 271,200 4.50 421,867 7.00 391,733 6.50
1st Source Bank 745,654 12.36 271,506 4.50 422,343 7.00 392,175 6.50
Tier 1 Capital (to Average Assets):
1st Source Corporation 872,755 12.14 287,593 4.00 N/A N/A 359,492 5.00
1st Source Bank 782,915 10.89 287,573 4.00 N/A N/A 359,467 5.00
As part of the CARES Act, PPP loan balances have been assigned a zero percent
risk weight and therefore had no impact on our total risk-weighted assets at
September 30, 2020 .
LIQUIDITY AND INTEREST RATE SENSITIVITY
Effective liquidity management ensures that the cash flow requirements of
depositors and borrowers, as well as our operating cash needs are met. Funds are
available from a number of sources, including the securities portfolio, the core
deposit base, access to the national brokered certificates of deposit market,
national listing service certificates of deposit, Federal Home Loan Bank (FHLB)
borrowings, Federal Reserve Bank (FRB) borrowings, and the capability to package
loans for sale.
We have borrowing sources available to supplement deposits and meet our funding
needs. 1st Source Bank has established relationships with several banks to
provide short term borrowings in the form of federal funds purchased. At
September 30, 2020 , we had no borrowings in the federal funds market. We could
borrow $225.00 million in additional funds for a short time from these banks on
a collective basis. As of September 30, 2020 , we had $55.36 million outstanding
in FHLB advances and could borrow an additional $500.50 million contingent on
the FHLB activity-based stock ownership requirement. We also had no outstandings
with the FRB and could borrow $456.53 million as of September 30, 2020 .
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Our loan to asset ratio was 77.18% at September 30, 2020 compared to 76.79% at
December 31, 2019 and 76.21% at September 30, 2019 . Cash and cash equivalents
totaled $154.22 million at September 30, 2020 compared to $83.37 million at
December 31, 2019 and $127.49 million at September 30, 2019 . The largest
contributors to the increase in cash and cash equivalents was higher deposit
balances due to both individual and business customers' propensity to save
during times of uncertainty. At September 30, 2020 , the Consolidated Statements
of Financial Condition was rate sensitive by $309.13 million more assets than
liabilities scheduled to reprice within one year, or approximately 1.09%.
Management believes that the present funding sources provide adequate liquidity
to meet our cash flow needs.
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 $737 million .
RESULTS OF OPERATIONS
Net income available to common shareholders for the three and nine month periods
ended September 30, 2020 was $20.06 million and $54.97 million , compared to
$24.44 million and $70.02 million for the same periods in 2019. Diluted net
income per common share was $0.78 and $2.14 for the three and nine month periods
ended September 30, 2020 , compared to $0.95 and $2.72 for the same periods in
2019. Return on average common shareholders' equity was 8.52% for the nine
months ended September 30, 2020 , compared to 11.83% in 2019. The return on total
average assets was 1.05% for the nine months ended September 30, 2020 , compared
to 1.45% in 2019.
Net income decreased for the nine months ended September 30, 2020 compared to
the first nine months of 2019. Net interest income decreased and the provision
for loan and lease losses increased which was offset by an increase in
noninterest income. Details of the changes in the various components of net
income are discussed further below.
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