First Merchants Annual Report 2007

Plain-text annual report

a na na na n n un un un u a la la la l r rrr e pe pe pp o r t 2 0 0 7 a n n u a l r e p o r t 2 0 0 7 www.ﬁ rstmerchants.com ﬁ rst merchants corpor ation market area c o r p o r a t e p r o f i l e First Merchants Corporation is a ﬁ nancial services company focused on building deep, lifelong client relationships. Headquartered in Muncie, Indiana, with four bank subsidiaries, a trust company and a multi-line insurance company, we deliver superior personalized ﬁ nancial solutions to consumer and closely held commercial clients in diverse community markets. With 66 locations in eighteen Indiana and three Ohio counties, we provide a full range of personal and business services including ﬁ nancing, mortgages, cash ﬂ ow management services and deposit solutions. ■ ﬁ rst merchants bank, n.a. ﬁ rst m Serves Ada Serves Adams, Delaware, Fayette, Hamilton, Henry, Howard, Jay, Marion, Miami, Randolph, Union, Wabash, Wayne Counties in Indiana, Marion M and Butler Ohio. ■ lafaye lafayette bank & trust, n.a. Serves Tip Serves Tippecanoe, Carroll, Jasper and White Counties. a n n u a l m e e t i n g ■ ﬁ rst merchants bank of centr al indiana, n.a. ﬁ rst m The annual meeting of stockholders of First Merchants Corporation will be held… Serves Ma Serves Madison County. ■ comme commerce national bank, n.a. Serves Fra Serves Franklin and Hamilton Counties in Ohio. ■ ﬁ rst merchants trust company ﬁ rst m Tuesday, April 29, 2007 (cid:129) 3:30 pm One of the One of the largest trust companies in the State of Indiana, provides c u l t u r e s t a t e m e n t We are a team of associates who support and expect superior results from our company and ourselves. Accountability and execution are the foundations of our success. c o r e v a l u e s client satisfaction: Focus on the client in all that we do. teamwork: Teams make better decisions. local decisions: Make decisions locally – stay close to the client. integrity: Maintain the highest standards with clients, associates, Horizon Convention Center 401 South High Street Muncie, Indiana 47305 a full com a full complement of trust and investment services. communities and stakeholders. ■ ﬁ rst merchants insur ance services ﬁ rst m Offers an e Offers an extensive line of commercial insurance products complemented quality: by persona by personal insurance and employee beneﬁ t plans. Provide predictable superior execution. ﬁ nancial highlights to our shareholders partnership proﬁ le investor summary fmc board of directors 1 2 4 6 7 afﬁ liate board of directors 8 ﬁ nancial review 9 ■ co corpor ate headquarters Firs First Merchants Corporation 200 East Jackson Street Muncie, IN 47305 765.747.1500 www.ﬁ rstmerchants.com st■ stock symbol: nasdaq: fr me people: Respect and value people as our competitive advantage. ﬁ nancial performance: Operate proﬁ table lines of business to beneﬁ t our stakeholders. The greater part of progress is the desire to progress. o u r m i s s i o n To deliver superior, personalized ﬁ nancial solutions to consumer and closely held commercial clients, in diverse community markets, by providing sound advice and products that exceed expectations. o u r v i s i o n A ﬁ nancial services company focused on building deep, lifelong client relationships and providing maximum shareholder value. We provide an environment where customers can bank with their neighbors, realizing that our business begins and ends with people. ■ corpor corporate headquarters First Merc First Merchants Corporation 200 East Jackson Street Muncie, Indiana 47305 765.747.1500 — seneca www.ﬁ rstmerchants.com f if if if i r sr sr sr s t tt t m em em em e r cr cr cr c h ah ah ah a n tn tn tt s s s s c occ oc o r pr pr pr p o roo ro r a ta ta ta t i oi oo n nnn a f f i l i a t e b o a r d s o f d i r e c t o r s ■ First Merchants Bank Ronald K. Fauquher Chairman Ontario Systems, LLC Senior Vice President Dennis A. Bieberich First Merchants Bank Senior Executive Offi cer Kevan B. Biggs Ideal Suburban Homes, Inc. Chief Executive Offi cer Thomas E. Chalfant Chalfant Farms, Inc. Vice President Richard A. Daniels McCullough-Hyde Memorial Hospital President Chief Executive Offi cer Greg A. Fleming Fleming Escavating, Inc. President John W. Forrester Wabash Electric President Michael B. Galliher A.E. Boyce Co., Inc. President Thomas K. Gardiner, MD Cardinal Health Systems, Inc. Executive Vice President Dr. Gregory L. Garner Midwest Eye Consultants, PC President Chief Executive Offi cer Mark K. Hardwick First Merchants Corporation Executive Vice President Chief Financial Offi cer John W. Hartmeyer Al Pete Meats, Inc. Chief Executive Offi cer Arthur W. Jasen B. Walter & Co., Inc. President Mark A. Kaehr R & K Incinerator President Eric J. Kelly Masonry Services, Inc. President Errol P. Klem Klem Golf, Inc. President Dr. Bonnie R. Maitlen B.R. Maitlen and Associates President James A. Meinerding First Merchants Bank President Chief Executive Offi cer Jon H. Moll DeFur Voran, LLP Partner Stephen R. Myron, MD Preferred Medical President Chief Executive Offi cer Gerald S. Paul Medreco, Inc. President Robert M. Pearson Wabash County REMC Chief Executive Offi cer Gary L. Whitenack Whitenack Farms Co-Owner Michael D. Wickersham Wick’s Pies, Inc. President Dr. Maria Williams-Hawkins Ball State University Associate Professor of Telecommunications ■ First Merchants Bank of Central Indiana George R. Likens Chairman Farmer Michael L. Baker First Merchants Bank of Central Indiana President Chief Executive Offi cer Dr. James L. Edwards Anderson University President Jeff rey A. Jenness Board of Pensions Church of God Executive Secretary Joseph R. Kilmer Attorney at Law C. David Kleinhenn Kleinhenn Company President Robert J. Pensec Carbide Grinding Company President Nancy Ricker Ricker’s Oil Secretary/Treasurer Co-Owner Stephen D. Skaggs Perfecto Tool & Engineering Co., Inc. President Curtis L. Stephenson First Merchants Insurance Services President Chief Executive Offi cer ■ Commerce National Bank ■ Lafayette Bank & Trust Company ■ First Merchants Loreto V. Canini Canini & Pellecchia, Inc. President Jameson Crane, Jr. Crane Group, Co. Vice President Rhonda J. DeMuth TDCI, Inc. Chief Executive Offi cer William L. Hoy Columbus Sign Company Chief Executive Offi cer Clark Kellogg CBS Sports Basketball Analyst Thomas D. McAuliff e Commerce National Bank Chairman of the Board Samuel E. McDaniel Sam McDaniel, LLC President John A. Romelfanger H & S Forest Products, Inc. Chief Executive Offi cer John W. Royer Kohr, Royer, Griffi th, Inc. (KRG) President Richard F. Ruhl Dick Ruhl Ford Sales, Inc. (retired) Mark C. Ryan New Albany Board of Education Board Member William A. Wickham WA Wickham & Associates Chairman Chief Executive Offi cer David L. Winks Capital Lighting, Inc. Vice President Robert J. Weeder Chairman Lafayette Bank & Trust Company President (retired) Jeff rey L. Kessler Vice Chairman of the Board Stall & Kessler Diamond Center Co-Owner Tony S. Albrecht Lafayette Bank & Trust Company President Chief Executive Offi cer Kelly V. Busch KVB Broadcasting Managing General Partner W. L. Hancock PSI Energy, A CINERGY Company General Manager (retired) Joseph B. Hornett Purdue Research Foundation Senior Vice President Treasurer Gary J. Lehman Fairfi eld Manufacturing Company, Inc. President Chief Executive Offi cer Eric P. Meister GTE North, Inc. Central Division Manager (retired) Michael C. Rechin First Merchants Corporation President Chief Executive Offi cer Directors Emeriti Richard A. Boehning Joseph A. Bonner Vernon N. Furrer Robert T. Jeff ares Charles E. Maki Roy D. Meeks Insurance Services Mark K. Hardwick Chairman First Merchants Corporation Executive Vice President Chief Financial Offi cer Michael D. Gilbert First Merchants Insurance Services Senior Vice President James A. Meinerding First Merchants Bank President Chief Executive Offi cer Michael C. Rechin First Merchants Corporation President Chief Executive Offi cer Curt L. Stephenson First Merchants Insurance Services President Chief Executive Offi cer ■ First Merchants Reinsurance Co., LTD. Michael L. Cox Chairman First Merchants Corporation President Chief Executive Offi cer (retired) Mark K. Hardwick Treasurer First Merchants Corporation Executive Vice President Chief Financial Offi cer Brian A. Edwards Secretary First Merchants Corporation Vice President Financial Services Offi cer ■ First Merchants Trust Company ■ Indiana Title Jon H. Moll Chairman DeFur Voran, LLP Partner Kimberly J. Ellington First Merchants Corporation Senior Vice President Human Resources Director Mark K. Hardwick First Merchants Corporation Executive Vice President Chief Financial Offi cer Terri E. Matchett First Merchants Trust Company President Chief Executive Offi cer Michael C. Rechin First Merchants Corporation President Chief Executive Offi cer Insurance Company David W. Heeter Chairman Mutual First Financial, Inc. Chief Executive Offi cer Jerome J. Gassen Ameriana Bancorp President Chief Executive Offi cer Mark K. Hardwick First Merchants Corporation Executive Vice President Chief Financial Offi cer James W. Smith Indiana Title Insurance Company Co-President James W. Trulock Indiana Title Insurance Company Co-President aaa nnn n n n u u u a a a l l l rr r e e e p p p o o rr r t t t 22 2 0 0 0 0 0 0 777 8 f i n a n c i a l h i g h l i g h t s Table dollar amounts in thousands, except per share data diluted net income per share $1.63 $1.64 $1.73 ■ at yea at year end ToToToToTT tatatatatal l ll AsAsAA sesesese Total Assets Stockholders’ Equity Total Loans Total Investments Total Deposits 2006 2007 $3,554,870 $3,782,087 327,325 339,936 2,698,014 2,880,578 465,217 451,167 2,750,538 2,844,121 2007 2005 2006 2007 2006 2005 Trust Accounts at Market Value (not included in banking assets) 1,653,000 1,652,000 ■ for th for the year InInnntetetetet rerererer stststst I I I Innnn Interest Income Interest Expense Net Interest Income Provision for Loan Losses Total Other Income Total Other Expenses Income Tax Expense Net Income ■ per sh per share BaBaBaBaB sisisisic c c c NeNeNeNeNeettt t t Basic Net Income Diluted Net Income Cash Dividends Book Value $ 208,606 $ 230,733 98,511 117,613 110,095 113,120 6,258 8,507 34,613 40,551 96,057 102,182 12,195 30,198 11,343 31,639 $ 1.64 $ 1.73 1.64 .92 1.73 .92 17.75 18.88 Market Value (Dec. 31 Bid Price) 27.19 21.84 ■ aver a aver ages during the year ToToToTootatatatatt l l l l AsAsAsAssseseseses Total Assets Total Loans Total Investments Total Deposits $3,371,386 $3,639,772 2,569,847 2,794,824 457,411 496,603 2,568,070 2,752,443 dividends per share $.92 $.92 $.92 2007 2005 2006 2007 2006 2005 aver age assets (in millions) $3,639.8 $3,371.4 $3,179.5 2005 2006 2007 2005 2006 2007 a n n u a l r e p o r t 2 0 0 7 1 t o o u r s h a r e h o l d e r s executive ofﬁ cers f irst Merchants ranks among an elite group of public companies that can report the achievement of improved EPS 31 of the last 32 years. It’s an accomplishment of which we are quite proud, and focused on sustaining for years to come. 2007 earnings per share totaled $1.73, a 5.5% increase over our 2006 results. Our total assets equaled $3.78 billion, an increase of $227 million, or 6.4 percent. Loans and investments, the Corporation’s primary earning assets, totaled $3.33 billion, an increase of $169 million, or 5.3 percent. Total non-interest income increased by $5.9 million, or 17.2 percent. All reported line items produced increases of at least 9.8 percent, reﬂ ecting the Corporation’s focus on fee-for-service business. The tactical execution of our strategic plan during 2007 is reﬂ ective of employee commitment to our customers and our company. As reported to you last year, we planned and achieved the consolidation of ﬁ ve bank charters into one, creating the largest bank headquartered in East Central Indiana. Throughout this project, our colleagues exempliﬁ ed themselves as the caring, energetic team members we know them to be, and kept their eye on the customer to ensure that service remains our primary product. A special thanks is owed to our bank board members who served as ambassadors of change in their local communities. Their tireless service and feedback keeps us connected to the issues that matter most to our customers. We’re a ﬁ nancial services company – large, diversiﬁ ed, dynamic, growing and innovative. The consolidation and enhanced focus on our brand provides us with the opportunity to more clearly articulate the core advantages we offer the marketplace: ■ ■ ■ We work hard to develop strong relationships with our clients. OUR Clients beneﬁ t from local decision m aking. WE offer clients broad ﬁ nancial services. We are organized around our customers. As you’ll read in the following pages, the relationships we develop with our customers provide them with a strong foundation upon which they can dream, build and grow. Our business is simple—we must ﬁ rst understand the customer’s needs, and then provide professional, personalized service and timely delivery. Our new tagline, “The strength of big, the service of small” describes how we are structured and how we deliver to our customers. We believe that we have the best of what banking can offer—the strength of our products and delivery systems, coupled with service that is provided locally by bankers who are known and trusted in their communities. We are transparent to the outside world as a collection of individuals who work each day as one company with one culture…a culture that expects superior results from our company and ourselves. Our competitive advantage is our people. Products and technology do not fulﬁ ll the promise behind the brand—people do. We are a company that has embraced a disciplined approach to the execution of our strategic plan and vision. And, we have a more clearly deﬁ ned focus on recruiting, developing and retaining great people who know how to build repeatable processes that will create and maintain satisﬁ ed customers. It is these customers who allow us to produce the ﬁ nancial 2 results that our shareholders desire. f if if if i r sr sr sr s t t ttt m em em em e r cr cr cr c h ah ah ah aa n tn tn tn tt s s ss c oc oc oc oc o r pr ppr pr o ro ro ro ro r a ta ta ta t i oi oi oo n n nn b o a r d o f d i r e c t o r s ■ Charles E. Schalliol Chairman of the Board Baker & Daniels, LLP Attorney & Consultant ■ Michael C. Rechin First Merchants Corporation President Chief Executive Offi cer ■ Richard A. Boehning Bennett, Boehning & Clary Of Counsel ■ Thomas B. Clark Jarden Corporation Chairman of the Board President Chief Executive Offi cer (retired) ■ Michael L. Cox ■ Roderick English First Merchants Corporation President Chief Executive Offi cer (retired) The James Monroe Group, LLC President Chief Executive Offi cer ■ Dr. Jo Ann M. Gora Ball State University President ■ William L. Hoy Columbus Sign Company Chief Executive Offi cer Michael C. Rechin President Chief Executive Offi cer Mark K. Hardwick Executive Vice President Chief Financial Offi cer Jami L. Bradshaw Senior Vice President Chief Accounting Offi cer Robert R. Connors Senior Vice President Chief Information Offi cer Kimberly J. Ellington Senior Vice President Human Resources Director Jeff rey B. Lorentson Senior Vice President Chief Risk Offi cer David W. Spade Senior Vice President Chief Credit Offi cer board committees Executive Committee Richard A. Boehning, Chairperson Barry J. Hudson Michael C. Rechin Charles E. Schalliol Audit Committee Jean L. Wojtowicz, Chairperson Thomas B. Clark Jo Ann M. Gora Terry L. Walker Compensation & Hum an Resources Committee Charles E. Schalliol, Chairperson Thomas B. Clark Roderick English Secretary to the Board Cynthia G. Holaday First Merchants Corporation Vice President Assistant Secretary to the Board C. Ronald Hall First Merchants Corporation Vice President Chairman Emeritus Stefan S. Anderson Nominating/ Governance Committee Thomas B. Clark, Chairperson Richard A. Boehning Charles E. Schalliol Jean L. Wojtowicz Pension & Retirement income & Savings Plan Administr ative Committee Kimberly J. Ellington, Plan Administrator Jami L. Bradshaw Michael C. Rechin ■ BarBBarBarBarBB ryryrrry JJJJJ HudHudHudHudHuHuu sosonsonsonsonon ■ Barry J. Hudson First National Bank Chairman of the Board (retired) ■ TerTerTerTerTerTerT ryryry LLLLLL WalWalWalWalWalkerkerkerkerkerkerr ■ Terry L. Walker Muncie Power Products, Inc. Chairman of the Board President Chief Executive Director ■ JeaJeaJeaJeaJean Ln Ln Ln Ln L WWWWWWojtojtojtojtojtowiowiowiowiow czczczczzz ■ Jean L. Wojtowicz Cambridge Capital Management Corp. President Chief Executive Offi cer a a a n n n n n n u u u a a a l l l rr r e e e p p p o o o r r r t t t 2 2 2 00 0 0 0 777 7 f m c i n v e s t o r s u m m a r y return on assets return on equity .95% .90% .90% .87% .87% 9.58% 9.45% 9.45% 9.56% $40,938 2005 2006 2007 2005 2006 2007 2007 2005 2006 2007 2006 2005 efﬁ ciency r atio* loan losses* 60.2% 62.2% 60.2% 62.37% .23% .24% .19% $4,200 ?% $68,272 t h e s t r e n g t h o f b i g . t h e s e r v i c e o f s m a l l . Our new tagline, “The strength of big, the service of small” describes how we are structured and how we deliver to our customers. We believe that we have the best of what banking can off er— the strength of our products and delivery systems, coupled with service that is provided locally by bankers who are known and trusted in their communities. ChChChChChCharararaa leleleeeesss E.EE.EE SSSSchchhhalallallilililil olollolol, ChChChChaiaiairmrmrmananannn ooooofffff ththtththt eeee BoBoBoBoBoBoarararararddd anananananddd Charles E. Schalliol, Chairman of the Board and Michael C. Rechin, President & Chief Executive Ofﬁ cer At a recent all-employee meeting, we celebrated our 2007 successes and individually recognized those who signiﬁ cantly contributed to our success. As each individual was recognized, their comments were not focused on themselves, but on the support their internal colleagues provided and their drive to serve their customers and communities. If just one word were used to describe initial investment (9/82) the day, it was passion. 2005 2006 2007 2005 2006 2007 2005 2006 2007 * indicates the cost to produce * indicates the cost to produce a dollar of revenue percent of average loans * as a percent of average loans percent of average loans * as a dividends received (through 12/31/07) market value (bid) trading history stock performance Our momentum is growing. We have strong teams, strong boards and a strong, growing company. We expect 2008 to exhibit a softening economy as evidenced by the second half of 2007. To compensate for the softening economy, we will continue to actively manage credit risk in all our business lines, and have increased resources to align growth objectives with prudent balance sheet management. Our conservative ﬁ nancial position is measured by asset quality, accounting and credit policies, capital levels, diversity of revenue sources and dispersing risk by geography, loan size and industry. Listed on NASDAQ/NMS on June 20, 1989 A purchase of 100 shares in September 1982, when the Now and in the future, First Merchants will become known as a company that sets high Trading Symbol: FRME holding company was organized, would have cost $4,200. 2007 Stock Price Range: High $27.46 Through three 2-for-1 stock splits, three 3-for-2 stock Low $18.30 splits, and three ﬁ ve percent (5%) stock dividends, the Current bid price as of 12/31/07: $21.84 number of shares held as of December 31, 2007, would 2007 NASDAQ Trading Volume: 14,151,447 shares be approximately 3,126 with a market value of $68,272. December 31, 2007 (cid:129) Shares outstanding: 18,002,787 In addition, dividends in the amount of $40,938 would 6 have been paid on the initial investment of $4,200. expectations for itself and exceeds those expectations. We are accountable to one another, our customers and our shareholders. We thank you for your continued investment and interest in First Merchants. SiSiSiSiSiSincncncncncncncerererererelelllllly,y,y,y,y,y,y, Sincerely, MMMMMMicicicicci hahahahhhhaelelelelell CCCCC ReReReReR chchchchchhininininiin Michael C. Rechin President and Chief Executive Ofﬁ cer a n n u a l r e p o r t 2 0 0 7 3 h o w f m c p a r t n e r s h i p f e d T O W N S E N D g r o w t h I nn n n nn pppp n post-World War II central Indiana, Vernon and Don Townsend started Local Decision Making When Hurricane Katrina struck New Orleans in August 2005, Townsend responded by sending more than 700 men to help remove debris and restore power. At a moment’s notice, Townsend needed the ﬂ exibility to provide food, shelter, and essentials to its storm damage relief crews. “The First Merchants team iiithththhh are our ‘ﬁ rst-responders’ when the call comes for help. Our working relationship with Jack, Chris Parker, and the support staff at First Merchants allows us to have the agility we need in our competitive industries to react quickly to opportunities,” Gary commented. “Over the years, we’ve had some ideas that were barely written down on paper, and I relied upon Jack to help us get to the next level.” out with a car, a tool trailer, and a strong work ethic. Driven solely by ououuu their desire to make ends meet, the two brothers founded Townsend Tree Service in 1945. Now, 63 years later, Townsend Tree Service stands tall as one of eight companies in The Townsend Corporation. Headquartered in Parker City, The Townsend Corporation operates in 20 states with 2,300 full-time employees, and a ﬂ eet of over 2,400 vehicles. Gary Townsend, Chairman and Chief Executive Ofﬁ cer, and Phil Chambers, President and Chief Operating Ofﬁ cer, have built a growing and diverse company. Since 1993, Townsend Corporation has grown from $25 million in annual revenue to $140 million in 2007. Strong Relationships From its tree and utility service beginnings to its newest business growth sector, wind energy and electrical construction, Townsend Corporation has relied upon the banking expertise of First Merchants since 1985. Gary Townsend commented, “Our relationship with First Merchants is a win-win. We’re currently interviewing additional Senior Management candidates, and our banker, Jack Demaree, is on the selection committee.” “The First Merchants team are our ‘fi rst-responders’ when the call comes for help. Our working relationship with Jack Demaree, Chris Parker, and the support When asked what makes Townsend so special, Gary and Phil quickly reply, staff at First Merchants allows us to have the “It’s family-owned, and family values still matter. When we’re out in the agility we need in our competitive industries ﬁ eld, it’s not unusual to meet someone who has been with us for over to react quickly to opportunities.” 4 — Gary Townsend Chairman Townsend Corporation 20 years who also have a spouse, child or other relative that work for us.” Gary Townsend (left) shares with Jack Demaree (front) Phil Chambers (center) and Chris Parker (right) his recollection of some early company experiences, in contrast to where they are today. Broad Financial Services With the growth Townsend has enjoyed over the past 15 years, the infrastructure and needs of the company are changing. Phil Chambers is focused on risk mitigation, identifying ﬁ nancial performance, and capital allocation to keep the company growing and prosperous for future generations. “Townsend is focused on growth while sustaining a community commitment,” noted Phil. “Our partnership with First Merchants, given their community emphasis and relationship orientation, is a good match. Our values align, as well as their interest and investment in our success. This partnership extends beyond banking into insurance and trust relationships as well.” 5 h o w f m c p a r t n e r s h i p f e d T O W N S E N D g r o w t h I nn n n nn pppp n post-World War II central Indiana, Vernon and Don Townsend started Local Decision Making When Hurricane Katrina struck New Orleans in August 2005, Townsend responded by sending more than 700 men to help remove debris and restore power. At a moment’s notice, Townsend needed the ﬂ exibility to provide food, shelter, and essentials to its storm damage relief crews. “The First Merchants team iiithththhh are our ‘ﬁ rst-responders’ when the call comes for help. Our working relationship with Jack, Chris Parker, and the support staff at First Merchants allows us to have the agility we need in our competitive industries to react quickly to opportunities,” Gary commented. “Over the years, we’ve had some ideas that were barely written down on paper, and I relied upon Jack to help us get to the next level.” out with a car, a tool trailer, and a strong work ethic. Driven solely by ououuu their desire to make ends meet, the two brothers founded Townsend Tree Service in 1945. Now, 63 years later, Townsend Tree Service stands tall as one of eight companies in The Townsend Corporation. Headquartered in Parker City, The Townsend Corporation operates in 20 states with 2,300 full-time employees, and a ﬂ eet of over 2,400 vehicles. Gary Townsend, Chairman and Chief Executive Ofﬁ cer, and Phil Chambers, President and Chief Operating Ofﬁ cer, have built a growing and diverse company. Since 1993, Townsend Corporation has grown from $25 million in annual revenue to $140 million in 2007. Strong Relationships From its tree and utility service beginnings to its newest business growth sector, wind energy and electrical construction, Townsend Corporation has relied upon the banking expertise of First Merchants since 1985. Gary Townsend commented, “Our relationship with First Merchants is a win-win. We’re currently interviewing additional Senior Management candidates, and our banker, Jack Demaree, is on the selection committee.” “The First Merchants team are our ‘fi rst-responders’ when the call comes for help. Our working relationship with Jack Demaree, Chris Parker, and the support When asked what makes Townsend so special, Gary and Phil quickly reply, staff at First Merchants allows us to have the “It’s family-owned, and family values still matter. When we’re out in the agility we need in our competitive industries ﬁ eld, it’s not unusual to meet someone who has been with us for over to react quickly to opportunities.” 4 — Gary Townsend Chairman Townsend Corporation 20 years who also have a spouse, child or other relative that work for us.” Gary Townsend (left) shares with Jack Demaree (front) Phil Chambers (center) and Chris Parker (right) his recollection of some early company experiences, in contrast to where they are today. Broad Financial Services With the growth Townsend has enjoyed over the past 15 years, the infrastructure and needs of the company are changing. Phil Chambers is focused on risk mitigation, identifying ﬁ nancial performance, and capital allocation to keep the company growing and prosperous for future generations. “Townsend is focused on growth while sustaining a community commitment,” noted Phil. “Our partnership with First Merchants, given their community emphasis and relationship orientation, is a good match. Our values align, as well as their interest and investment in our success. This partnership extends beyond banking into insurance and trust relationships as well.” 5 f m c i n v e s t o r s u m m a r y return on assets return on equity .95% .90% .90% .87% .87% 9.58% 9.45% 9.45% 9.56% $40,938 2005 2006 2007 2005 2006 2007 2007 2005 2006 2007 2006 2005 efﬁ ciency r atio* loan losses* 60.2% 62.2% 60.2% 62.37% .23% .24% .19% $4,200 ?% $68,272 t h e s t r e n g t h o f b i g . t h e s e r v i c e o f s m a l l . Our new tagline, “The strength of big, the service of small” describes how we are structured and how we deliver to our customers. We believe that we have the best of what banking can off er— the strength of our products and delivery systems, coupled with service that is provided locally by bankers who are known and trusted in their communities. ChChChChChCharararaa leleleeeesss E.EE.EE SSSSchchhhalallallilililil olollolol, ChChChChaiaiairmrmrmananannn ooooofffff ththtththt eeee BoBoBoBoBoBoarararararddd anananananddd Charles E. Schalliol, Chairman of the Board and Michael C. Rechin, President & Chief Executive Ofﬁ cer At a recent all-employee meeting, we celebrated our 2007 successes and individually recognized those who signiﬁ cantly contributed to our success. As each individual was recognized, their comments were not focused on themselves, but on the support their internal colleagues provided and their drive to serve their customers and communities. If just one word were used to describe initial investment (9/82) the day, it was passion. 2005 2006 2007 2005 2006 2007 2005 2006 2007 * indicates the cost to produce * indicates the cost to produce a dollar of revenue percent of average loans * as a percent of average loans percent of average loans * as a dividends received (through 12/31/07) market value (bid) trading history stock performance Our momentum is growing. We have strong teams, strong boards and a strong, growing company. We expect 2008 to exhibit a softening economy as evidenced by the second half of 2007. To compensate for the softening economy, we will continue to actively manage credit risk in all our business lines, and have increased resources to align growth objectives with prudent balance sheet management. Our conservative ﬁ nancial position is measured by asset quality, accounting and credit policies, capital levels, diversity of revenue sources and dispersing risk by geography, loan size and industry. Listed on NASDAQ/NMS on June 20, 1989 A purchase of 100 shares in September 1982, when the Now and in the future, First Merchants will become known as a company that sets high Trading Symbol: FRME holding company was organized, would have cost $4,200. 2007 Stock Price Range: High $27.46 Through three 2-for-1 stock splits, three 3-for-2 stock Low $18.30 splits, and three ﬁ ve percent (5%) stock dividends, the Current bid price as of 12/31/07: $21.84 number of shares held as of December 31, 2007, would 2007 NASDAQ Trading Volume: 14,151,447 shares be approximately 3,126 with a market value of $68,272. December 31, 2007 (cid:129) Shares outstanding: 18,002,787 In addition, dividends in the amount of $40,938 would 6 have been paid on the initial investment of $4,200. expectations for itself and exceeds those expectations. We are accountable to one another, our customers and our shareholders. We thank you for your continued investment and interest in First Merchants. SiSiSiSiSiSincncncncncncncerererererelelllllly,y,y,y,y,y,y, Sincerely, MMMMMMicicicicci hahahahhhhaelelelelell CCCCC ReReReReR chchchchchhininininiin Michael C. Rechin President and Chief Executive Ofﬁ cer a n n u a l r e p o r t 2 0 0 7 3 t o o u r s h a r e h o l d e r s executive ofﬁ cers f irst Merchants ranks among an elite group of public companies that can report the achievement of improved EPS 31 of the last 32 years. It’s an accomplishment of which we are quite proud, and focused on sustaining for years to come. 2007 earnings per share totaled $1.73, a 5.5% increase over our 2006 results. Our total assets equaled $3.78 billion, an increase of $227 million, or 6.4 percent. Loans and investments, the Corporation’s primary earning assets, totaled $3.33 billion, an increase of $169 million, or 5.3 percent. Total non-interest income increased by $5.9 million, or 17.2 percent. All reported line items produced increases of at least 9.8 percent, reﬂ ecting the Corporation’s focus on fee-for-service business. The tactical execution of our strategic plan during 2007 is reﬂ ective of employee commitment to our customers and our company. As reported to you last year, we planned and achieved the consolidation of ﬁ ve bank charters into one, creating the largest bank headquartered in East Central Indiana. Throughout this project, our colleagues exempliﬁ ed themselves as the caring, energetic team members we know them to be, and kept their eye on the customer to ensure that service remains our primary product. A special thanks is owed to our bank board members who served as ambassadors of change in their local communities. Their tireless service and feedback keeps us connected to the issues that matter most to our customers. We’re a ﬁ nancial services company – large, diversiﬁ ed, dynamic, growing and innovative. The consolidation and enhanced focus on our brand provides us with the opportunity to more clearly articulate the core advantages we offer the marketplace: ■ ■ ■ We work hard to develop strong relationships with our clients. OUR Clients beneﬁ t from local decision m aking. WE offer clients broad ﬁ nancial services. We are organized around our customers. As you’ll read in the following pages, the relationships we develop with our customers provide them with a strong foundation upon which they can dream, build and grow. Our business is simple—we must ﬁ rst understand the customer’s needs, and then provide professional, personalized service and timely delivery. Our new tagline, “The strength of big, the service of small” describes how we are structured and how we deliver to our customers. We believe that we have the best of what banking can offer—the strength of our products and delivery systems, coupled with service that is provided locally by bankers who are known and trusted in their communities. We are transparent to the outside world as a collection of individuals who work each day as one company with one culture…a culture that expects superior results from our company and ourselves. Our competitive advantage is our people. Products and technology do not fulﬁ ll the promise behind the brand—people do. We are a company that has embraced a disciplined approach to the execution of our strategic plan and vision. And, we have a more clearly deﬁ ned focus on recruiting, developing and retaining great people who know how to build repeatable processes that will create and maintain satisﬁ ed customers. It is these customers who allow us to produce the ﬁ nancial 2 results that our shareholders desire. f if if if i r sr sr sr s t t ttt m em em em e r cr cr cr c h ah ah ah aa n tn tn tn tt s s ss c oc oc oc oc o r pr ppr pr o ro ro ro ro r a ta ta ta t i oi oi oo n n nn b o a r d o f d i r e c t o r s ■ Charles E. Schalliol Chairman of the Board Baker & Daniels, LLP Attorney & Consultant ■ Michael C. Rechin First Merchants Corporation President Chief Executive Offi cer ■ Richard A. Boehning Bennett, Boehning & Clary Of Counsel ■ Thomas B. Clark Jarden Corporation Chairman of the Board President Chief Executive Offi cer (retired) ■ Michael L. Cox ■ Roderick English First Merchants Corporation President Chief Executive Offi cer (retired) The James Monroe Group, LLC President Chief Executive Offi cer ■ Dr. Jo Ann M. Gora Ball State University President ■ William L. Hoy Columbus Sign Company Chief Executive Offi cer Michael C. Rechin President Chief Executive Offi cer Mark K. Hardwick Executive Vice President Chief Financial Offi cer Jami L. Bradshaw Senior Vice President Chief Accounting Offi cer Robert R. Connors Senior Vice President Chief Information Offi cer Kimberly J. Ellington Senior Vice President Human Resources Director Jeff rey B. Lorentson Senior Vice President Chief Risk Offi cer David W. Spade Senior Vice President Chief Credit Offi cer board committees Executive Committee Richard A. Boehning, Chairperson Barry J. Hudson Michael C. Rechin Charles E. Schalliol Audit Committee Jean L. Wojtowicz, Chairperson Thomas B. Clark Jo Ann M. Gora Terry L. Walker Compensation & Hum an Resources Committee Charles E. Schalliol, Chairperson Thomas B. Clark Roderick English Secretary to the Board Cynthia G. Holaday First Merchants Corporation Vice President Assistant Secretary to the Board C. Ronald Hall First Merchants Corporation Vice President Chairman Emeritus Stefan S. Anderson Nominating/ Governance Committee Thomas B. Clark, Chairperson Richard A. Boehning Charles E. Schalliol Jean L. Wojtowicz Pension & Retirement income & Savings Plan Administr ative Committee Kimberly J. Ellington, Plan Administrator Jami L. Bradshaw Michael C. Rechin ■ BarBBarBarBarBB ryryrrry JJJJJ HudHudHudHudHuHuu sosonsonsonsonon ■ Barry J. Hudson First National Bank Chairman of the Board (retired) ■ TerTerTerTerTerTerT ryryry LLLLLL WalWalWalWalWalkerkerkerkerkerkerr ■ Terry L. Walker Muncie Power Products, Inc. Chairman of the Board President Chief Executive Director ■ JeaJeaJeaJeaJean Ln Ln Ln Ln L WWWWWWojtojtojtojtojtowiowiowiowiow czczczczzz ■ Jean L. Wojtowicz Cambridge Capital Management Corp. President Chief Executive Offi cer a a a n n n n n n u u u a a a l l l rr r e e e p p p o o o r r r t t t 2 2 2 00 0 0 0 777 7 f if if if i r sr sr sr s t tt t m em em em e r cr cr cr c h ah ah ah a n tn tn tt s s s s c occ oc o r pr pr pr p o roo ro r a ta ta ta t i oi oo n nnn a f f i l i a t e b o a r d s o f d i r e c t o r s ■ First Merchants Bank Ronald K. Fauquher Chairman Ontario Systems, LLC Senior Vice President Dennis A. Bieberich First Merchants Bank Senior Executive Offi cer Kevan B. Biggs Ideal Suburban Homes, Inc. Chief Executive Offi cer Thomas E. Chalfant Chalfant Farms, Inc. Vice President Richard A. Daniels McCullough-Hyde Memorial Hospital President Chief Executive Offi cer Greg A. Fleming Fleming Escavating, Inc. President John W. Forrester Wabash Electric President Michael B. Galliher A.E. Boyce Co., Inc. President Thomas K. Gardiner, MD Cardinal Health Systems, Inc. Executive Vice President Dr. Gregory L. Garner Midwest Eye Consultants, PC President Chief Executive Offi cer Mark K. Hardwick First Merchants Corporation Executive Vice President Chief Financial Offi cer John W. Hartmeyer Al Pete Meats, Inc. Chief Executive Offi cer Arthur W. Jasen B. Walter & Co., Inc. President Mark A. Kaehr R & K Incinerator President Eric J. Kelly Masonry Services, Inc. President Errol P. Klem Klem Golf, Inc. President Dr. Bonnie R. Maitlen B.R. Maitlen and Associates President James A. Meinerding First Merchants Bank President Chief Executive Offi cer Jon H. Moll DeFur Voran, LLP Partner Stephen R. Myron, MD Preferred Medical President Chief Executive Offi cer Gerald S. Paul Medreco, Inc. President Robert M. Pearson Wabash County REMC Chief Executive Offi cer Gary L. Whitenack Whitenack Farms Co-Owner Michael D. Wickersham Wick’s Pies, Inc. President Dr. Maria Williams-Hawkins Ball State University Associate Professor of Telecommunications ■ First Merchants Bank of Central Indiana George R. Likens Chairman Farmer Michael L. Baker First Merchants Bank of Central Indiana President Chief Executive Offi cer Dr. James L. Edwards Anderson University President Jeff rey A. Jenness Board of Pensions Church of God Executive Secretary Joseph R. Kilmer Attorney at Law C. David Kleinhenn Kleinhenn Company President Robert J. Pensec Carbide Grinding Company President Nancy Ricker Ricker’s Oil Secretary/Treasurer Co-Owner Stephen D. Skaggs Perfecto Tool & Engineering Co., Inc. President Curtis L. Stephenson First Merchants Insurance Services President Chief Executive Offi cer ■ Commerce National Bank ■ Lafayette Bank & Trust Company ■ First Merchants Loreto V. Canini Canini & Pellecchia, Inc. President Jameson Crane, Jr. Crane Group, Co. Vice President Rhonda J. DeMuth TDCI, Inc. Chief Executive Offi cer William L. Hoy Columbus Sign Company Chief Executive Offi cer Clark Kellogg CBS Sports Basketball Analyst Thomas D. McAuliff e Commerce National Bank Chairman of the Board Samuel E. McDaniel Sam McDaniel, LLC President John A. Romelfanger H & S Forest Products, Inc. Chief Executive Offi cer John W. Royer Kohr, Royer, Griffi th, Inc. (KRG) President Richard F. Ruhl Dick Ruhl Ford Sales, Inc. (retired) Mark C. Ryan New Albany Board of Education Board Member William A. Wickham WA Wickham & Associates Chairman Chief Executive Offi cer David L. Winks Capital Lighting, Inc. Vice President Robert J. Weeder Chairman Lafayette Bank & Trust Company President (retired) Jeff rey L. Kessler Vice Chairman of the Board Stall & Kessler Diamond Center Co-Owner Tony S. Albrecht Lafayette Bank & Trust Company President Chief Executive Offi cer Kelly V. Busch KVB Broadcasting Managing General Partner W. L. Hancock PSI Energy, A CINERGY Company General Manager (retired) Joseph B. Hornett Purdue Research Foundation Senior Vice President Treasurer Gary J. Lehman Fairfi eld Manufacturing Company, Inc. President Chief Executive Offi cer Eric P. Meister GTE North, Inc. Central Division Manager (retired) Michael C. Rechin First Merchants Corporation President Chief Executive Offi cer Directors Emeriti Richard A. Boehning Joseph A. Bonner Vernon N. Furrer Robert T. Jeff ares Charles E. Maki Roy D. Meeks Insurance Services Mark K. Hardwick Chairman First Merchants Corporation Executive Vice President Chief Financial Offi cer Michael D. Gilbert First Merchants Insurance Services Senior Vice President James A. Meinerding First Merchants Bank President Chief Executive Offi cer Michael C. Rechin First Merchants Corporation President Chief Executive Offi cer Curt L. Stephenson First Merchants Insurance Services President Chief Executive Offi cer ■ First Merchants Reinsurance Co., LTD. Michael L. Cox Chairman First Merchants Corporation President Chief Executive Offi cer (retired) Mark K. Hardwick Treasurer First Merchants Corporation Executive Vice President Chief Financial Offi cer Brian A. Edwards Secretary First Merchants Corporation Vice President Financial Services Offi cer ■ First Merchants Trust Company ■ Indiana Title Jon H. Moll Chairman DeFur Voran, LLP Partner Kimberly J. Ellington First Merchants Corporation Senior Vice President Human Resources Director Mark K. Hardwick First Merchants Corporation Executive Vice President Chief Financial Offi cer Terri E. Matchett First Merchants Trust Company President Chief Executive Offi cer Michael C. Rechin First Merchants Corporation President Chief Executive Offi cer Insurance Company David W. Heeter Chairman Mutual First Financial, Inc. Chief Executive Offi cer Jerome J. Gassen Ameriana Bancorp President Chief Executive Offi cer Mark K. Hardwick First Merchants Corporation Executive Vice President Chief Financial Offi cer James W. Smith Indiana Title Insurance Company Co-President James W. Trulock Indiana Title Insurance Company Co-President aaa nnn n n n u u u a a a l l l rr r e e e p p p o o rr r t t t 22 2 0 0 0 0 0 0 777 8 f i n a n c i a l h i g h l i g h t s Table dollar amounts in thousands, except per share data diluted net income per share $1.63 $1.64 $1.73 ■ at yea at year end ToToToToTT tatatatatal l ll AsAsAA sesesese Total Assets Stockholders’ Equity Total Loans Total Investments Total Deposits 2006 2007 $3,554,870 $3,782,087 327,325 339,936 2,698,014 2,880,578 465,217 451,167 2,750,538 2,844,121 2007 2005 2006 2007 2006 2005 Trust Accounts at Market Value (not included in banking assets) 1,653,000 1,652,000 ■ for th for the year InInnntetetetet rerererer stststst I I I Innnn Interest Income Interest Expense Net Interest Income Provision for Loan Losses Total Other Income Total Other Expenses Income Tax Expense Net Income ■ per sh per share BaBaBaBaB sisisisic c c c NeNeNeNeNeettt t t Basic Net Income Diluted Net Income Cash Dividends Book Value $ 208,606 $ 230,733 98,511 117,613 110,095 113,120 6,258 8,507 34,613 40,551 96,057 102,182 12,195 30,198 11,343 31,639 $ 1.64 $ 1.73 1.64 .92 1.73 .92 17.75 18.88 Market Value (Dec. 31 Bid Price) 27.19 21.84 ■ aver a aver ages during the year ToToToTootatatatatt l l l l AsAsAsAssseseseses Total Assets Total Loans Total Investments Total Deposits $3,371,386 $3,639,772 2,569,847 2,794,824 457,411 496,603 2,568,070 2,752,443 dividends per share $.92 $.92 $.92 2007 2005 2006 2007 2006 2005 aver age assets (in millions) $3,639.8 $3,371.4 $3,179.5 2005 2006 2007 2005 2006 2007 a n n u a l r e p o r t 2 0 0 7 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 _______________________________ FORM 10-K [Mark One] [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2007 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________to_________ Commission file number 0-17071 FIRST MERCHANTS CORPORATION (Exact name of registrant as specified in its charter) Indiana 35-1544218 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 200 East Jackson 47305-2814 Muncie, Indiana (Zip Code) (Address of principal executive offices) Registrant's telephone number, including area code: (765) 747-1500 Securities registered pursuant to Section 12 (b) of the Act: None Securities registered pursuant to Section 12 (g) of the Act: Common Stock, $.125 stated value per share (Title of class) Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ ] No [X] Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X] Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “ large accelerated filer,” ” accelerated filer,” and “ smaller reporting company” . Rule 12b-2 of the Exchange Act. Large accelerated filer [ ] Accelerated filer[X] Non-accelerated filer[ ] Smaller Reporting Company [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes [ ] No[X] The aggregate market value (not necessarily a reliable indication of the price at which more than a limited number of shares would trade) of the voting stock held by non-affiliates of the registrant was $439,397,000 as of the last business day of the registrant's most recently completed second fiscal quarter (June 30, 2007). As of February 20, 2008 there were 18,551,275 outstanding common shares, without par value, of the registrant. DOCUMENTS INCORPORATED BY REFERENCE Documents Part of Form 10-K into which incorporated Portions of the Registrant’s Definitive Part III (Items 10 through 14) Proxy Statement for Annual Meeting of Shareholders to be held April 29, 2008 1 TABLE OF CONTENTS FIRST MERCHANTS CORPORATION Five-Year Summary of Selected Financial Data 3 Statement Regarding Forward-Looking Statements 4 PART I PART II PART III PART IV Item 1. Item 1A. Item 1B. Item 2. Item 3. Item 4. Item 5. Item 6. Item 7. Item 7A. Item 8. Item 9. Item 9A. Item 9B. Item 10. Item 11. Item 12. Item 13. Item 14. Business Risk Factors Unresolved Staff Comments Properties Legal Proceedings Submission of Matters to a Vote of Security Holders Supplemental Information – Executive Officers of the Registrant Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Selected Financial Data Management’s Discussion and Analysis of Financial Condition and Results of Operations Quantitative and Qualitative Disclosure about Market Risk Financial Statements and Supplementary Data Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Controls and Procedures Other Information Directors, Executive Officers and Corporate Governance Executive Compensation Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Certain Relationships and Related Transactions Principal Accountant Fees and Services Item 15. Exhibits and Financial Statement Schedules 5 21 24 25 25 25 26 27 29 30 41 42 71 71 72 73 73 73 73 73 74 2 FIVE-YEAR SUMMARY OF SELECTED FINANCIAL DATA ================================================================================================================================== (Dollars in Thousands, except share data) 2007 2006 2005 2004 2003 ================================================================================================================================== Operations Net Interest Income Fully Taxable Equivalent (FTE) Basis .............. $ 117,247 $ 114,076 $ 114,907 $ 108,986 $ 106,899 Less Tax Equivalent Adjustment ......................... 4,127 3,981 3,778 3,597 3,757 ---------- ---------- ---------- ---------- ---------- Net Interest Income .................................... 113,120 110,095 111,129 105,389 103,142 Provision for Loan Losses .............................. 8,507 6,258 8,354 5,705 9,477 ---------- ---------- ---------- ---------- ---------- Net Interest Income After Provision for Loan Losses ................... 104,613 103,837 102,775 99,684 93,665 Total Other Income ..................................... 40,551 34,613 34,717 34,554 35,902 Total Other Expenses ................................... 102,182 96,057 93,957 91,642 91,279 ---------- ---------- ---------- ---------- ---------- Income Before Income Tax Expense .................. 42,982 42,393 43,535 42,596 38,288 Income Tax Expense ..................................... 11,343 12,195 13,296 13,185 10,717 ---------- ---------- ---------- ---------- ---------- Net Income ............................................. $ 31,639 $ 30,198 $ 30,239 $ 29,411 $ 27,571 ========== ========== ========== ========== ========== Per Share Data 1 Basic Net Income ....................................... $ 1.73 $ 1.64 $ 1.64 $ 1.59 $ 1.51 Diluted Net Income ..................................... 1.73 1.64 1.63 1.58 1.50 Cash Dividends Paid .................................... .92 .92 .92 .92 .90 December 31 Book Value ................................. 18.88 17.75 17.02 16.93 16.42 December 31 Market Value (Bid Price) ................... 21.84 27.19 26.00 28.30 25.51 Average Balances Total Assets ........................................... $3,639,772 $3,371,386 $3,179,464 $3,109,104 $2,960,195 Total Loans 2 ........................................... 2,794,824 2,569,847 2,434,134 2,369,017 2,281,614 Total Deposits ......................................... 2,752,443 2,568,070 2,418,752 2,365,306 2,257,075 Securities Sold Under Repurchase Agreements (long-term portion) ............................... 181 Total Federal Home Loan Bank Advances .................. 259,463 234,629 227,311 225,375 208,733 Total Subordinated Debentures, Revolving Credit Lines and Term Loans ...................... 104,680 99,456 106,811 96,230 94,203 Total Stockholders' Equity ............................. 330,786 319,519 315,525 310,004 293,603 Year-end Balances Total Assets ........................................... $3,782,087 $3,554,870 $3,237,079 $3,191,668 $3,076,812 Total Loans 2 ........................................... 2,880,578 2,698,014 2,462,337 2,431,418 2,356,546 Total Deposits ......................................... 2,884,121 2,750,538 2,382,576 2,408,150 2,362,101 Securities Sold Under Repurchase Agreements (long-term portion) .............................. 320 Total Federal Home Loan Bank Advances .................. 294,101 242,408 247,865 223,663 212,779 Total Subordinated Debentures, Revolving Credit Lines and Term Loans ...................... 115,826 83,956 103,956 97,206 97,782 Total Stockholders' Equity ............................. 339,936 327,325 313,396 314,603 303,965 Financial Ratios Return on Average Assets ............................... .87% .90% .95% .95% .93% Return on Average Stockholders' Equity ................. 9.56 9.45 9.58 9.49 9.39 Average Earning Assets to Total Assets ................. 90.91 91.15 90.93 90.28 89.99 Allowance for Loan Losses as % of Total Loans .......... .98 .99 1.02 .93 1.08 Dividend Payout Ratio .................................. 53.18 56.10 56.44 58.23 60.00 Average Stockholders' Equity to Average Assets ......... 9.09 9.48 9.92 9.97 9.92 Tax Equivalent Yield on Earning Assets ................ 7.10 6.92 6.26 5.72 5.98 Cost of Supporting Liabilities ......................... 3.55 3.21 2.29 1.84 1.97 Net Interest Margin on Earning Assets .................. 3.55 3.71 3.97 3.88 4.01 1 Restated for all stock dividends and stock splits. 2 Includes loans held for sale. 3 FORWARD-LOOKING STATEMENTS First Merchants Corporation (“Corporation”) from time to time includes forward-looking statements in its oral and written communication. The Corporation may include forward-looking statements in filings with the Securities and Exchange Commission, such as Form 10-K and Form 10-Q, in other written materials and in oral statements made by senior management to analysts, investors, representatives of the media and others. The Corporation intends these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and the Corporation is including this statement for purposes of these safe harbor provisions. Forward-looking statements can often be identified by the use of words like “believe”, “continue”, “pattern”, "estimate", "project", "intend", "anticipate", "expect" and similar expressions or future or conditional verbs such as “will”, “would”, “should”, “could”, “might”, “can”, “may” or similar expressions. These forward-looking statements include: • • • • statements of the Corporation's goals, intentions and expectations; statements regarding the Corporation's business plan and growth strategies; statements regarding the asset quality of the Corporation's loan and investment portfolios; and estimates of the Corporation's risks and future costs and benefits. These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, those discussed in Item 1A, “RISK FACTORS”. Because of these and other uncertainties, the Corporation's actual future results may be materially different from the results indicated by these forward-looking statements. In addition, the Corporation's past results of operations do not necessarily indicate its future results. 4 PART I: ITEM 1. BUSINESS PART I Item 1. BUSINESS GENERAL First Merchants Corporation (the "Corporation") is a financial holding company headquartered in Muncie, Indiana. The Corporation's Common Stock is traded on NASDAQ's National Market System under the symbol FRME and was organized in September 1982. Since its organization, the Corporation has grown to include four affiliate banks with sixty-six banking locations in eighteen Indiana and three Ohio counties. In addition to its branch network, the Corporation’s delivery channels include ATMs, check cards, interactive voice response systems and internet technology. The Corporation’s business activities are currently limited to one significant business segment, which is community banking. The bank subsidiaries of the Corporation include the following: • • • • First Merchants Bank, National Association (“First Merchants”) in Delaware, Hamilton, Marion, Henry, Randolph, Union, Fayette, Wayne, Butler (OH), Jay, Adams, Wabash, Howard and Miami counties; First Merchants Bank of Central Indiana, National Association (“Central Indiana”) in Madison County; Lafayette Bank and Trust Company, National Association (“Lafayette”), in Tippecanoe, Carroll, Jasper, and White counties; and Commerce National Bank (“Commerce”) in Franklin and Hamilton counties in Ohio. The Corporation operates First Merchants Trust Company, National Association, a trust and asset management services company. The Corporation also operates First Merchants Insurance Services, Inc., a full-service property, casualty, personal lines, and employee benefit insurance agency headquartered in Muncie, Indiana. The Corporation is also the majority owner of Indiana Title Insurance Company, LLC, which is a full-service title insurance agency. The Corporation operates First Merchants Reinsurance Co. Ltd., a small life reinsurance company whose primary business includes underwriting short-duration contracts of credit life and accidental and health insurance policies and debt cancellation contracts. Such policies and contracts are purchased by the Corporation's bank customers to cover the amount of debt incurred by the insured. No policies are issued for loans other than those originated by the subsidiary banks. First Merchants Reinsurance Co. Ltd. limits its self-insurance risk to the first $15,000 of exposure under each credit life policy and $350 per month on each accident and health policy. The company maintains the same standard for its debt cancellation contracts. The total self-insurance exposure as of December 31, 2007 totaled $22.5 million. All inter-company transactions are eliminated during the preparation of consolidated financial statements. On April 1, 2007, the Corporation combined five of its bank charters into one. Frances Slocum Bank & Trust Company, National Association, Decatur Bank & Trust Company, National Association, The First National Bank of Portland and United Communities National Bank combined with First Merchants Bank, N.A. Also on April 1, 2007, the name of The Madison Community Bank was changed to First Merchants Bank of Central Indiana, National Association. As of December 31, 2007, the Corporation had consolidated assets of $3.8 billion, consolidated deposits of $2.8 billion and stockholders' equity of $340 million. The Corporation is presently engaged in conducting commercial banking business through the offices of its four banking subsidiaries. As of December 31, 2007, the Corporation and its subsidiaries had 1,121 full-time equivalent employees. Through its bank subsidiaries, the Corporation offers a broad range of financial services, including accepting time, savings and demand deposits; making consumer, commercial, agri-business and real estate mortgage loans; renting safe deposit facilities; providing personal and corporate trust services; providing full-service brokerage; and providing other corporate services, letters of credit and repurchase agreements. Through various non-bank subsidiaries, the Corporation also offers personal and commercial lines of insurance and engages in the title agency business and the reinsurance of credit life, accident, and health insurance. AVAILABLE INFORMATION The Corporation makes its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, available on its website at www.firstmerchants.com without charge, as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission. These documents can also be read and copied at the Securities and Exchange Commission's Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. 5 PART I: ITEM 1. BUSINESS GENERAL continued Please call the Securities and Exchange Commission at 1-800-SEC-0330 for further information on the public reference room. Our SEC filings are also available to the public at the Securities and Exchange Commission's website at http://www.sec.gov. Additionally, the Corporation will also provide without charge, a copy of its Annual Report on Form 10-K to any shareholder by mail. Requests should be sent to Ms. Cindy Holaday, Shareholder Relations Officer, First Merchants Corporation, P.O. Box 792, Muncie, IN 47308-0792. ACQUISITION POLICY The Corporation anticipates that it will continue its policy of geographic expansion of its banking business through the acquisition of banks whose operations are consistent with its banking philosophy. Management routinely explores opportunities to acquire financial institutions and other financial services- related businesses and to enter into strategic alliances to expand the scope of its services and its customer base. COMPETITION The Corporation's banking subsidiaries are located in Indiana and Ohio counties where other financial services companies provide similar banking services. In addition to the competition provided by the lending and deposit gathering subsidiaries of national manufacturers, retailers, insurance companies and investment brokers, the banking subsidiaries compete vigorously with other banks, thrift institutions, credit unions and finance companies located within their service areas. REGULATION AND SUPERVISION OF FIRST MERCHANTS CORPORATION AND SUBSIDIARIES BANK HOLDING COMPANY REGULATION The Corporation is registered as a bank holding company and has elected to be a financial holding company. It is subject to the supervision of, and regulation by the Board of Governors of the Federal Reserve System ("Federal Reserve") under the Bank Holding Company Act of 1956, as amended (the "BHC Act"). Bank holding companies are required to file periodic reports with and are subject to periodic examination by the Federal Reserve. The Federal Reserve has issued regulations under the BHC Act requiring a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. Thus, it is the policy of the Federal Reserve that a bank holding company should stand ready to use its resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity. Additionally, under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), a bank holding company is required to guarantee the compliance of any subsidiary bank that may become "undercapitalized" (as defined in the FDICIA section of this Form 10-K) with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal banking agency. Under the BHC Act, the Federal Reserve has the authority to require a bank holding company to terminate any activity or relinquish control of a non-bank subsidiary (other than a non-bank subsidiary of a bank) upon the determination that such activity constitutes a serious risk to the financial stability of any bank subsidiary. The BHC Act requires the Corporation to obtain the prior approval of the Federal Reserve before: 1. Acquiring direct or indirect control or ownership of any voting shares of any bank or bank holding company if, after such acquisition, the bank holding company will directly or indirectly own or control more than 5% of the voting shares of the bank or bank holding company; 2. Merging or consolidating with another bank holding company; or 3. Acquiring substantially all of the assets of any bank. The BHC Act generally prohibits bank holding companies that have not become financial holding companies from (i) engaging in activities other than banking or managing or controlling banks or other permissible subsidiaries, and (ii) acquiring or retaining direct or indirect control of any company engaged in the activities other than those activities determined by the Federal Reserve to be closely related to banking or managing or controlling banks. The BHC Act does not place territorial restrictions on such non-banking related activities. CAPITAL ADEQUACY GUIDELINES FOR BANK HOLDING COMPANIES The Corporation is required to comply with the Federal Reserve's risk-based capital guidelines. These guidelines require a minimum ratio of capital to risk-weighted assets of 8% (including certain off-balance sheet activities such as standby letters of credit). At least half of the total required capital must be "Tier 1 capital," consisting principally of stockholders' equity, noncumulative perpetual preferred stock, a limited amount of cumulative perpetual preferred stock and minority interest in the equity accounts of consolidated subsidiaries, less certain goodwill items. The remainder may consist of a limited amount of subordinate debt and intermediate-term preferred stock, certain hybrid capital instruments and other debt securities, cumulative perpetual preferred stock, and a limited amount of the general loan loss allowance. 6 PART I: ITEM 1. BUSINESS CAPITAL ADEQUACY GUIDELINES FOR BANK HOLDING COMPANIES continued In addition to the risk-based capital guidelines, the Federal Reserve has adopted a Tier 1 (leverage) capital ratio under which the Corporation must maintain a minimum level of Tier 1 capital to average total consolidated assets. The ratio is 3% in the case of bank holding companies, which have the highest regulatory examination ratings and are not contemplating significant growth or expansion. All other bank holding companies are expected to maintain a ratio of at least 1% to 2% above the stated minimum. The following are the Corporation's regulatory capital ratios as of December 31, 2007: ============================================================================= Regulatory Minimum Corporation Requirement ============================================================================= Tier 1 Capital: 8.8% 4.0% (to Risk-weighted Assets) Total Capital: 10.6% 8.0% BANK REGULATION Each of the Corporation's bank subsidiaries are national banks and are supervised, regulated and examined by the Office of the Comptroller of the Currency (the "OCC"). The OCC has the authority to issue cease-and-desist orders if it determines that activities of the bank regularly represent an unsafe and unsound banking practice or a violation of law. Federal law extensively regulates various aspects of the banking business such as reserve requirements, truth-in-lending and truth-in-savings disclosures, equal credit opportunity, fair credit reporting, trading in securities and other aspects of banking operations. Current federal law also requires banks, among other things, to make deposited funds available within specified time periods. BANK CAPITAL REQUIREMENTS The OCC has adopted risk-based capital ratio guidelines to which national banks are subject. The guidelines establish a framework that makes regulatory capital requirements more sensitive to differences in risk profiles. Risk-based capital ratios are determined by allocating assets and specified off-balance sheet commitments to four risk-weighted categories, with higher levels of capital being required for the categories perceived as representing greater risk. Like the capital guidelines established by the Federal Reserve, these guidelines divide a bank's capital into tiers. Banks are required to maintain a total risk-based capital ratio of 8%. The OCC may, however, set higher capital requirements when a bank's particular circumstances warrant. Banks experiencing or anticipating significant growth are expected to maintain capital ratios, including tangible capital positions, well above the minimum levels. In addition, the OCC established guidelines prescribing a minimum Tier 1 leverage ratio (Tier 1 capital to adjusted total assets as specified in the guidelines). These guidelines provide for a minimum Tier 1 leverage ratio of 3% for banks that meet specified criteria, including that they have the highest regulatory rating and are not experiencing or anticipating significant growth. All other banks are required to maintain a Tier 1 leverage ratio of 3% plus an additional 100 to 200 basis points. All of the Corporation's affiliate banks exceed the risk-based capital guidelines of the OCC as of December 31, 2007. FDIC IMPROVEMENT ACT OF 1991 The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") requires, among other things, federal bank regulatory authorities to take "prompt corrective action" with respect to banks, which do not meet minimum capital requirements. For these purposes, FDICIA establishes five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The FDIC has adopted regulations to implement the prompt corrective action provisions of FDICIA. "Undercapitalized" banks are subject to growth limitations and are required to submit a capital restoration plan. A bank's compliance with such plan is required to be guaranteed by the bank's parent holding company. If an "undercapitalized" bank fails to submit an acceptable plan, it is treated as if it is significantly 7 PART I: ITEM 1. BUSINESS FDIC IMPROVEMENT ACT OF 1991 continued undercapitalized. "Significantly undercapitalized" banks are subject to one or more restrictions, including an order by the FDIC to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cease receipt of deposits from correspondent banks, and restrictions on compensation of executive officers. "Critically undercapitalized" institutions may not, beginning 60 days after becoming "critically undercapitalized," make any payment of principal or interest on certain subordinated debt or extend credit for a highly leveraged transaction or enter into any transaction outside the ordinary course of business. In addition, "critically undercapitalized" institutions are subject to appointment of a receiver or conservator. As of December 31, 2007, each bank subsidiary of First Merchants is "well capitalized" based on the "prompt corrective action" ratios and deadlines described above. It should be noted, however, that a bank's capital category is determined solely for the purpose of applying the OCC's "prompt corrective action" regulations and that the capital category may not constitute an accurate representation of the bank's overall financial condition or prospects. DEPOSIT INSURANCE The Corporation's affiliated banks are insured up to regulatory limits by the FDIC; and, accordingly, are subject to deposit insurance assessments to maintain the Bank Insurance Fund (the "BIF") and the Savings Association Insurance Fund ("SAIF") administered by the FDIC. The FDIC has adopted regulations establishing a permanent risk-related deposit insurance assessment system. Under this system, the FDIC places each insured bank in one of nine risk categories based on (i) the bank's capitalization, and (ii) supervisory evaluations provided to the FDIC by the institution's primary federal regulator. Each insured bank's insurance assessment rate is then determined by the risk category in which it is classified by the FDIC. DIVIDEND LIMITATIONS National banking laws restrict the amount of dividends that an affiliate bank may declare in a year without obtaining prior regulatory approval. National banks are limited to the bank's retained net income (as defined) for the current year plus those for the previous two years. At December 31, 2007, the Corporation's affiliate banks had a total of $40,084,000 retained net profits available for 2008 dividends to the Corporation without prior regulatory approval. BROKERED DEPOSITS Under FDIC regulations, no FDIC-insured depository institution can accept brokered deposits unless it (i) is well capitalized, or (ii) is adequately capitalized and received a waiver from the FDIC. In addition, these regulations prohibit any depository institution that is not well capitalized from (a) paying an interest rate on deposits in excess of 76 basis points over certain prevailing market rates or (b) offering "pass through" deposit insurance on certain employee benefit plan accounts unless it provides certain notice to affected depositors. INTERSTATE BANKING AND BRANCHING Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 ("Riegle-Neal"), subject to certain concentration limits, required regulatory approvals and other requirements, (i) financial holding companies such as the Corporation are permitted to acquire banks and bank holding companies located in any state; (ii) any bank that is a subsidiary of a bank holding company is permitted to receive deposits, renew time deposits, close loans, service loans and receive loan payments as an agent for any other bank subsidiary of that holding company; and (iii) banks are permitted to acquire branch offices outside their home states by merging with out-of-state banks, purchasing branches in other states, and establishing de novo branch offices in other states. FINANCIAL SERVICES MODERNIZATION ACT The Gramm-Leach-Bliley Act of 1999 (the "Financial Services Modernization Act") establishes a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the existing BHC Act. Under this legislation, bank holding companies would be permitted to conduct essentially unlimited securities and insurance activities as well as other activities determined by the Federal Reserve Board to be financial in nature or related to financial services. As a result, the Corporation is able to provide securities and insurance services. Furthermore, under this legislation, the Corporation is able to acquire, or be acquired, by brokerage and 8 PART I: ITEM 1. BUSINESS FINANCIAL SERVICES MODERNIZATION ACT continued securities firms and insurance underwriters. In addition, the Financial Services Modernization Act broadens the activities that may be conducted by national banks through the formation of financial subsidiaries. Finally, the Financial Services Modernization Act modifies the laws governing the implementation of the Community Reinvestment Act and addresses a variety of other legal and regulatory issues affecting both day- to-day operations and long-term activities of financial institutions. A bank holding company may become a financial holding company if each of its subsidiary banks is well capitalized, is well managed and has at least a satisfactory rating under the Community Reinvestment Act, by filing a declaration that the bank holding company wishes to become a financial holding company. Also effective March 11, 2000, no regulatory approval is required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. The Federal Reserve Bank of Chicago approved the Corporation's application to become a Financial Holding Company effective September 13, 2000. USA PATRIOT ACT As part of the USA Patriot Act, signed into law on October 26, 2001, Congress adopted the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the "Act"). The Act authorizes the Secretary of the Treasury, in consultation with the heads of other government agencies, to adopt special measures applicable to financial institutions such as banks, bank holding companies, broker-dealers and insurance companies. Among its other provisions, the Act requires each financial institution: (i) to establish an anti-money laundering program; (ii) to establish due diligence policies, procedures and controls that are reasonably designed to detect and report instances of money laundering in United States private banking accounts and correspondent accounts maintained for non-United States persons or their representatives; and (iii) to avoid establishing, maintaining, administering, or managing correspondent accounts in the United States for, or on behalf of, a foreign shell bank that does not have a physical presence in any country. In addition, the Act expands the circumstances under which funds in a bank account may be forfeited and requires covered financial institutions to respond under certain circumstances to requests for information from federal banking agencies within 120 hours. Treasury regulations implementing the due diligence requirements were issued in 2002. These regulations required minimum standards to verify customer identity, encouraged cooperation among financial institutions, federal banking agencies, and law enforcement authorities regarding possible money laundering or terrorist activities, prohibited the anonymous use of "concentration accounts," and required all covered financial institutions to have in place an anti-money laundering compliance program. The Act also amended the Bank Holding Company Act and the Bank Merger Act to require the federal banking agencies to consider the effectiveness of a financial institution's anti-money laundering activities when reviewing an application under these acts. THE SARBANES-OXLEY ACT The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act"), which became law on July 30, 2002, added new legal requirements for public companies affecting corporate governance, accounting and corporate reporting. The Sarbanes-Oxley Act provides for, among other things: • • • • • • • • a prohibition on personal loans made or arranged by the issuer to its directors and executive officers (except for loans made by a bank subject to Regulation O); independence requirements for audit committee members; independence requirements for company auditors; certification of financial statements on Forms 10-K and 10-Q reports by the chief executive officer and the chief financial officer; the forfeiture by the chief executive officer and chief financial officer of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by such officers in the twelve-month period following initial publication of any financial statements that later require restatement due to corporate misconduct; disclosure of off-balance sheet transactions; two-business day filing requirements for insiders filing Form 4s; disclosure of a code of ethics for financial officers and filing a Form 8-K for a change in or waiver of such code; 9 PART I: ITEM 1. BUSINESS THE SARBANES-OXLEY ACT continued • • • • the reporting of securities violations "up the ladder" by both in-house and outside attorneys; restrictions on the use of non-GAAP financial measures in press releases and SEC filings; the formation of a public accounting oversight board; and various increased criminal penalties for violations of securities laws. The Sarbanes-Oxley Act contains provisions, which became effective upon enactment on July 30, 2002, including provisions, which became effective from within 30 days to one year from enactment. The SEC has been delegated the task of enacting rules to implement various provisions. In addition, each of the national stock exchanges developed new corporate governance rules, including rules strengthening director independence requirements for boards, the adoption of corporate governance codes and charters for the nominating, corporate governance and audit committees. ADDITIONAL MATTERS The Corporation and its affiliate banks are subject to the Federal Reserve Act, which restricts financial transactions between banks and affiliated companies. The statute limits credit transactions between banks, affiliated companies and its executive officers and its affiliates. The statute prescribes terms and conditions for bank affiliate transactions deemed to be consistent with safe and sound banking practices, and restricts the types of collateral security permitted in connection with the bank's extension of credit to an affiliate. Additionally, all transactions with an affiliate must be on terms substantially the same or at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated parties. In addition to the matters discussed above, the Corporation's affiliate banks are subject to additional regulation of their activities, including a variety of consumer protection regulations affecting their lending, deposit and collection activities and regulations affecting secondary mortgage market activities. The earnings of financial institutions are also affected by general economic conditions and prevailing interest rates, both domestic and foreign, and by the monetary and fiscal policies of the United States Government and its various agencies, particularly the Federal Reserve. The Federal Reserve regulates the supply of credit in order to influence general economic conditions, primarily through open market operations in United States government obligations, varying the discount rate on financial institution borrowings, varying reserve requirements against financial institution deposits, and restricting certain borrowings by financial institutions and their subsidiaries. The monetary policies of the Federal Reserve have had a significant effect on the operating results of the bank subsidiaries in the past and are expected to continue to do so in the future. Additional legislation and administrative actions affecting the banking industry may be considered by the United States Congress, state legislatures and various regulatory agencies, including those referred to above. It cannot be predicted with certainty whether such legislation or administrative action will be enacted or the extent to which the banking industry in general or the Corporation and its affiliate banks in particular would be affected. 10 PART I: ITEM 1. BUSINESS STATISTICAL DATA The following tables set forth statistical data on the Corporation and its subsidiaries. DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL The daily average balance sheet amounts, the related interest income or expense, and average rates earned or paid are presented in the following table: ====================================================================================================================================== Interest Interest Interest Average Income/ Average Average Income/ Average Average Income/ Average (Dollars in Thousands) Balance Balance Rate Balance Balance Rate Balance Balance Rate ====================================================================================================================================== ----- ----- ----- 2007 2006 2005 Assets: Federal Funds Sold ............ $ 3,308 $ 172 5.2% $ 6,983 $ 373 5.3% $ 8,385 $ 264 3.1% Interest-bearing Deposits...... 10,580 582 5.5 7,831 500 6.4 16,683 695 4.2 Federal Reserve and Federal Home Loan Bank Stock. 24,221 1,299 5.4 23,473 1,256 5.4 23,019 1,185 5.1 Securities: 1 Taxable ....................... 300,854 13,744 4.6 289,692 12,316 4.3 263,435 9,612 3.6 Tax-exempt 2 ................... 175,152 10,074 5.8 175,072 10,100 5.8 162,965 9,807 6.0 ---------- -------- ---------- -------- ---------- -------- Total Securities............. 476,006 23,818 5.0 464,764 22,416 4.8 426,400 19,419 4.6 Mortgage Loans Held for Sale..... 6,107 549 9.0 4,620 176 3.8 2,746 113 4.1 Loans: 3 Commercial .................... 1,955,750 151,158 7.7 1,704,026 128,888 7.6 1,569,270 105,740 6.7 Real Estate Mortgage........... 412,008 26,288 6.4 441,407 27,813 6.3 464,426 27,334 5.9 Installment ................... 400,191 29,276 7.3 405,006 29,891 7.4 385,097 25,248 6.6 Tax-exempt 2 .................... 20,768 1,718 8.3 14,788 1,274 8.6 12,595 989 7.9 ---------- -------- ---------- -------- ---------- -------- Total Loans ................. 2,794,824 208,989 7.5 2,569,847 188,042 7.3 2,434,134 159,424 6.5 ---------- -------- ---------- -------- ---------- -------- Total Earning Assets......... 3,308,939 234,860 7.1 3,072,898 212,587 6.9 2,908,621 180,987 6.3 ---------- -------- ---------- -------- ---------- -------- Net Unrealized Gain (Loss) on Securities Available for Sale........... (3,624) (7,353) (1,217) Allowance for Loan Losses........ (27,495) (26,443) (24,889) Cash and Due from Banks.......... 64,571 58,305 53,037 Premises and Equipment .......... 43,945 40,227 38,284 Other Assets .................... 253,436 233,752 205,628 --------- --------- --------- Total Assets ................ $3,639,772 $3,371,386 $3,179,464 ========== ========== ========== Liabilities: Interest-bearing Deposits: NOW Accounts ................ $ 490,908 11,034 2.2% $ 396,477 6,065 1.5% $ 395,356 2,058 0.5% Money Market Deposit Accounts 246,706 7,648 3.1 251,746 7,551 3.0 280,508 4,899 1.7 Savings Deposits ............ 264,134 4,604 1.7 259,052 3,927 1.5 319,552 2,583 0.8 Certificates and Other Time Deposits ............. 1,407,151 66,635 4.7 1,333,408 56,771 4.3 1,149,679 36,581 3.2 ---------- -------- ---------- -------- ---------- -------- Total Interest-bearing Deposits..................... 2,408,899 89,921 3.7 2,240,683 74,314 3.3 2,145,095 46,121 2.2 Borrowings ...................... 515,562 27,692 5.4 445,806 24,197 5.4 412,091 19,959 4.8 ---------- -------- ---------- -------- ---------- -------- Total Interest-bearing Liabilities................. 2,924,461 117,613 4.0 2,686,489 98,511 3.7 2,557,186 66,080 2.6 Noninterest-bearing Deposits..... 343,544 327,387 273,657 Other Liabilities ............... 40,981 37,991 33,096 ---------- ---------- ---------- Total Liabilities............ 3,308,986 3,051,867 2,863,939 Stockholders' Equity ............ 330,786 319,519 315,525 ---------- ---------- ---------- Total Liabilities and Stockholders' Equity........ $3,639,772 117,613 3.6 $3,371,386 98,511 3.2 $3,179,464 66,080 2.3 ========== -------- ========== -------- ========== -------- Net Interest Income ......... $117,247 $114,076 $114,907 ======== ======== ======== Net Interest Margin.......... 3.5 3.7 4.0 1 Average balance of securities is computed based on the average of the historical amortized cost balances without the effects of the fair value adjustment. 2 Tax-exempt securities and loans are presented on a fully taxable equivalent basis, using a marginal tax rate of 35% for 2007, 2006, and 2005. Those totals equal $4,127, $3,981 and $3,778, respectively. 3 Nonaccruing loans have been included in the average balances. 11 PART I: ITEM 1. BUSINESS ANALYSIS OF CHANGES IN NET INTEREST INCOME The following table presents net interest income components on a tax-equivalent basis and reflects changes between periods attributable to movement in either the average balance or average interest rate for both earning assets and interest-bearing liabilities. The volume differences were computed as the difference in volume between the current and prior year times the interest rate of the prior year, while the interest rate changes were computed as the difference in rate between the current and prior year times the volume of the prior year. Volume/rate variances have been allocated on the basis of the absolute relationship between volume variances and rate variances. ============================================================================================================================================ (Dollars in Thousands on Fully Taxable Equivalent Basis) Increase (Decrease) Due To Increase (Decrease) Due To ============================================================================================================================================ 2007 Compared to 2006 2006 Compared to 2005 Volume Rate Total Volume Rate Total ======== ======== ======= ======== ======== ======= Interest Income: Federal Funds Sold ............... $ (298) $ 97 $ (201) $ (50) $ 159 $ 109 Interest-bearing Deposits ........ 200 (118) 82 (467) 272 (195) Federal Reserve and Federal Home Loan Bank Stock ........... 40 3 43 24 47 71 Securities ....................... 550 852 1,402 1,809 1,188 2,997 Mortgage Loans Held for Sale ..... 71 302 373 72 (9) 63 Loans ............................ 16,640 3,934 20,574 9,098 19,457 28,555 -------- --------- --------- -------- --------- --------- Totals ........................... 17,203 5,070 22,273 10,486 21,114 31,600 -------- --------- --------- -------- --------- --------- Interest Expense: NOW Accounts ..................... 1,673 3,296 4,969 6 4,001 4,007 Money Market Deposit Accounts........................ (153) 250 97 (547) 3,199 2,652 Savings Deposits.................. 78 599 677 (565) 1,909 1,344 Certificates and Other Time Deposits................... 3,256 6,608 9,864 6,480 13,710 20,190 Borrowings........................ 3,749 (254) 3,495 1,713 2,525 4,238 -------- --------- --------- -------- --------- --------- Totals.......................... 8,603 10,499 19,102 7,087 25,344 32,431 -------- --------- --------- -------- --------- --------- Change in Net Interest Income (Fully Taxable Equivalent Basis)................ $ 8,600 $ (5,429) $ 3,171 $ 3,399 $ (4,230) $ (831) ======== ========= ======== ========= Tax Equivalent Adjustment Using Marginal Rate of 35% for 2007, 2006, and 2005.......................... (146) (203) ---------- ---------- Change in Net Interest Income........................... $ 3,025 $ (1,034) ========= ========== 12 PART I: ITEM 1. BUSINESS INVESTMENT SECURITIES The amortized cost, gross unrealized gains, gross unrealized losses and approximate market value of the investment securities at the dates indicated were: ====================================================================================================================================== GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR (Dollars in Thousands) COST GAINS LOSSES VALUE ====================================================================================================================================== Available for Sale at December 31, 2007 U.S. Treasury ............................... $ 1,501 $ 18 $ 1,519 U.S. Government-sponsored Agency Securities.. 67,793 240 $ 98 67,935 State and Municipal ......................... 150,744 2,324 156 152,912 Mortgage-backed Securities .................. 199,591 1,654 1,444 199,801 Corporate Obligations........ ............... 13,740 1,294 12,446 Marketable Equity Securities ................ 6,835 612 6,223 -------- -------- -------- -------- Total Available for Sale ................. 440,204 4,236 3,604 440,836 -------- -------- -------- -------- Held to Maturity at December 31, 2007 State and Municipal ......................... 10,317 237 298 10,256 Mortgage-backed Securities .................. 14 14 -------- -------- -------- -------- Total Held to Maturity ................... 10,331 237 298 10,270 -------- -------- -------- -------- Total Investment Securities .............. $450,535 $ 4,473 $ 3,902 $451,106 ======== ======== ======== ======== Available for Sale at December 31, 2006 U.S. Treasury .......................................... $ 1,502 $ 1 $ 1,503 U.S. Government-sponsored Agency Securities ............ 87,193 69 $ 1,284 85,978 State and Municipal .................................... 168,262 2,251 892 169,621 Mortgage-backed Securities ............................. 195,228 600 3,983 191,845 Other Asset-backed Securities .......................... Marketable Equity Securities ........................... 7,296 310 6,986 -------- -------- -------- -------- Total Available for Sale ............................ 459,481 2,921 6,469 455,933 -------- -------- -------- -------- Held to Maturity at December 31, 2006 State and Municipal .................................... 9,266 432 200 9,498 Mortgage-backed Securities ............................. 18 18 -------- -------- -------- -------- Total Held to Maturity .............................. 9,284 432 200 9,516 -------- -------- -------- -------- Total Investment Securities ......................... $468,765 $ 3,353 $ 6,669 $465,449 ======== ======== ======== ======== Available for Sale at December 31, 2005 U.S. Treasury .......................................... $ 1,586 $ 1 $ 1,585 U.S. Government-sponsored Agency Securities ............ 83,026 $ 1 1,836 81,191 State and Municipal .................................... 167,095 2,159 1,131 168,123 Mortgage-backed Securities ............................. 168,019 139 5,656 162,502 Other Asset-backed Securities .......................... 1 1 Marketable equity securities ........................... 9,660 435 9,225 -------- -------- -------- -------- Total Available for Sale ............................ 429,387 2,299 9,059 422,627 -------- -------- -------- -------- Held to Maturity at December 31, 2005 State and Municipal .................................... 11,609 283 412 11,480 Mortgage-backed Securities ............................. 30 30 -------- -------- -------- -------- Total Held to Maturity .............................. 11,639 283 412 11,510 -------- -------- -------- -------- Total Investment Securities ......................... $441,026 $ 2,582 $ 9,471 $434,137 ======== ======== ======== ======== ====================================================================================================================================== (Dollars in Thousands) ====================================================================================================================================== 2007 Cost Yield Cost Yield Cost Yield 2006 2005 Federal Reserve and Federal Home Loan Bank Stock at December 31: Federal Reserve Bank Stock .................... $ 9,223 6.0% $ 9,091 6.0% $ 8,913 6.0% Federal Home Loan Bank Stock .................. 16,027 4.3 14,600 4.3 14,287 4.3 ------- ------- ------- Total ..................................... $25,250 4.9% $23,691 4.9% $23,200 4.9% ======= ======= ======= ----- ----- ----- The fair value of Federal Reserve and Federal Home Loan Bank stock approximates cost. 13 PART I: ITEM 1. BUSINESS INVESTMENT SECURITIES continued There were no issuers included in our investment security portfolio at December 31, 2007, 2006 or 2005 where the aggregate carrying value of any one issuer exceeded 10 percent of the Corporation's stockholders' equity at those dates. The term "issuer" excludes the U.S. Government and its sponsored agencies and corporations. The maturity distribution (Dollars in Thousands) and average yields for the securities portfolio at December 31, 2007 were: Securities available for sale December 31, 2007: ===================================================================================================================================== Within 1 Year 1-5 Years 5-10 Years (Dollars in Thousands) Amount Yield1 Amount Yield1 Amount Yield1 ===================================================================================================================================== U.S. Treasury................................ $ 1,519 4.8% U.S. Government-sponsored Agency Securities.. 43,357 3.8 $ 24,479 4.7 $ 99 4.6% State and Municipal.......................... 31,580 4.4 74,076 5.3 39,371 6.6 Corporate Obligations ....................... 30 0.0 ------- -------- ------- Total.................................... $76,456 4.1% $ 98,585 5.1% $39,470 6.6% ======= ======== ======= Marketable Equity and Mortgage - Due After Ten Years Backed Securities Total ------------------- ----------------------- ----- Amount Yield1 Amount Yield1 Amount Yield1 ------ ------ ------ ------ ------ ------ U.S. Treasury........................ $ 1,519 4.8% U.S. Government-sponsored Agency Securities................. 67,935 4.1 State and Municipal.................. $ 7,885 7.8% 152,912 5.6 Marketable Equity Securities......... $ 6,223 5.5% 6,223 5.5 Corporate Obligations ............... 12,416 6.5 12,446 6.5 Mortgage-backed Securities........... 199,801 4.8 199,801 4.8 -------- --------- -------- Total............................ $ 20,301 7.0% $ 206,024 4.8% $440,836 5.0% ======== ========= ======== Securities held to maturity at December 31, 2007: ===================================================================================================================================== Within 1 Year 1-5 Years 5-10 Years (Dollars in Thousands) Amount Yield1 Amount Yield1 Amount Yield1 ===================================================================================================================================== State and Municipal.................. $ 704 7.4% $ 276 7.8% $ 810 6.0% Mortgage-Backed Due After Ten Years Securities Total ===================== ================= ======= Amount Yield1 Amount Yield1 Amount Yield1 ------ ------ ------ ------ ------ ------ State and Municipal.................. $ 8,527 7.1% $10,317 7.1% Other Asset-backed Securities........ $ 14 8.4% 14 8.4 ------- ------- ------- Total............................ $ 8,527 7.1% $ 14 8.4% $10,331 7.1% ======= ======= ======= 1 Interest yields on state and municipal securities are presented on a fully taxable equivalent basis using a 35% tax rate. 14 PART I: ITEM 1. BUSINESS INVESTMENT SECURITIES continued The following tables show the Corporation’s gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2007 and 2006: ==================================================================================================================================== GROSS GROSS GROSS FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED (Dollars in Thousands) VALUE LOSSES VALUE LOSSES VALUE LOSSES ==================================================================================================================================== Less than 12 12 Months or Months Longer Total -------------- -------------- Temporarily Impaired Investment Securities at December 31, 2007: U.S. Government-sponsored Agency Securities ............... $ 45,572 $ (98) $45,572 $ (98) State and Municipal ....................................... $ 858 $ (7) 60,996 (447) 61,854 (454) Mortgage-backed Securities ................................ 3,489 (30) 86,161 (1,414) 89,560 (1,444) Corporate Obligations ..................................... 12,415 (1,294) 12,415 (1,294) Marketable Equity Securities .............................. 900 (612) 900 (612) -------- ------- -------- ------- -------- -------- Total Temporarily Impaired Investment Securities ....... $ 16,762 $(1,331) $193,629 $(2,571) $210,391 $ (3,902) ======== ======= ======== ======= ======== ======== --------- --------------------------------------------------------------------- GROSS GROSS GROSS FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED VALUE LOSSES VALUE LOSSES VALUE LOSSES --------------------------------------------------------------------- Months Longer Total -------------- -------------- --------- Less than 12 12 Months or Temporarily Impaired Investment Securities at December 31, 2006: U.S. Government-sponsored agency securities ............... $ 1,576 $ (3) $ 71,702 $(1,281) $ 73,278 $ (1,284) State and Municipal ....................................... 9,608 (35) 81,841 (1,057) 91,449 (1,092) Mortgage-backed Securities ................................ 7,459 (20) 126,555 (3,963) 134,014 (3,983) Corporate Obligations .................................... 28 (6) 28 (6) Marketable Equity Securities .............................. 1,215 (304) 1,215 (304) -------- ------- -------- ------- -------- -------- Total Temporarily Impaired Investment Securities ....... $ 19,858 $ (362) $280,126 $(6,307) $299,984 $ (6,669) ======== ======= ======== ======= ======== ======== LOAN PORTFOLIO TYPES OF LOANS ====================================================================================================================================== (Dollars in Thousands) 2007 2006 2005 2004 2003 ====================================================================================================================================== Loans at December 31: Commercial and Industrial Loans.............. $ 662,701 $ 537,305 $ 461,102 $ 451,227 $ 435,221 Agricultural Production Financing and Other Loans to Farmers....... 114,324 100,098 95,130 98,902 95,048 Real Estate Loans: Construction............................... 165,425 169,491 174,783 164,738 149,865 Commercial and Farmland.................... 947,234 861,429 734,865 709,163 564,578 Residential................................ 744,627 749,921 751,217 761,163 866,477 Individuals' Loans for Household and Other Personal Expenditures.. 187,880 223,504 200,139 198,532 196,093 Tax-exempt Loans............................. 16,423 14,423 8,263 8,203 16,363 Lease Financing Receivables, Net of Unearned Income .................... 8,351 8,010 8,713 11,311 7,919 Other Loans.................................. 29,878 28,420 23,215 24,812 21,939 ---------- ---------- ---------- ---------- ---------- Allowance for Loan Losses................... (28,228) (26,540) (25,188) (22,548) (25,493) ---------- ---------- ---------- ---------- ---------- Total Loans............................. $2,848,615 $2,666,061 $2,432,239 $2,405,503 $2,328,010 ========== ========== ========== ========== ========== 2,879,843 2,692,601 2,457,427 2,428,501 2,353,503 Residential Real Estate Loans Held for Sale at December 31, 2007, 2006, 2005, 2004 and 2003 were $3,735,000, $5,413,000, $4,910,000, $3,367,000, and $3,043,000, respectively. 15 PART I: ITEM 1. BUSINESS MATURITIES AND SENSITIVITIES OF LOANS TO CHANGES IN INTEREST RATES Presented in the table below are the maturities of loans (excluding residential real estate, individuals' loans for household and other personal expenditures and lease financing) outstanding as of December 31, 2007. Also presented are the amounts due after one year classified according to the sensitivity to changes in interest rates. ===================================================================================================================================== Maturing Maturing Maturing Within 1 - 5 Over (Dollars in Thousands) 1 Year Years 5 Years Total ===================================================================================================================================== Commercial and Industrial Loans................ $ 365,246 $ 215,075 $ 82,380 $ 662,701 Agricultural Production Financing and Other Loans to Farmers................... 88,359 17,721 8,244 114,324 Real Estate - Construction..................... 121,260 40,901 3,264 165,425 Real Estate - Commercial and Farmland.......... 342,938 469,754 134,542 947,234 Tax-exempt Loans............................... 9,953 3,363 3,107 16,423 Other Loans.................................... 21,465 5,158 3,255 29,878 ---------- --------- --------- ---------- Total.................................... $ 949,221 $ 751,972 $234,792 $1,935,985 ========== ========= ========= ========== ================================================ 1 - 5 Over Years 5 Years ================================================ Maturing Maturing Loans Maturing After One Year with: Fixed Rate.............................. $ 259,354 $ 211,689 Variable Rate........................... 492,618 23,103 ------------- ------------ Total................................. $ 751,972 $ 234,792 ============= ============ NONACCRUING, CONTRACTUALLY PAST DUE 90 DAYS OR MORE OTHER THAN NONACCRUING AND RESTRUCTURED LOANS ===================================================================================================================================== (Dollars in Thousands) 2007 2006 ===================================================================================================================================== 2005 2003 2004 Non-accrual Loans......................... $ 29,031 $ 17,926 $ 10,030 Loans Contractually Past Due 90 Days or More Other Than Nonaccruing..... 3,578 2,870 3,965 1,907 6,530 Restructured Loans........................ 145 84 310 2,019 641 ------- ------- ------- ------- ------- Total Non-performing Loans........... $32,754 $ 20,880 $ 14,305 $ 19,281 $ 26,624 ======= ======= ======= ======= ======= $ 15,355 $ 19,453 Nonaccruing loans are loans, which are reclassified to a nonaccruing status when in management's judgment the collateral value and financial condition of the borrower do not justify accruing interest. Interest previously recorded, but not deemed collectible, is reversed and charged against current income. Interest income on these loans is then recognized when collected. Restructured loans are loans for which the contractual interest rate has been reduced or other concessions are granted to the borrower, because of a deterioration in the financial condition of the borrower resulting in the inability of the borrower to meet the original contractual terms of the loans. Interest income of $1,143,000 for the year ended December 31, 2007, was recognized on the nonaccruing and restructured loans listed in the table above, whereas interest income of $2,009,000 would have been recognized under their original loan terms. Potential problem loans: Management has identified certain other loans totaling $65,867,000 as of December 31, 2007, not included in the table above, or the impaired loan table in the footnotes to the consolidated financial statements, about which there are doubts as to the borrowers' ability to comply with present repayment terms. For the Corporation, all criticized loans, including substandard, doubtful and loss credits are included in the impaired loan total. The Corporation's affiliate banks generate commercial, mortgage and consumer loans from customers located primarily in north central and east-central Indiana and Butler, Franklin and Hamilton counties in Ohio. The Banks' loans are generally secured by specific items of collateral, including real property, consumer assets, and business assets. 16 PART I: ITEM 1. BUSINESS SUMMARY OF LOAN LOSS EXPERIENCE The following table summarizes the loan loss experience for the years indicated. ============================================================================================================================== (Dollars in Thousands) 2007 2006 2005 2004 2003 ============================================================================================================================== Allowance for Loan Losses: Balance at January1 .................... $ 26,540 $ 25,188 $ 22,548 $ 25,493 $ 22,417 Charge offs: Commercial and Industrial1 ........... 2,403 1,369 3,763 7,455 5,023 Real Estate Mortgage2 ............... 4,309 3,613 2,117 1,588 2,111 Individuals' Loans for Household and Other Personal Expenditures, Including Other Loans................ 1,845 1,528 1,864 1,858 5,005 -------- -------- -------- -------- -------- Total Charge offs.................... 8,557 6,510 7,744 10,901 12,139 -------- -------- -------- -------- -------- Recoveries: Commercial and Industrial3 ............ 551 291 1,283 1,629 1,002 Real Estate Mortgage4 ................. 750 863 122 161 421 Individuals' Loans For Household and Other Personal Expenditures, Including Other Loans................ 437 450 625 461 588 -------- -------- -------- -------- -------- Total Recoveries..................... 1,738 1,604 2,030 2,251 2,011 -------- -------- -------- -------- -------- Net Charge offs.......................... 6,819 4,906 5,714 8,650 10,128 -------- -------- -------- -------- -------- Provisions for Loan Losses............... 8,507 6,258 8,354 5,705 9,477 Allowance Acquired in Purchase........... 3,727 -------- -------- -------- -------- -------- Balance at December 31................... $28,228 $26,540 $25,188 $22,548 $25,493 ======== ======== ======== ======== ======== Ratio of Net Charge offs During the Period to Average Loans Outstanding During the Period.......... .24% .19% .23% .37% .44% See the information regarding the analysis of loan loss experience in the Asset Quality/Provision for Loan Losses section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included as Item 7 of this Annual Report on Form 10-K. 1 Category also includes the charge offs for lease financing, loans to financial institutions, tax-exempt loans and agricultural production financing and other loans to farmers. 2 Category includes the charge offs for construction, commercial and farmland and residential real estate loans. 3 Category also includes the recoveries for lease financing, loans to financial institutions, tax-exempt loans and agricultural production financing and other loans to farmers. 4 Category includes the recoveries for construction, commercial and farmland and residential real estate loans. 17 PART I: ITEM 1. BUSINESS SUMMARY OF LOAN LOSS EXPERIENCE continued Allocation of the Allowance for Loan Losses at December 31: Presented below is an analysis of the composition of the allowance for loan losses and percent of loans in each category to total loans. ============================================================================================================================== 2007 2006 (Dollars in Thousands) ============================================================================================================================== Amount Percent Amount Percent 1.................. $ 9,598 34.1% $ 9,598 31.0% 2....................... 12,561 58.8 12,479 60.5 Balance at December 31: Commercial and Industrial Real Estate Mortgage Individuals' Loans for Household and Other Personal Expenditures, Including Other Loans..................... 5,969 7.1 4,363 8.5 Unallocated................................. 100 N/A 100 N/A -------- ------ -------- ------ Totals...................................... $ 28,228 100.0% $ 26,540 100.0% ======== ====== ======== ====== 2005 2004 ------------------------- ------------------------- Amount Per Cent Amount Per Cent -------- -------- -------- -------- .................. $ 7,430 30.9% $ 16,821 30.9% 2....................... 13,149 60.6 1,916 60.9 Balance at December 31: Commercial and Industrial1 Real Estate Mortgage Individuals' Loans for Household and Other Personal Expenditures, Including Other Loans..................... 4,509 8.5 3,711 8.5 Unallocated................................. 100 N/A 100 N/A -------- ------ -------- ------ Totals...................................... $ 25,188 100.0% $ 22,548 100.0% ======== ====== ======== ====== 2003 ------------------------- Amount Per Cent -------- -------- Balance at December 31: Commercial and industrial1 .................. $ 17,517 29.9% 2....................... 4,441 60.8 Real estate mortgage Individuals' Loans for Household and Other Personal Expenditures, Including Other Loans..................... 3,435 9.3 Unallocated. .... .......................... 100 N/A -------- ------ Totals...................................... $ 25,493 100.0% ======== ====== At December 31, 2007, the Corporation had no concentration of loans exceeding 10 percent of total loans, which are not otherwise disclosed. Loan concentrations are considered to exist when there are amounts loaned to a multiple number of borrowers engaged in similar activities, which would cause them to be similarly impacted by economic or other conditions. Loan Administration and Loan Loss Charge-off Procedures Primary responsibility and accountability for day-to-day lending activities rests with the Corporation's affiliate banks. Loan personnel at each bank have the authority to extend credit under guidelines approved by the bank's board of directors. Executive and board loan committees active at each bank serve as vehicles for communication between the banks and for the pooling of knowledge, judgment and experience of the Corporation's affiliate banks. These committees provide valuable input to lending personnel, act as an approval body, and monitor the overall quality of the banks' loan portfolios. The Corporation also maintains a loan grading and review program for its affiliate banks, which includes quarterly reviews of problem loans, delinquencies and charge offs. The purpose of this program is to evaluate loan administration, credit quality, loan documentation and the adequacy of the allowance for loan losses. 1 Category also includes the allowance for loan losses and percent of loans for lease financing, loans to financial institutions, tax-exempt loans, agricultural production financing and other loans to farmers and construction real estate loans. 2 Category includes the allowance for loan losses and percent of loans for commercial real estate, farmland and residential real estate loans. 18 PART I: ITEM 1. BUSINESS Loan Administration and Loan Loss Charge-off Procedures continued The Corporation maintains an allowance for loan losses to cover probable credit losses identified during its loan review process. The allowance is increased by the provision for loan losses and decreased by charge offs less recoveries. All charge offs are approved by the Banks’ senior loan officer and are reported to the Banks' Boards. The Banks charge off loans when a determination is made that all or a portion of a loan is uncollectible or as a result of examinations by regulators and the independent auditors. Provision for Loan Losses In banking, loan losses are one of the costs of doing business. Although the Banks' management emphasize the early detection and charge-off of loan losses, it is inevitable that at any time certain losses exist in the portfolio, which have not been specifically identified. Accordingly, the provision for loan losses is charged to earnings on an anticipatory basis, and recognized loan losses are deducted from the allowance so established. Over time, all net loan losses must be charged to earnings. During the year, an estimate of the loss experience for the year serves as a starting point in determining the appropriate level for the provision. However, the amount actually provided in any period may be greater or less than net loan losses, based on management's judgment as to the appropriate level of the allowance for loan losses. The determination of the provision in any period is based on management's continuing review and evaluation of the loan portfolio, and its judgment as to the impact of current economic conditions on the portfolio. The evaluation by management includes consideration of past loan loss experience, changes in the composition of the loan portfolio, and the current condition and amount of loans outstanding. Impaired loans are measured by the present value of expected future cash flows, or the fair value of the collateral of the loans, if collateral dependent. For the Corporation, all criticized loans, including substandard, doubtful and loss credits are included in the impaired loan total. Information on impaired loans is summarized below: ========================================================================================================================== (Dollars in Thousands) 2007 2006 2005 ========================================================================================================================== As of, and for the Year Ending December 31: Impaired Loans With an Allowance............................ $ 21,304 $ 17,291 $ 7,540 Impaired Loans for which the Discounted Cash Flows or Collateral Value Exceeds the Carrying Value of the Loan................................ 65,645 43,029 44,840 ------------ ------------ ------------ Total Impaired Loans.................................. $ 86,949 $ 60,320 $ 52,380 ============== ============== ============== Total Impaired Loans as a Percent of Total Loans.............. 3.02% 2.24% 2.13% Allowance for Impaired Loans (Included in the Corporation's Allowance for Loan Losses).................. $ 6,034 $ 4,130 $ 2,824 Average Balance of Impaired Loans........................... 103,272 66,139 44,790 Interest Income Recognized on Impaired Loans................ 6,675 5,143 3,511 Cash Basis Interest Included Above.......................... 1,143 1,364 650 DEPOSITS The average balances, interest income and expense and average rates on deposits for the years ended December 2007, 2006 and 2005 are presented within the "Distribution of Assets, Liabilities and Stockholders' Equity, Interest Rates and Interest Differential" table on page 11 of this Form 10-K. As of December 31, 2007, certificates of deposit and other time deposits of $100,000 or more mature as follows: ===================================================================================================================== Maturing Maturing Maturing Maturing 3 Months 3-6 6-12 Over 12 (Dollars in Thousands) or less Months Months Months Total ===================================================================================================================== Certificates of Deposit and Other Time Deposits.......... $269,578 $ 91,199 $ 85,216 $ 49,637 $495,630 Percent ....................... 54% 19% 17% 10% 100% 19 PART I: ITEM 1. BUSINESS RETURN ON EQUITY AND ASSETS See the information regarding return on equity and assets presented within the "Five – Year Summary of Selected Financial Data" on page 3 of this Form 10-K. SHORT-TERM BORROWINGS ============================================================================================= (Dollars in Thousands) 2007 2006 2005 ============================================================================================= Balance at December 31: Securities Sold Under Repurchase Agreements (Short-term Portion).................. $ 72,247 $ 42,750 $106,415 Federal Funds Purchased............................ 52,350 56,150 50,000 -------- -------- -------- Total Short-term Borrowings................ $124,597 $ 98,900 $156,415 ======== ======== ======== Securities sold under repurchase agreements are borrowings maturing within one year and are secured by U.S. Treasury and U.S. Government-sponsored agency securities. Pertinent information with respect to short-term borrowings is summarized below: ============================================================================================= (Dollars in Thousands) 2007 2006 2005 ============================================================================================= Weighted Average Interest Rate on Outstanding Balance at December 31: Securities Sold Under Repurchase Agreements (Short-term Portion).............. 3.7% 4.4% 3.8% Total Short-term Borrowings..................... 3.9 4.9 4.3 Weighted Average Interest Rate During the Year: Securities Sold Under Repurchase Agreements(Short-term Portion)............... 4.3% 4.4% 2.1% Total Short-term Borrowings..................... 4.9 4.6 2.3 Highest Amount Outstanding at Any Month End During the Year: Securities Sold Under Repurchase Agreements (Short-term Portion).............. $ 98,735 $ 98,765 $ 68,198 Total Short-term Borrowings..................... 226,894 219,337 144,898 Average Amount Outstanding During the Year: Securities Sold Under Repurchase Agreements (Short-term Portion).............. $ 62,040 $ 73,818 $ 77,969 Total Short-term Borrowings..................... 127,345 109,577 95,447 20 PART I: ITEM 1A. AND ITEM 1B. ITEM 1A. RISK FACTORS RISK FACTORS There are a number of factors, including those specified below, that may adversely affect the Corporation's business, financial results or stock price. Additional risks that the Corporation currently does not know about or currently views as immaterial may also impair the Corporation's business or adversely impact its financial results or stock price. INDUSTRY RISK FACTORS • The Corporation's business and financial results are significantly affected by general business and economic conditions. The Corporation's business activities and earnings are affected by general business conditions in the United States and abroad. These conditions include short-term and long-term interest rates, inflation, monetary supply, fluctuations in both debt and equity capital markets, and the strength of the United States economy and the state and local economies in which the Corporation operates. For example, an economic downturn, an increase in unemployment, or other events that affect household and/or corporate incomes could result in a deterioration of credit quality, a change in the allowance for loan losses, or reduced demand for loan or fee-based products and services. Changes in the financial performance and condition of the Corporation's borrowers could negatively affect repayment of those borrowers' loans. In addition, changes in securities market conditions and monetary fluctuations could adversely affect the availability and terms of funding necessary to meet the Corporation's liquidity needs. • Changes in the domestic interest rate environment could reduce the Corporation's net interest income. The operations of financial institutions, such as the Corporation, are dependent to a large degree on net interest income, which is the difference between interest income from loans and investments and interest expense on deposits and borrowings. An institution's net interest income is significantly affected by market rates of interest, which in turn are affected by prevailing economic conditions, by the fiscal and monetary policies of the federal government and by the policies of various regulatory agencies. Like all financial institutions, the Corporation's balance sheet is affected by fluctuations in interest rates. Volatility in interest rates can also result in the flow of funds away from financial institutions into direct investments. Direct investments, such as U.S. Government and corporate securities and other investment vehicles, including mutual funds, generally pay higher rates of return than financial institutions, because of the absence of federal insurance premiums and reserve requirements. • Changes in the laws, regulations and policies governing banks and financial services companies could alter the Corporation's business environment and adversely affect operations. The Board of Governors of the Federal Reserve System regulates the supply of money and credit in the United States. Its fiscal and monetary policies determine in a large part the Corporation's cost of funds for lending and investing and the return that can be earned on those loans and investments, both of which affect the Corporation's net interest margin. Federal Reserve Board policies can also materially affect the value of financial instruments that the Corporation holds, such as debt securities. The Corporation and its bank subsidiaries are heavily regulated at the federal and state levels. This regulation is to protect depositors, federal deposit insurance funds and the banking system as a whole. Congress and state legislatures and federal and state agencies continually review banking laws, regulations and policies for possible changes. Changes in statutes, regulations or policies could affect the Corporation in substantial and unpredictable ways, including limiting the types of financial services and products that the Corporation offers and/or increasing the ability of non-banks to offer competing financial services and products. The Corporation cannot predict whether any of this potential legislation will be enacted, and if enacted, the effect that it or any regulations would have on the Corporation's financial condition or results of operations. • The banking and financial services industry is highly competitive, and competitive pressures could intensify and adversely affect the Corporation's financial results. The Corporation operates in a highly competitive industry that could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. The Corporation competes with other banks, savings and loan associations, mutual savings banks, finance companies, mortgage banking companies, credit unions and investment companies. In addition, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks. Many of the Corporation's competitors have fewer regulatory constraints and some have lower cost structures. Also, the potential need to adapt to industry changes in information technology systems, on which the Corporation and financial services industry are highly dependent, could present operational issues and require capital spending. 21 PART I: ITEM 1A. AND ITEM 1B. INDUSTRY RISK FACTORS continued • Acts or threats of terrorism and political or military actions taken by the United States or other governments could adversely affect general economic or industry conditions. Geopolitical conditions may also affect the Corporation's earnings. Acts or threats or terrorism and political or military actions taken by the United States or other governments in response to terrorism, or similar activity, could adversely affect general economic or industry conditions. CORPORATION RISK FACTORS • The Corporation's allowance for loan losses may not be adequate to cover actual losses. The Corporation maintains an allowance for loan losses to provide for loan defaults and non- performance. The allowance for loan losses represents management's estimate of probable losses inherent in the Corporation's loan portfolio. The Corporation's allowance consists of three components: probable losses estimated from individual reviews of specific loans, probable losses estimated from historical loss rates, and probable losses resulting from economic, environmental, qualitative or other deterioration above and beyond what is reflected in the first two components of the allowance. The process for determining the adequacy of the allowance for loan losses is critical to our financial results. It requires management to make difficult, subjective and complex judgments, as a result of the need to make estimates about the effect of matters that are uncertain. Therefore, the allowance for loan losses, considering current factors at the time, including economic conditions and ongoing internal and external examination processes, will increase or decrease as deemed necessary to ensure the allowance for loan losses remains adequate. In addition, the allowance as a percentage of charge offs and nonperforming loans will change at different points in time based on credit performance, loan mix and collateral values. • The Corporation may suffer losses in its loan portfolio despite its underwriting practices. The Corporation seeks to mitigate the risks inherent in its loan portfolio by adhering to specific underwriting practices. The Corporation's strategy for credit risk management includes conservative credit policies and underwriting criteria for all loans, as well as an overall credit limit for each customer significantly below legal lending limits. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit quality reviews and management reviews of large credit exposures and loans experiencing deterioration of credit quality. There is a continuous review of the loan portfolio, including an internally administered loan "watch" list and an independent loan review. The evaluation takes into consideration identified credit problems, as well as the possibility of losses inherent in the loan portfolio that are not specifically identified. Although the Corporation believes that its underwriting criteria are appropriate for the various kinds of loans it makes, the Corporation may incur losses on loans due to the factors previously discussed. • Because the nature of the financial services business involves a high volume of transactions, the Corporation faces significant operational risks. The Corporation operates in diverse markets and relies on the ability of its employees and systems to process a high number of transactions. Operational risk is the risk of loss resulting from the Corporation's operations, including, but not limited to, the risk of fraud by employees or persons outside of the Corporation, the execution of unauthorized transactions by employees, errors relating to transaction processing and technology, breaches of the internal control system and compliance requirements and business continuation and disaster recovery. This risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards, adverse business decisions or their implementation, and customer attrition due to potential negative publicity. In the event of a breakdown in the internal control system, improper operation of systems or improper employee actions, the Corporation could suffer financial loss, face regulatory action and suffer damage to its reputation. • A natural disaster could harm the Corporation's business. Natural disasters could harm the Corporation's operations directly through interference with communications, as well as through the destruction of facilities and operational, financial and management information systems. These events could prevent the Corporation from gathering deposits, originating loans and processing and controlling its flow of business. 22 PART I: ITEM 1A. AND ITEM 1B. CORPORATION RISK FACTORS continued • The Corporation faces systems failure risks as well as security risks, including "hacking" and "identity theft". The computer systems and network infrastructure the Corporation uses could be vulnerable to unforeseen problems. Our operations are dependent upon our ability to protect computer equipment against damage from fire, power loss or telecommunication failure. Any damage or failure that causes an interruption in our operations could adversely affect our business and financial results. In addition, our computer systems and network infrastructure present security risks, and could be susceptible to hacking or identity theft. • The Corporation relies on dividends from its subsidiaries for its liquidity needs. The Corporation is a separate and distinct legal entity from its bank and non-bank subsidiaries. The Corporation receives substantially all of its cash from dividends paid by its subsidiaries. These dividends are the principal source of funds to pay dividends on the Corporation's stock and interest and principal on its debt. Various federal and state laws and regulations limit the amount of dividends that our bank subsidiaries may pay to the Corporation. • The Corporation's reported financial results depend on management's selection of accounting methods and certain assumptions and estimates. The Corporation's accounting policies and methods are fundamental to how it records and reports its financial condition and results of operations. The Corporation's management must exercise judgment in selecting and applying many of these accounting policies and methods, so they comply with Generally Accepted Accounting Principles and reflect management's judgment of the most appropriate manner to report the Corporation's financial condition and results. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which might be reasonable under the circumstances yet might result in the Corporation's reporting materially different results than would have been reported under a different alternative. Certain accounting policies are critical to presenting the Corporation's financial condition and results, and require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions or estimates. These critical accounting policies include: the allowance for loan losses; the valuation of investment securities; the valuation of goodwill and intangible assets; and pension accounting. Because of the uncertainty of estimates involved in these matters, the Corporation may be required to do one or more of the following: significantly increase the allowance for loan losses and/or sustain loan losses that are significantly higher than the reserve provided; recognize significant provision for impairment of its investment securities; recognize significant impairment on its goodwill and intangible assets; or significantly increase its pension liability. For more information, refer to “Critical Accounting Policies” under Item 7. Part II. Management’s Discussion and Analysis of Financial Condition and Results of Operations. • Changes in accounting standards could materially impact the Corporation's financial statements. From time to time, the Financial Accounting Standards Board changes the financial accounting and reporting standards that govern the preparation of the Corporation's financial statements. These changes can be hard to predict and can materially impact how the Corporation records and reports its financial condition and results of operations. In some cases, the Corporation could be required to apply a new or revised standard retroactively, resulting in the Corporation's restating prior period financial statements. • Significant legal actions could subject the Corporation to substantial uninsured liabilities. The Corporation is from time to time subject to claims related to its operations. These claims and legal actions, including supervisory actions by the Corporation's regulators, could involve large monetary claims and significant defense costs. To protect itself from the cost of these claims, the Corporation maintains insurance coverage in amounts and with deductibles that it believes are appropriate for its operations. However, the Corporation's insurance coverage may not cover all claims against the Corporation or continue to be available to the Corporation at a reasonable cost. As a result, the Corporation may be exposed to substantial uninsured liabilities, which could adversely affect the Corporation's results of operations and financial condition. 23 PART I: ITEM 1A. AND ITEM 1B. CORPORATION RISK FACTORS continued • Negative publicity could damage the Corporation's reputation and adversely impact its business and financial results. Reputation risk, or the risk to the Corporation's earnings and capital from negative publicity, is inherent in the Corporation's business. Negative publicity can result from the Corporation's actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions, and actions taken by government regulators and community organizations in response to those activities. Negative publicity can adversely affect the Corporation's ability to keep and attract customers and can expose the Corporation to litigation and regulatory action. Although the Corporation takes steps to minimize reputation risk in dealing with customers and other constituencies, the Corporation is inherently exposed to this risk. • Acquisitions may not produce revenue enhancements or cost savings at levels or within timeframes originally anticipated and may result in unforeseen integration difficulties. The Corporation regularly explores opportunities to acquire banks, financial institutions, or other financial services businesses or assets. The Corporation cannot predict the number, size or timing of acquisitions. Difficulty in integrating an acquired business or company may cause the Corporation not to realize expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from the acquisition. The integration could result in higher than expected deposit attrition (run-off), loss of key employees, disruption of the Corporation's business or the business of the acquired company, or otherwise adversely affect the Corporation's ability to maintain relationships with customers and employees or achieve the anticipated benefits of the acquisition. Also, the negative effect of any divestitures required by regulatory authorities in acquisitions or business combinations may be greater than expected. • The Corporation's stock price can be volatile. The Corporation's stock price can fluctuate widely in response to a variety of factors, including: actual or anticipated variations in the Corporation's quarterly operating results; recommendations by securities analysts; significant acquisitions or business combinations; strategic partnerships, joint ventures or capital commitments; operating and stock price performance of other companies that investors deem comparable to the Corporation; new technology used or services offered by the Corporation's competitors; news reports relating to trends, concerns and other issues in the banking and financial services industry, and changes in government regulations. General market fluctuations, industry factors and general economic and political conditions and events, including terrorist attacks, economic slowdowns or recessions, interest rate changes, credit loss trends or currency fluctuations, could also cause the Corporation's stock price to decrease, regardless of the Corporation's operating results. ITEM 1B. UNRESOLVED STAFF COMMENTS None. 24 PART I: ITEM 2., ITEM 3. AND ITEM 4. ITEM 2. PROPERTIES. The headquarters of the Corporation and First Merchants are located in a five-story building at 200 East Jackson Street, Muncie, Indiana. The building is owned by First Merchants. The Corporation's affiliate banks conduct business through numerous facilities owned and leased by the respective affiliate banks. Of the 66 banking offices operated by the Corporation's affiliate banks, 46 are owned by the respective banks and 20 are leased from non-affiliated third parties. None of the properties owned by the Corporation's affiliate banks are subject to any major encumbrances. The net investment of the Corporation and subsidiaries in real estate and equipment at December 31, 2007 was $44,445,000. ITEM 3. LEGAL PROCEEDINGS. There is no pending legal proceeding, other than ordinary routine litigation incidental to the business of the Corporation or its subsidiaries, of a material nature to which the Corporation or its subsidiaries is a party or of which any of their properties are subject. Further, there is no material legal proceeding in which any director, officer, principal shareholder, or affiliate of the Corporation, or any associate of any such director, officer or principal shareholder, is a party, or has a material interest, adverse to the Corporation or any of its subsidiaries. None of the routine legal proceedings, individually or in the aggregate, in which the Corporation or its affiliates are involved are expected to have a material adverse impact on the financial position or the results of operations of the Corporation. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted during the fourth quarter of 2007 to a vote of security holders, through the solicitation of proxies or otherwise. 25 SUPPLEMENTAL INFORMATION SUPPLEMENTAL INFORMATION - EXECUTIVE OFFICERS OF THE REGISTRANT. The names, ages, and positions with the Corporation and subsidiary banks of all executive officers of the Corporation and all persons chosen to become executive officers are listed below. The officers are elected by the Board of Directors of the Corporation for a term of one (1) year or until the election of their successors. There are no arrangements between any officer and any other person pursuant to which he was selected as an officer. Michael C. Rechin, 49, President and Chief Executive Officer, Corporation1 Chief Executive Officer of the Corporation since April 2007; Chief Operating Officer, Corporation since November 2005; Executive Vice President, Corporate Banking National City Bank from 1995 to November 2005.1 Mark K. Hardwick, 37, Executive Vice President and Chief Financial Officer, Corporation Executive Vice President and Chief Financial Officer of the Corporation since December 2005; Senior Vice President and Chief Financial Officer from April 2002 to December 2005; Corporate Controller, Corporation from November 1997 to April 2002. Jami L. Bradshaw, 45, Senior Vice President and Chief Accounting Officer, Corporation Senior Vice President and Chief Accounting Officer since May 2007; Vice President and Corporate Controller, Corporation from 2006 to May 2007; Assistant Vice President and Assistant Controller from 2002 to 2006. Robert R. Connors, 58, Senior Vice President, Chief Information Officer, Corporation and First Merchants Senior Vice President and Chief Information Officer of the Corporation and First Merchants since January 2006; Senior Vice President of Operations and Technology, Corporation and First Merchants from August 2002 to January 2006. Kimberly J. Ellington, 48, Senior Vice President and Director of Human Resources, Corporation Senior Vice President and Director of Human Resources since 2004; Vice President and Director of Human Resources, Corporation from 1999 to 2004. Jeffrey B. Lorentson, 44, Senior Vice President and Chief Risk Officer, Corporation Senior Vice President and Chief Risk Officer since June 2007; Corporate Controller of First Indiana Bank from June 2006 to June 2007; First Vice President and Corporate Controller of the Corporation from 2003 to 2006; Vice President and Corporate Controller of the Corporation from 2002 to 2003. David W. Spade, 55, Senior Vice President and Chief Credit Officer, Corporation Senior Vice President and Chief Credit Officer of the Corporation since February 2007; Vice President and Chief Credit Officer of the Corporation from December 2006 to February 2007; 1 Michael L. Cox retired as the President and Chief Executive Officer of the Corporation on April 24, 2007, the date of the Corporation’s annual meeting of shareholders. Mr. Rechin became the President and Chief Executive Officer at that time. 26 PART II: ITEM 5. AND ITEM 6. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES. PERFORMANCE GRAPH The following graph compares the cumulative 5-year total return to shareholders on First Merchants Corporation's common stock relative to the cumulative total returns of the Russell 2000 index and the Russell 2000 Financial Services index. The graph assumes that the value of the investment in the Corporation's common stock and in each of the indexes (including reinvestment of dividends) was $100 on December 31, 2002 and tracks it through December 31, 2007. First Merchants Corporation Russell 2000 Russell 2000 Financial Services 100.00 100.00 100.00 121.92 147.25 139.84 140.26 174.24 169.34 133.47 182.18 173.06 144.77 215.64 206.72 121.13 212.26 171.95 12/31/02 12/31/03 12/31/04 12/31/05 12/31/06 12/31/07 The stock price performance included in this graph is not necessarily indicative of future stock price performance. 27 PART II: ITEM 5. AND ITEM 6. STOCK INFORMATION ================================================================================================================================ PRICE PER SHARE QUARTER HIGH LOW DIVIDENDS DECLARED1 ================================================================================================================================ 2007 2006 2007 2006 2007 2006 -------------------------- --------------------------- --------------------------- First Quarter ............. $ 27.46 $ 29.42 $ 22.75 $ 24.37 $ .23 $ .23 Second Quarter ............. 25.00 26.50 21.51 22.20 .23 .23 Third Quarter .............. 24.95 25.00 18.30 22.51 .23 .23 Fourth Quarter ............. 23.44 27.99 19.92 22.81 .23 .23 The table above lists per share prices and dividend payments during 2007 and 2006. Prices are as reported by the National Association of Securities Dealers Automated Quotation - National Market System. Numbers rounded to nearest cent when applicable. COMMON STOCK LISTING First Merchants Corporation common stock is traded over-the-counter on the NASDAQ National Market System. Quotations are carried in many daily papers. The NASDAQ symbol is FRME (Cusip #320817-10-9). At the close of business on February 20, 2008, the number of shares outstanding was 18,551,275. There were 6,180 stockholders of record on that date. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASES The following table presents information relating to the Corporation's purchases of its equity securities during the quarter ended December 31, 2007, as follows:2 ========================================================================================================================= TOTAL NUMBER OF MAXIMUM NUMBER OF TOTAL NUMBER OF AVERAGE PRICE SHARES PURCHASED AS PART SHARES THAT MAY YET PERIOD SHARES PURCHASED PAID PER SHARE OF PUBLICALLY ANNOUNCED BE PURCHASED UNDER PLANS OR PROGRAMS1 THE PLANS OR PROGRAMS2 ========================================================================================================================= October 1-31, 2007 0 0 0 150,000 November 1-30, 2007 124,0632 December 1-31, 2007 41,1983 22.29 41,000 485,000 20.87 124,000 26,000 On January 23, 2007, the Corporation's Board authorized management to repurchase up to 250,000 shares of the Corporation's Common Stock. This authorization was not publicly announced and expired January 22, 2008. On July 24, 2007, the Corporation's Board authorized management to repurchase up to 150,000 shares of the Corporation's Common Stock. This authorization was not publicly announced and also expired on January 22, 2008. On October 23, 2007 the Corporation’s Board authorized management to repurchase up to 150,000 shares of the Corporation’s Common Stock. This authorization expired on January 22, 2008 and was publicly announced on Form 8-K filed on October 29, 2007. On December 4, 2007, the Corporation’s Board authorized management to repurchase up to 500,000 shares of the Corporation’s Common Stock. This authorization expires on December 31, 2008 and was publicly announced on Form 8-K filed on December 11, 2007. 1 The Liquidity section of Management’s Discussion & Analysis of Financial Condition and Results of Operations included as Item 7 of this Annual Report on Form 10-K and Note 14 to Consolidated Financial Statements included as Item 8 of this Annual Report on Form 10-K include discussions regarding dividend restrictions from the bank subsidiaries to the Corporation. 2 Of the 124,063 shares, 124,000 were purchased in open market transactions pursuant to the above-listed authorizations. The remaining 63 shares were purchased in connection with the exercise of certain outstanding stock options. 3 Of the 41,198 shares, 41,000 were purchased in open market transactions pursuant to the above-listed authorizations. The remaining 198 shares were purchased in connection with the exercise of certain outstanding stock options. 28 PART II: ITEM 5. AND ITEM 6. EQUITY COMPENSATION PLAN INFORMATION The following table provides information about the Corporation’s common stock that may be issued under equity compensation plans as of December 31, 2007. ==================================================================================================================================== Number of securities remaining Number of securities to Weighted-average available for future issuance be issued upon exercise exercise price of under equity compensations of outstanding options, outstanding options, plans (excluding securities Plan category warrants and rights warrants and rights reflected in first column) ==================================================================================================================================== Equity Compensation Plans Approved by Stockholders 1,018,076 $ 24.37 400,0001 Equity Compensation Plans Not Approved by Stockholders2 36,354 22.33 ----------------------- -------------------- ----------------------------- Total 1,054,430 $ 24.30 400,0001 ======================= ==================== ============================= ITEM 6. SELECTED FINANCIAL DATA. The selected financial data is presented within the "Five – Year Summary of Selected Financial Data" on page 3 of this Annual Report on Form 10-K. 1 This number does not include shares remaining available for future issuance under the 1999 Long-term Equity Incentive Plan, which was approved by the Corporation’s shareholders at the 1999 annual meeting. The aggregate number of shares that are available for grants under that Plan in any calendar year is equal to the sum of: (a) 1% of the number of common shares of the Corporation outstanding as of the last day of the preceding calendar year; plus (b) the number of shares that were available for grants, but not granted, under the Plan in any previous year; but in no event will the number of shares available for grants in any calendar year exceed 1 ½% of the number of common shares of the Corporation outstanding as of the last day of the preceding calendar year. The 1999 Long-term Equity Incentive Plan will expire in 2009. 2 The only plan reflected above that was not approved by the Corporation’s stockholders relates to certain First Merchants Corporation Stock Option Agreements (“Agreements”). These Agreements provided for non-qualified stock options of the common stock of the Corporation, awarded between 1995 and 2002 to each director of First Merchants Bank, National Association who, on the date of the grants: (a) were serving as a director of First Merchants; (b) were not an employee of the Corporation, First Merchants, or any of the Corporation’s other affiliated banks or the non-bank subsidiaries; and (c) were not serving as a director of the Corporation. The exercise price of the shares was equal to the fair market value of the shares upon the grant of the option. Options became 100 percent vested when granted and are fully exercisable six months after the date of the grant, for a period of ten years. 29 PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. CRITICAL ACCOUNTING POLICIES Generally accepted accounting principles require management to apply significant judgment to certain accounting, reporting and disclosure matters. Management must use assumptions and estimates to apply those principles where actual measurement is not possible or practical. For a complete discussion of the Corporation’s significant accounting policies, see the notes to the consolidated financial statements and discussion throughout this Form 10-K. Below is a discussion of the Corporation’s critical accounting policies. These policies are critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the Corporation’s financial statements. Management has reviewed the application of these policies with the Corporation’s Audit Committee. Allowance for Loan Losses. The allowance for loan losses represents management’s estimate of probable losses inherent in the Corporation’s loan portfolio. In determining the appropriate amount of the allowance for loan losses, management makes numerous assumptions, estimates and assessments. The Corporation’s strategy for credit risk management includes conservative credit policies and underwriting criteria for all loans, as well as an overall credit limit for each customer significantly below legal lending limits. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit quality reviews and management reviews of large credit exposures and loans experiencing deterioration of credit quality. The Corporation’s allowance consists of three components: probable losses estimated from individual reviews of specific loans, probable losses estimated from historical loss rates, and probable losses resulting from economic, environmental, qualitative or other deterioration above and beyond what is reflected in the first two components of the allowance. Larger commercial loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropriate, reserves are allocated to individual loans based on management’s estimate of the borrower’s ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Corporation. Included in the review of individual loans are those that are impaired as provided in SFAS No. 114, Accounting by Creditors for Impairment of a Loan. Any allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or fair value of the underlying collateral. The Corporation evaluates the collectibility of both principal and interest when assessing the need for a loss accrual. Historical loss rates are applied to other commercial loans not subject to specific reserve allocations. Homogenous loans, such as consumer installment and residential mortgage loans, are not individually risk graded. Reserves are established for each pool of loans using loss rates based on a three-year average net charge-off history by loan category. Historical loss allocations for commercial and consumer loans may be adjusted for significant factors that, in management’s judgment, reflect the impact of any current conditions on loss recognition. Factors which management considers in the analysis include the effects of the national and local economies, trends in loan growth and charge-off rates, changes in mix, concentrations of loans in specific industries, asset quality trends (delinquencies, charge offs and nonaccrual loans), risk management and loan administration, changes in the internal lending policies and credit standards, examination results from bank regulatory agencies and the Corporation’s internal loan review. An unallocated reserve, primarily based on the factors noted above, is maintained to recognize the imprecision in estimating and measuring loss when evaluating reserves for individual loans or pools of loans. Allowances on individual loans and historical loss allocations are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions. The Corporation’s primary market areas for lending are north-central and east-central Indiana and Columbus, Ohio. When evaluating the adequacy of allowance, consideration is given to this regional geographic concentration and the closely associated effect changing economic conditions have on the Corporation’s customers. The Corporation has not substantively changed any aspect of its overall approach in the determination of the allowance for loan losses. There have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period allowance. Valuation of Securities. The Corporation’s available-for-sale security portfolio is reported at fair value. The fair value of a security is determined based on quoted market prices. If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments. Available-for- sale and held-to-maturity securities are reviewed quarterly for possible other-than-temporary impairment. The review includes an analysis of the facts and circumstances of each individual investment such as the 30 PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CRITICAL ACCOUNTING POLICIES continued length of time the fair value has been below cost, the expectation for that security’s performance, the creditworthiness of the issuer and the Corporation’s ability to hold the security to maturity. A decline in value that is considered to be other-than temporary is recorded as a loss within other operating income in the consolidated statements of income. Pension. The Corporation provides pension benefits to its employees. In accordance with applicable accounting rules, the Corporation does not consolidate the assets and liabilities associated with the pension plan. Instead, the Corporation recognizes the funded status of the plan in the balance sheet. The measurement of the funded status and the annual pension expense involves actuarial and economic assumptions. The assumptions used in pension accounting relate to the expected rate of return on plan assets, the rate of increase in salaries, the interest-crediting rate, the discount rate, and other assumptions. See Note 16 “Employee Benefit Plans” in the Annual Report for the specific assumptions used by the Corporation. The annual pension expense for the Corporation is currently most sensitive to the discount rate. Each 25 basis point reduction in the 2007 discount rate of 5.5 percent would increase the Corporation’s 2007 pension expense by approximately $95,000. In addition, each 25 basis point reduction in the 2007 expected rate of return of 7.75 percent would increase the Corporation’s 2007 pension expense by approximately $101,000. Goodwill and Intangibles. For purchase acquisitions, the Corporation is required to record the assets acquired, including identified intangible assets, and the liabilities assumed at their fair value, which in many instances involves estimates based on third-party valuations, such as appraisals, or internal valuations based on discounted cash flow analyses or other valuation techniques that may include estimates of attrition, inflation, asset growth rates or other relevant factors. In addition, the determination of the useful lives for which an intangible asset will be amortized is subjective. Goodwill and indefinite-lived assets recorded must be reviewed for impairment on an annual basis, as well as on an interim basis, if events or changes indicate that the asset might be impaired. An impairment loss must be recognized for any excess of carrying value over fair value of the goodwill or the indefinite-lived intangible with subsequent reversal of the impairment loss being prohibited. The tests for impairment fair values are based on internal valuations using management's assumptions of future growth rates, future attrition, discount rates, multiples of earnings or other relevant factors. The resulting estimated fair values could have a significant impact on the carrying values of goodwill or intangibles and could result in impairment losses being recorded in future periods. Derivative Instruments. As part of our asset/liability management program, the Corporation will utilize, from time-to-time, interest rate floors, caps or swaps to reduce its sensitivity to interest rate fluctuations. These are derivative instruments, which are recorded as assets or liabilities in the consolidated balance sheets at fair value. Changes in the fair values of derivatives are reported in the consolidated income statements or other comprehensive income (OCI) depending on the use of the derivative and whether the instrument qualifies for hedge accounting. The key criterion for the hedge accounting is that the hedged relationship must be highly effective in achieving offsetting changes in those cash flows that are attributable to the hedged risk, both at inception of the hedge and on an ongoing basis. Derivatives that qualify for the hedge accounting treatment are designated as either: a hedge of the fair value of the recognized asset or liability or of an unrecognized firm commitment (a fair value hedge) or a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (a cash flow hedge). To date, the Corporation has only entered into a cash flow hedge. For cash flow hedges, changes in the fair values of the derivative instruments are reported in OCI to the extent the hedge is effective. The gains and losses on derivative instruments that are reported in OCI are reflected in the consolidated income statement in the periods in which the results of operations are impacted by the variability of the cash flows of the hedged item. Generally, net interest income is increased or decreased by amounts receivable or payable with respect to the derivatives, which qualify for hedge accounting. At inception of the hedge, the Corporation establishes the method it uses for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. The ineffective portion of the hedge, if any, is recognized currently in the consolidated statements of income. The Corporation excludes the time value expiration of the hedge when measuring ineffectiveness. RESULTS OF OPERATIONS As of December 31, 2007 total assets equaled $3,782,087,000, an increase of $227,217,000 from December 31, 2006. Loans and investments, the Corporation’s primary earning assets, increased by $168,500,000, or 5.4 percent. During 2007, management strategically reduced several earning asset categories, with a view toward higher performance and capital maximization. Details of these changes are discussed within the “EARNING ASSETS” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations. 31 PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS continued As of December 31, 2006 total assets equaled $3,554,870,000, an increase of $317,791,000 from December 31, 2005. Of this amount, loans increased $235,677,000, investments increased $30,951,000, intangibles, including goodwill, decreased $195,000 and cash value of life insurance increased by $20,634,000. Details of these changes are discussed within the “EARNING ASSETS” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations. Net income for 2007 totaled $31,639,000, an increase of $1,441,000, or 4.8 percent from 2006. Diluted earnings per share totaled $1.73, a 5.6 percent increase from $1.64 reported in 2006. The increase was primarily attributed to increases in earning assets. This volume increase was offset by a decrease in net interest margin of 16 basis points and increased expenses related to two strategic non-recurring expenses. The first is related to the early redemption of the Corporation’s subordinated debentures payable to First Merchants Capital Trust I and subsequent redemption by First Merchants Capital Trust I of its outstanding common and preferred fixed rate securities (NASDAQ-FRMEP). The early redemption of the debentures required the Corporation to accelerate the recognition of the remaining unamortized underwriting fee of approximately $1.8 million, or $.06 per share. The second is related to expenses of $1.1 million related to the successful completion of the Corporation’s integration of Commerce National Bank, as well as the charter and data mergers of four banks into First Merchants Bank, National Association. These factors and others are discussed within the respective sections of Management’s Discussion and Analysis of Financial condition and Results of Operations. Net income for 2006 totaled $30,198,000, a decrease of $41,000, or .1 percent from 2005. Diluted earnings per share totaled $1.64, a .6 percent increase from $1.63 reported in 2005. Net interest margin declined by 26 basis points in 2006 to 3.71 percent from 3.97 percent in 2005. As a result, net interest income declined by $1,034,000 despite strong improvements in earning assets. These factors and others are discussed within the respective sections of Management’s Discussion and Analysis of Financial condition and Results of Operations. Return on equity totaled 9.56 percent in 2007, 9.45 percent in 2006, and 9.58 percent in 2005. Return on assets totaled .87 percent in 2007, .90 percent in 2006 and .95 percent in 2005. Multiple factors impacting the reported financial results are discussed within the respective sections of Management's Discussion and Analysis of Financial Condition and Results of Operations. CAPITAL The Corporation’s regulatory capital continues to exceed regulatory “well capitalized” standards. To be categorized as well capitalized, the Banks must maintain a minimum total capital to risk-weighted assets, Tier I capital to risk-weighted assets and Tier I capital to average assets of 10 percent, 6 percent and 5 percent, respectively. Tier I regulatory capital consists primarily of total stockholders’ equity and subordinated debentures issued to business trusts categorized as qualifying borrowings, less non-qualifying intangible assets and unrealized net securities gains or losses. The Corporation's Tier I capital to average assets ratio was 7.19 percent and 7.37 percent at December 31, 2007 and 2006, respectively. In addition, at December 31, 2007, the Corporation had a Tier I risk-based capital ratio of 8.75 percent and total risk-based capital ratio of 10.55 percent. Regulatory capital guidelines require a Tier I risk- based capital ratio of at least 4.0 percent and a total risk-based capital ratio of at least 8.0 percent. The Corporation’s GAAP capital ratio, defined as total stockholders’ equity to total assets, equaled 8.99 percent as of December 31, 2007, down from 9.21 percent in 2006. The Corporation’s tangible capital ratio, defined as total stockholders’ equity less intangibles net of tax to total assets less intangibles net of tax, equaled 5.72 percent as of December 31, 2007, up from 5.67 percent in 2006. Management believes that all of the above capital ratios are meaningful measurements for evaluating the safety and soundness of the Corporation. Additionally, management believes the following table is also meaningful when considering performance measures of the Corporation. The table details and reconciles tangible earnings per share, return on tangible capital and tangible assets to traditional GAAP measures. 32 PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAPITAL continued ======================================================================================== December 31, (Dollars in Thousands) 2007 2006 ======================================================================================== Average Goodwill..................................... $ 123,191 $ 121,831 Average Core Deposit Intangible (CDI)................ 13,868 16,103 Average Deferred Tax on CDI.......................... (3,659) (4,994) ---------- ---------- Intangible Adjustment.............................. $ 133,400 $ 132,940 ========== ========== Average Stockholders’ Equity (GAAP Capital).......... $ 330,786 $ 319,519 Intangible Adjustment................................ (133,400) (132,940) ---------- ---------- Average Tangible Capital........................... $ 197,386 $ 186,579 ========== ========== Average Assets....................................... $3,639,772 $3,371,386 Intangible Adjustment................................ (133,400) (132,940) ---------- ---------- Average Tangible Assets............................ $3,506,372 $3,328,446 ========== ========== Net Income........................................... $ 31,639 $ 30,198 CDI Amortization, Net of Tax......................... 1,919 1,920 ---------- ---------- Tangible Net Income................................ $ 33,558 $ 32,118 ========== ========== Diluted Earnings Per Share........................... $ 1.73 $ 1.64 Diluted Tangible Earnings Per Share.................. $ 1.83 $ 1.75 Return on Average GAAP Capital....................... 9.56% 9.45% Return on Average Tangible Capital................... 17.00% 17.21% Return on Average Assets............................. 0.87% 0.90% Return on Average Tangible Assets.................... 0.96% 0.99% ASSET QUALITY/PROVISION FOR LOAN LOSSES The Corporation’s primary business focus is small business and middle market commercial and residential real estate, auto and small consumer lending, which results in portfolio diversification. Management ensures that appropriate methods to understand and underwrite risk are utilized. Commercial loans are individually underwritten and judgmentally risk rated. They are periodically monitored and prompt corrective actions are taken on deteriorating loans. Retail loans are typically underwritten with statistical decision-making tools and are managed throughout their life cycle on a portfolio basis. The allowance for loan losses is maintained through the provision for loan losses, which is a charge against earnings. The amount provided for loan losses and the determination of the adequacy of the allowance are based on a continuous review of the loan portfolio, including an internally administered loan "watch" list and an independent loan review. The evaluation takes into consideration identified credit problems, as well as the possibility of losses inherent in the loan portfolio that are not specifically identified. (See Critical Accounting Policies) At December 31, 2007, non-performing loans totaled $32,754,000, an increase of $11,874,000. Loans 90 days past due other than non-accrual and restructured loans increased by $769,000. The amount of non-accrual loans totaled $29,031,000 at December 31, 2007. Non-performing loans will increase or decrease going forward due to portfolio growth, routine problem loan recognition and resolution through collections, sales or charge offs. The performance of any loan can be affected by external factors, such as economic conditions, or factors particular to a borrower, such as actions of a borrower’s management. At December 31, 2007, impaired loans totaled $86,949,000, an increase of $26,629,000 from year-end 2006. At December 31, 2007, a specific allowance for losses was not deemed necessary for impaired loans totaling $65,645,000, but a specific allowance of $6,034,000 was recorded for the remaining balance of impaired loans of $21,304,000 and is included in the Corporation’s allowance for loan losses. The average balance of impaired loans for 2007 was $103,272,000. The increase of total impaired loans is primarily due to the increase of performing, substandard classified loans, which comprise a portion of the Corporation’s total impaired loans. A loan is deemed impaired when, based on current information or events, it is probable that all amounts due of principal and interest according to the contractual terms of the loan agreement will not be collected. For the Corporation, all criticized loans, including substandard, doubtful and loss credits, are included in the impaired loan total. At December 31, 2007, the allowance for loan losses was $28,228,000, an increase of $1,688,000 from year- end 2006. As a percent of loans, the allowance was .98 percent at December 31, 2007 and .99 percent at December 31, 2006. Management believes that the allowance for loan losses is adequate to cover losses inherent in the loan portfolio at December 31, 2007. The process for determining the adequacy of the allowance for loan losses is critical to our financial results. It requires management to make difficult, 33 PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ASSET QUALITY/PROVISION FOR LOAN LOSSES continued subjective and complex judgments, as a result of the need to make estimates about the effect of matters that are uncertain. Therefore, the allowance for loan losses, considering current factors at the time, including economic conditions and ongoing internal and external examination processes, will increase or decrease as deemed necessary to ensure the allowance for loan losses remains adequate. In addition, the allowance as a percentage of charge offs and nonperforming loans will change at different points in time based on credit performance, loan mix and collateral values. The provision for loan losses in 2007 was $8,507,000, or 30 basis points, an increase of $2,249,000 from $6,258,000, or 24 basis points, in 2006, reflecting the increase of 5 basis points in net charge offs during the year. The provision for loan losses in 2006 was $6,258,000, or 24 basis points, a decrease of $2,096,000 from $8,354,000, or 34 basis points, in 2005, reflecting the decline of 4 basis points in net charge offs during the year. The following table summarizes the non-accrual, contractually past due 90 days or more other than non- accruing and restructured loans for the Corporation. ================================================================================ December 31, (Dollars in Thousands) 2007 2006 ================================================================================ Non-accrual Loans .............................. $29,031 $17,926 Loans Contractually Past Due 90 Days or More Other than Non-accruing ..................... 3,578 2,870 Restructured Loans ............................. 145 84 ------- ------- Total ....................................... $32,754 $20,880 ======= ======= The table below represents loan loss experience for the years indicated. ======================================================================================================== (Dollars in Thousands) 2007 2006 2005 ======================================================================================================== Allowance for Loan Losses: Balance at January 1 .................................. $26,540 $25,188 $22,548 ------- ------- ------- Charge offs ............................................ 8,557 6,510 7,744 Recoveries ............................................ 1,738 1,604 2,030 ------- ------- ------- Net charge offs ........................................ 6,819 4,906 5,714 Provision for Loan Losses ............................. 8,507 6,258 8,354 ------- ------- ------- Balance at December 31 ................................ $28,228 $26,540 $25,188 ======= ======= ======= Ratio of Net Charge offs During the Period to Average Loans Outstanding During the Period .......... .24% .19% .23% 34 PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY Liquidity management is the process by which the Corporation ensures that adequate liquid funds are available. These funds are necessary in order for the Corporation and its subsidiaries to meet financial commitments on a timely basis. These commitments include withdrawals by depositors, funding credit obligations to borrowers, paying dividends to shareholders, paying operating expenses, funding capital expenditures, and maintaining deposit reserve requirements. Liquidity is monitored and closely managed by the asset/liability committee at each subsidiary and by the Corporation’s asset/liability committee. Liquidity is dependent upon the receipt of dividends from bank subsidiaries, which are subject to certain regulatory limitations as explained in Note 14 to the consolidated financial statements, and access to other funding sources. Liquidity of our bank subsidiaries is derived primarily from core deposit growth, principal payments received on loans, the sale and maturity of investment securities, net cash provided by operating activities, and access to other funding sources. The most stable source of liability-funded liquidity for both the long-term and short-term is deposit growth and retention in the core deposit base. In addition, the Corporation utilizes advances from the Federal Home Loan Bank (“FHLB”) and a revolving line of credit with LaSalle Bank, N.A. (“LaSalle”) as funding sources. At December 31, 2007, total borrowings from the FHLB were $294,101,000. Our bank subsidiaries have pledged certain mortgage loans and certain investments to the FHLB. The total available remaining borrowing capacity from FHLB at December 31, 2007, was $18,486,000. At December 31, 2007, the revolving line of credit with LaSalle Bank had a balance of $25,000,000 with no remaining borrowing capacity. For further discussion, see Note 10 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. The principal source of asset-funded liquidity is investment securities classified as available-for-sale, the market values of which totaled $440,836,000 at December 31, 2007, a decrease of $15,097,000, or 3.3 percent below December 31, 2006. Securities classified as held-to-maturity that are maturing within a short period of time can also be a source of liquidity. Securities classified as held-to-maturity and that are maturing in one year or less totaled $704,000 at December 31, 2007. In addition, other types of assets, such as cash and due from banks, federal funds sold and securities purchased under agreements to resell, and loans and interest-bearing deposits with other banks maturing within one year are sources of liquidity. In the normal course of business, the Corporation is a party to a number of other off-balance sheet activities that contain credit, market and operational risk that are not reflected in whole or in part in the Corporation’s consolidated financial statements. Such activities include traditional off-balance sheet credit-related financial instruments, commitments under operating leases and long-term debt. The Corporation provides customers with off-balance sheet credit support through loan commitments and standby letters of credit. Summarized credit-related financial instruments at December 31, 2007 are as follows: ======================================================================================= At December 31, (Dollars in Thousands) ======================================================================================= 2007 Amounts of Commitments: Loan Commitments to Extend Credit ............................... Standby Letters of Credit ....................................... $ 747,070 25,431 ---------- $ 772,501 ========== Since many of the commitments are expected to expire unused, or be only partially used, the total amount of unused commitments in the preceding table does not necessarily represent future cash requirements. 35 PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY continued In addition to owned banking facilities, the Corporation has entered into a number of long-term leasing arrangements to support the ongoing activities. The required payments under such commitments and other borrowing arrangements at December 31, 2007 are as follows: =========================================================================================================== 2013 and (Dollars in Thousands) 2008 2009 2010 2011 2012 after Total =========================================================================================================== Operating Leases $ 1,708 $ 1,385 $ 1,178 $ 953 $ 600 $ 73 $ 5,897 Federal Funds Purchased 52,350 52,350 Securities Sold Under Repurchase Agreements 72,247 10,000 14,250 10,000 106,497 Federal Home Loan Bank advances 108,398 53,351 46,080 18,944 51,679 15,649 294,101 Subordinated Debentures, Revolving Credit Lines and Term Loans 25,000 90,826 115,826 -------- ------- ------- ------- -------- -------- -------- Total $259,703 $54,736 $57,258 $19,897 $ 66,529 $116,548 $574,671 ======== ======= ======= ======= ======== ======== ======== INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK Asset/Liability Management has been an important factor in the Corporation's ability to record consistent earnings growth through periods of interest rate volatility and product deregulation. Management and the Board of Directors monitor the Corporation's liquidity and interest sensitivity positions at regular meetings to review how changes in interest rates may affect earnings. Decisions regarding investment and the pricing of loan and deposit products are made after analysis of reports designed to measure liquidity, rate sensitivity, the Corporation’s exposure to changes in net interest income given various rate scenarios and the economic and competitive environments. It is the objective of the Corporation to monitor and manage risk exposure to net interest income caused by changes in interest rates. It is the goal of the Corporation’s Asset/Liability function to provide optimum and stable net interest income. To accomplish this, management uses two asset liability tools. GAP/Interest Rate Sensitivity Reports and Net Interest Income Simulation Modeling are both constructed, presented and monitored quarterly. Management believes that the Corporation's liquidity and interest sensitivity position at December 31, 2007, remained adequate to meet the Corporation’s primary goal of achieving optimum interest margins while avoiding undue interest rate risk. The following table presents the Corporation’s interest rate sensitivity analysis as of December 31, 2007. =================================================================================================================================== At December 31, 2007 (Dollars in Thousands) 1-180 DAYS 181-365 DAYS 1-5 YEARS BEYOND 5 YEARS TOTAL =================================================================================================================================== Rate-Sensitive Assets: Interest-bearing Deposits ............................... $ 24,931 $ 24,931 Investment Securities ................................... 68,237 $ 48,785 $ 294,972 $ 39,173 451,167 Loans ................................................... 1,418,945 445,722 914,738 101,173 2,880,578 Federal Reserve and Federal Home Loan Bank stock ........ 25,250 25,250 ---------- ---------- ---------- ---------- ---------- Total Rate-sensitive Assets ........................ 1,512,113 494,507 1,234,960 140,346 3,381,926 ---------- ---------- ---------- ---------- ---------- Rate-Sensitive Liabilities: Federal Funds Purchased ................................. 52,350 52,350 Interest-bearing Deposits ............................... 1,843,652 301,391 318,066 20,463 2,478,421 Securities Sold Under Repurchase Agreements ............. 72,247 10,000 24,250 106,497 Federal Home Loan Bank Advances ......................... 109,050 10,631 119,837 54,583 294,101 Subordinated Debentures, Revolving Credit Lines and Term Loans ................................. 55,000 60,826 115,826 ---------- ---------- ---------- ---------- ---------- Total Rate-sensitive Liabilities ................... 2,132,299 312,022 447,903 160,122 3,047,195 ---------- ---------- ---------- ---------- ---------- Interest Rate Sensitivity gap by Period .................... $ (613,597) $ 182,485 $ 787,057 $ (16,517) Cumulative Rate Sensitivity gap ............................ (613,597) (431,113) 355,945 339,428 Cumulative Rate Sensitivity gap Ratio at December 31, 2007 .................................... 71.1% 82.3% 112.3% 111.2% at December 31, 2006 .................................... 73.5% 78.0% 113.3% 113.0% The Corporation had a cumulative negative gap of $437,207,000 in the one-year horizon at December 31, 2007, just over 11.6 percent of total assets. The Corporation places its greatest credence in net interest income simulation modeling. The above GAP/Interest Rate Sensitivity Report is believed by the Corporation's management to have two major shortfalls. The GAP/Interest Rate Sensitivity Report fails to precisely gauge how often an interest rate sensitive product reprices, nor is it able to measure the magnitude of potential future rate movements. 36 PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK continued Net interest income simulation modeling, or earnings-at-risk, measures the sensitivity of net interest income to various interest rate movements. The Corporation's asset liability process monitors simulated net interest income under three separate interest rate scenarios; base, rising and falling. Estimated net interest income for each scenario is calculated over a 12-month horizon. The immediate and parallel changes to the base case scenario used in the model are presented below. The interest rate scenarios are used for analytical purposes and do not necessarily represent management's view of future market movements. Rather, these are intended to provide a measure of the degree of volatility interest rate movements may introduce into the earnings of the Corporation. The base scenario is highly dependent on numerous assumptions embedded in the model, including assumptions related to future interest rates. While the base sensitivity analysis incorporates management's best estimate of interest rate and balance sheet dynamics under various market rate movements, the actual behavior and resulting earnings impact will likely differ from that projected. For mortgage-related assets, the base simulation model captures the expected prepayment behavior under changing interest rate environments. Assumptions and methodologies regarding the interest rate or balance behavior of indeterminate maturity products, such as savings, money market, NOW and demand deposits, reflect management's best estimate of expected future behavior. The comparative rising and falling scenarios below assume further interest rate changes in addition to the base simulation discussed above. These changes are immediate and parallel changes to the base case scenario. In addition, total rate movements (beginning point minus ending point) to each of the various driver rates utilized by management in the base simulation are as follows: ================================================================================ Driver Rates RISING FALLING ================================================================================ Prime 200 Basis Points (200) Basis Points Federal Funds 200 One-Year CMT 200 Two-Year CMT 200 CD's 200 FHLB Advances 200 (200) (200) (200) (193) (200) Results for the base, rising and falling interest rate scenarios are listed below based upon the Corporation’s rate sensitive assets and liabilities at December 31, 2007. The net interest income shown represents cumulative net interest income over a 12-month time horizon. Balance sheet assumptions used for the base scenario are the same for the rising and falling simulations. ================================================================================ BASE RISING FALLING ================================================================================ Net Interest Income (Dollars in Thousands) $117,693 $120,089 $116,063 Variance from Base $ 2,396 $ (1,630) Percent of Change from Base 2.0% (1.4)% The comparative rising and falling scenarios below assume further interest rate changes in addition to the base simulation discussed above. These changes are immediate and parallel changes to the base case scenario. In addition, total rate movements (beginning point minus ending point) to each of the various driver rates utilized by management in the base simulation are as follows: ================================================================================ Driver Rates RISING FALLING ================================================================================ Prime 200 Basis Points (200) Basis Points Federal Funds 200 (200) One-Year CMT 200 (200) 200 (200) Two-Year CMT (200) Three-Year CMT Five-Year CMT (200) CD's 200 (191) FHLB Advances 200 (200) 200 200 Results for the base, rising and falling interest rate scenarios are listed below. The net interest income shown represents cumulative net interest income over a 12-month time horizon. Balance sheet assumptions used for the base scenario are the same for the rising and falling simulations. =============================================================================== BASE RISING FALLING =============================================================================== Net Interest Income (Dollars in Thousands) $109,090 $108,036 $108,429 Variance from Base $ (1,054) $ (631) Percent of Change from Base (.96)% (.58)% 37 PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS EARNING ASSETS The following table presents the earning asset mix as of December 31, 2007, and December 31, 2006. Earnings assets increased by $183,720,000. Loans increased by $182,564,000. The largest loan segments that increased were in commercial and industrial of $125,396,000 and commercial and farmland real estate of $85,805,000. Loan categories that decreased included residential real estate and loans to individuals. The residential real estate loan category decreased primarily due the sale of $27 million of seasoned, long- duration conforming mortgage loans. The loans to individuals decreased as management strategically reduced its indirect lending function, our lowest yielding loan category. Investments decreased by $14,050,000 as lower yielding investments matured and were reinvested in the higher yielding loans. ================================================================================================== (Dollars in Thousands) December 31, ================================================================================================== 2007 2006 -------- -------- Interest-bearing Time Deposits $ 24,931 $ 11,284 Investment Securities Available for Sale ............ 440,836 455,933 Investment Securities Held to Maturity .............. 10,331 9,284 Mortgage Loans Held for Sale ........................ 3,735 5,413 Loans ............................................... 2,876,843 2,692,601 Federal Reserve and Federal Home Loan Bank stock .... 25,250 23,691 --------- --------- Total ........................................... $3,381,926 $3,198,206 ========= ========= DEPOSITS AND BORROWINGS The table below reflects the level of deposits and borrowed funds (federal funds purchased; repurchase agreements; Federal Home Loan Bank advances; subordinated debentures, revolving credit lines and term loans) based on year-end levels at December 31, 2007 and 2006. ================================================================================================== (Dollars in Thousands) December 31, ================================================================================================== 2007 2006 ---------- ---------- Deposits ........................................ $2,844,121 $2,750,538 Federal Funds Purchased.......................... 52,350 56,150 Securities Sold Under Repurchase Agreements...... 106,497 42,750 Federal Home Loan Bank Advances ................. 294,101 242,408 Subordinated Debentures, Revolving Credit Lines and Term Loans................................ 115,826 99,456 ---------- ---------- $3,412,895 $3,191,302 ========== ========== The Corporation has continued to leverage its capital position with Federal Home Loan Bank advances, as well as repurchase agreements, which are pledged against acquired investment securities as collateral for the borrowings. The interest rate risk is included as part of the Corporation’s interest simulation discussed in Management’s Discussion and Analysis of Financial Condition and Results of Operations under the headings “LIQUIDITY” and “INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK”. NET INTEREST INCOME Net interest income is the primary source of the Corporation's earnings. It is a function of net interest margin and the level of average earning assets. The following table presents the Corporation's asset yields, interest expense, and net interest income as a percent of average earning assets for the three-year period ending in 2007. In 2007, asset yields increased 18 basis points on a fully taxable equivalent basis (FTE) and interest cost increased 34 basis points, resulting in a 16 basis point (FTE) decrease in net interest margin as compared to 2006. During the period, growth in earning assets produced a positive volume variance of $8,600,000 (FTE), while interest rate compression produced a negative rate variance of $5,429,000 (FTE), resulting in an increase of $3,025,000 in net interest income. In 2006, asset yields increased 66 basis points (FTE) and interest cost increased 92 basis points, resulting in a 26 basis point (FTE) decrease in net interest margin as compared to 2005. The increase in interest income and interest expense was primarily a result of four 25 basis point overnight federal funds rate increases by the Federal Open Market Committee during this period. During the period, interest rate compression produced a negative rate variance of $8,021,000, while growth in earning assets produced a positive volume variance of $6,987,000, resulting in a decline of $1,034,000 in net interest income. 38 PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS NET INTEREST INCOME continued ========================================================================================================= (Dollars in Thousands) December 31, ========================================================================================================= 2007 2006 2005 ------ ------ ------ Net Interest Income................................... $ 113,120 $ 110,095 $ 111,129 FTE Adjustment........................................ $ 4,127 $ 3,981 $ 3,778 Net Interest Income on a Fully Taxable Equivalent Basis................. $ 117,247 $ 114,076 $ 114,907 Average Earning Assets................................ $3,308,939 $3,072,898 $2,891,121 Interest Income (FTE) as a Percent of Average Earning Assets........................... 7.10% 6.92% 6.26% Interest Expense as a Percent of Average Earning Assets........................... 3.55% 3.21% 2.29% Net Interest Income (FTE) as a Percent of Average Earning Assets........................... 3.55% 3.71% 3.97% Average earning assets include the average balance of securities classified as available for sale, computed based on the average of the historical amortized cost balances without the effects of the fair value adjustment. In addition, annualized amounts are computed utilizing a 30/360 basis. OTHER INCOME The Corporation offers a wide range of fee-based services. Fee schedules are regularly reviewed by a pricing committee to ensure that the products and services offered by the Corporation are priced to be competitive and profitable. Other income in 2007 amounted to $40,551,000, a 17.2 percent increase from 2006. The change in other income from 2007 to 2006 was primarily attributable to fluctuations within the following other income items: • • • • • Earnings on bank-owned life insurance increased $1,365,000 compared to the same period in 2006 due to a purchase of $18,000,000 of new life insurance policies in mid-2006, and $4,500,000 in 2007. Additionally, a death benefit of $440,000 was received in 2007. Service charges for 2007 were $1,159,000 higher than in 2006 due to fee increases. The sale of a branch building and other real estate resulted in gains of $987,000 in 2007. Insurance commissions increased $811,000 from 2006 due to the purchase of an insurance agency in late 2006. Trust fees increased $747,000 compared to the same period in 2006 as a result of increased trust business. Other income in 2006 amounted to $34,613,000, a .3 percent decrease from 2005. The change in other income from 2006 to 2005 was minor and primarily attributable to fluctuations within the following other income items: • • • • Fees on debit cards and ATMs increased by approximately $297,000 as compared to the same period in 2005. This was primarily a result of increase card usage by customers. Earnings on cash surrender value of life insurance increased approximately $619,000 compared to the same period in 2005 due to a purchase of $18,000,000 of new life insurance policies in 2006. Net gains and fees on sales of mortgage loans decreased by $731,000 from the same period in 2005 due to stabilizing mortgage interest rates resulting in reduced mortgage originations. A cash payment was received in 2005 of approximately $232,000, related to our membership in a credit card network that was merged with another card network. No such payment was received during 2006. OTHER EXPENSES Other expenses represent non-interest operating expenses of the Corporation. Total other expenses for 2007 were $102,182,000, $6,125,000 or 6.4 percent higher than the prior year of $96,057,000. The change in other expenses from 2007 to 2006 was primarily attributable to fluctuations within the following other expense items: • Salary and employee benefits grew $2,718,000, or 4.8 percent due to staff additions and normal salary increases. Approximately $635,000 of the increase is due to share-based compensation expense recorded in 2007. 39 PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OTHER EXPENSES continued • • The Corporation wrote off $1,800,000 in unamortized underwriting fees associated with the First Merchants Capital Trust I subordinated debentures being called during 2007. Going forward, this early redemption will provide the Corporation with savings of $1.2 million annually. Other expenses increased $1,129,000 primarily due to integration expenses related to bank combinations and name changes. Other expenses amounted to $96,057,000 in 2006, an increase of 2.2 percent from the prior year. Salaries and benefit expense grew $2,100,000, or 3.9 percent, due to staff additions and normal salary increases. Approximately $833,000 of the increase is due to share-based compensation expense recorded in 2006. INCOME TAXES Income tax expense totaled $11,343,000 for 2007, which is a decrease of $852,000 from 2006. The effective tax rates for the periods ending December 31, 2007, 2006 and 2005 were 26.4 percent, 28.8 percent and 30.5 percent, respectively. The effective tax rate has remained lower than the federal statutory income tax rate of 35 percent, primarily due to the Corporation’s tax-exempt investment income on securities and loan income generated by subsidiaries domiciled in a state with no state or local income tax, income tax credits generated from investments in affordable housing projects, increases in tax-exempt earnings from bank-owned life insurance contracts and reduced state taxes, resulting from the effect of state income apportionment. INFLATION Changing prices of goods, services and capital affect the financial position of every business enterprise. The level of market interest rates and the price of funds loaned or borrowed fluctuate due to changes in the rate of inflation and various other factors, including government monetary policy. Fluctuating interest rates affect the Corporation's net interest income, loan volume and other operating expenses, such as employee salaries and benefits, reflecting the effects of escalating prices, as well as increased levels of operations and other factors. As the inflation rate increases, the purchasing power of the dollar decreases. Those holding fixed-rate monetary assets incur a loss, while those holding fixed- rate monetary liabilities enjoy a gain. The nature of a financial holding company’s operations is such that there will generally be an excess of monetary assets over monetary liabilities, and, thus, a financial holding company will tend to suffer from an increase in the rate of inflation and benefit from a decrease. OTHER The Securities and Exchange Commission maintains a website that contains reports, proxy and information statements and other information regarding registrants that file electronically with the commission, including the Corporation, and that address is (http://www.sec.gov). 40 PART II: ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The quantitative and qualitative disclosures about market risk information are presented under Item 7 under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" within the section "Interest Sensitivity and Disclosures About Market Risk", of this Annual Report on Form 10-K. 41 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Audit Committee, Board of Directors and Stockholders First Merchants Corporation Muncie, Indiana We have audited the accompanying consolidated balance sheets of First Merchants Corporation as of December 31, 2007, and 2006, and the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2007. The Company's management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. Our audits included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Merchants Corporation as of December 31, 2007 and 2006, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with accounting principles generally accepted in the Unites States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), First Merchants Corporation's internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated February 8, 2008, expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting. Indianapolis, Indiana February 8, 2008 42 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS (in thousands, except share data) December 31, =================================================================================================================================== 2007 2006 =================================================================================================================================== Assets Cash and Due From Banks .......................................................... $ 134,683 $ 89,957 Interest-bearing Time Deposits ................................................... 24,931 11,284 Investment Securities Available for Sale ............................................................ 440,836 455,933 Held to Maturity (Fair Value of $10,270 and $9,516) ........................... 10,331 9,284 ----------- ----------- Total Investment Securities ................................................. 451,167 465,217 Mortgage Loans Held for Sale ..................................................... 3,735 5,413 Loans, Net of Allowance for Loan Losses of $28,228 and $26,540.................... 2,848,615 2,666,061 Premises and Equipment ........................................................... 44,445 42,393 Federal Reserve and Federal Home Loan Bank Stock ................................. 25,250 23,691 Interest Receivable .............................................................. 23,402 24,345 Core Deposit Intangibles ........................................................ 12,412 15,470 Goodwill.......................................................................... 123,444 123,168 Cash value of Life Insurance...................................................... 70,970 64,213 Other Assets ..................................................................... 19,033 23,658 ----------- ----------- Total Assets ................................................................. $ 3,782,087 $ 3,554,870 =========== =========== Liabilities Deposits Noninterest-bearing ............................................................ $ 370,397 $ 362,058 Interest-bearing ............................................................... 2,473,724 2,388,480 ----------- ----------- Total Deposits ............................................................... 2,844,121 2,750,538 Borrowings ....................................................................... 568,774 440,764 Interest Payable ................................................................. 8,325 9,326 Other Liabilities ................................................................ 20,931 26,917 ----------- ----------- Total Liabilities ............................................................ 3,442,151 3,227,545 ----------- ----------- Commitments and Contingent Liabilities Stockholders' Equity Preferred Stock, No-par Value Authorized and Unissued -- 500,000 Shares Common Stock, $.125 Stated Value Authorized -- 50,000,000 Shares Issued and Outstanding – 18,002,787 and 18,439,843 Shares .................... 2,250 2,305 Additional Paid-in Capital ....................................................... 137,801 146,460 Retained Earnings ................................................................ 202,750 187,965 Accumulated Other Comprehensive Loss ............................................. (2,865) (9,405) ----------- ----------- Total Stockholders' Equity .................................................. 339,936 327,325 ----------- ----------- Total Liabilities and Stockholders' Equity .................................. $ 3,782,087 $ 3,554,870 =========== =========== See notes to consolidated financial statements. 43 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF INCOME (in thousands, except share data) Year Ended December 31, =================================================================================================================================== 2007 2006 2005 =================================================================================================================================== Interest Income Loans Receivable Taxable ............................................................. $207,268 $186,768 $158,436 Tax Exempt .......................................................... 1,120 828 643 Investment Securities Taxable ............................................................. 13,744 12,316 9,612 Tax Exempt .......................................................... 6,548 6,565 6,374 Federal Funds Sold .................................................... 172 373 264 Deposits with Financial Institutions .................................. 582 500 695 Federal Reserve and Federal Home Loan Bank Stock ...................... 1,299 1,256 1,185 -------- -------- -------- Total Interest Income ............................................. 230,733 208,606 177,209 -------- -------- -------- Interest Expense Deposits .............................................................. 89,921 74,314 46,121 Federal Funds Purchased ............................................... 3,589 1,842 623 Securities Sold Under Repurchase Agreements ........................... 3,856 3,228 1,612 Federal Home Loan Bank Advances ....................................... 12,497 10,734 9,777 Subordinated Debentures, Revolving Credit Lines and Term Loans ......................................... 7,750 8,124 7,432 Other Borrowings ...................................................... 269 515 -------- -------- -------- Total Interest Expense ........................................... 117,613 98,511 66,080 -------- -------- -------- Net Interest Income ...................................................... 113,120 110,095 111,129 Provision for Loan Losses ............................................. 8,507 6,258 8,354 -------- -------- -------- Net Interest Income After Provision for Loan Losses ...................... 104,613 103,837 102,775 -------- -------- -------- Other Income Fiduciary Activities .................................................. 8,372 7,625 7,481 Service Charges on Deposit Accounts ................................... 12,421 11,262 11,298 Other Customer Fees ................................................... 6,479 5,517 5,094 Net Realized Gains (Losses) on Sales of Available-for-sale Securities .............................. (4) (2) Commission Income ..................................................... 5,113 4,302 3,821 Earnings on Cash Surrender Value of Life Insurance ................................................... 3,651 2,286 1,667 Net Gains and Fees on Sales of Loans .................................. 2,438 2,171 2,902 Other Income .......................................................... 2,077 1,454 2,456 -------- -------- -------- Total Other Income ............................................... 40,551 34,613 34,717 -------- -------- -------- Other Expenses Salaries and Employee Benefits ........................................ 58,843 56,125 54,059 Net Occupancy Expenses ................................................ 6,647 5,886 5,796 Equipment Expenses .................................................... 6,769 7,947 7,562 Marketing Expenses..................................................... 2,205 1,932 2,012 Outside Data Processing Fees .......................................... 3,831 3,449 4,010 Printing and Office Supplies .......................................... 1,410 1,496 1,369 Core Deposit Amortization.............................................. 3,159 3,066 3,102 Write-off of Unamortized Underwriting Expenses ........................ 1,771 Other Expenses ........................................................ 17,547 16,156 16,047 -------- -------- -------- Total Other Expenses ............................................. 102,182 96,057 93,957 -------- -------- -------- Income Before Income Tax ................................................. 42,982 42,393 43,535 Income Tax Expense .................................................... 11,343 12,195 13,296 -------- -------- -------- Net Income ............................................................... $ 31,639 $ 30,198 $ 30,239 ======== ======== ======== Net Income Per Share: Basic ................................................................. $ 1.73 $ 1.64 $ 1.64 Diluted ............................................................... 1.73 1.64 1.63 See notes to consolidated financial statements. 44 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME =================================================================================================================================== Year Ended December 31, (in thousands, except share data) 2007 2006 2005 ==================================================================================================================================== Net Income ........................................................................... $ 31,639 $ 30,198 $ 30,239 -------- -------- -------- Other Comprehensive Income (Loss), Net of Tax: Unrealized Losses on Securities Available for Sale: Unrealized Holding Gains/(Losses) Arising During the Period, Net of Income Tax Benefit (Expense) of $(1,437), $(1,242), and $3,562.......... 2,743 2,087 (6,615) Reclassification Adjustment for Gains (Losses) Included in Net Income, Net of Income Tax (Expenses) Benefit of $0, $(2), and $(1)..................... 2 1 Unrealized Gains (Losses) on Cash Flow Hedge Assets: Unrealized Gain (Loss) Arising During the Period, Net of Income Tax Benefit of $(501), $83, and $0............................... 1,057 (125) Unrealized Loss on Pension Minimum Funding Liability: Unrealized Loss Arising During the Period, Net of Income Tax Benefit of $0, $0, and $1,767 ............................... (2.651) Defined Benefit Pension Plans, Net of Income Tax Expense of ($1,827) Net Gain Arising During Period .................................................. 2,725 Prior Service Cost Arising During Period ........................................ 30 Amortization of Prior Service Cost .............................................. (15) 6,540 1,964 (9,265) -------- -------- --------- COMPREHENSIVE INCOME $ 38,179 $ 32,162 $ 20,974 ======== ======== ========= -------- -------- --------- CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY COMMON STOCK ======================= ADDITIONAL RETAINED ACCUMULATED OTHER SHARES AMOUNT PAID-IN CAPITAL EARNINGS COMPREHENSIVE TOTAL INCOME (LOSS) ----------- -------- -------------- --------- ------------------- -------- Balances, December 31, 2004 18,573,997 $ 2,322 $150,862 $161,459 $ (40) $314,603 Net Income for 2005.......................... 30,239 30,239 Cash Dividends ($.92 per Share).............. (16,981) (16,981) Other Comprehensive Income (Loss), Net of Tax ............................... (9,265) (9,265) Stock Issued Under Employee Benefit Plans ... 43,238 6 908 914 Stock Issued Under Dividend Reinvestment and Stock Purchase Plan .................. 35,565 4 929 933 Stock Options Exercised ..................... 121,750 15 2,159 2,174 Stock Redeemed .............................. (374,598) (47) (9,611) (9,658) Issuance of Stock Related to Acquisition..... 16,762 2 435 437 ----------- -------- -------- --------- --------- --------- Balances, December 31, 2005 18,416,714 2,302 145,682 174,717 (9,305) 313,396 =========== ======== ======== ========= ========= ========= Net Income for 2006.......................... 30,198 30,198 Cash Dividends ($.92 per Share).............. (16,950) (16,950) Other Comprehensive Income (Loss), Net of Tax ............................... 1,964 1,964 Adjustment to Initially Apply FASB Statement No. 158, Net of Tax ...................... (2,064) (2,064) Share-based Compensation .................... 972 972 Stock Issued Under Employee Benefit Plans ... 41,391 5 852 857 Stock Issued Under Dividend Reinvestment and Stock Purchase Plan .................. 48,788 6 1,184 1,190 Stock Options Exercised ..................... 90,138 11 1,598 1,609 Stock Redeemed .............................. (234,495) (29) (5,661) (5,690) Issuance of Stock Related to Acquisition..... 77,307 10 1,833 1,843 ----------- -------- -------- --------- --------- --------- Balances, December 31, 2006 18,439,843 $ 2,305 $146,460 $ 187,965 $ (9,405) $ 327,325 ----------- -------- -------- --------- --------- --------- Net Income for 2007.......................... 31,639 31,639 Cash Dividends ($.92 per Share).............. (16,854) (16,854) Other Comprehensive Income (Loss), Net of Tax ............................... 6,540 6,540 Tax Benefit from Stock Options Exercised .... 116 116 Share-based Compensation .................... 3,292 1,468 1,468 Stock Issued Under Employee Benefit Plans ... 38,537 5 782 787 Stock Issued Under Dividend Reinvestment and Stock Purchase Plan .................. 51,168 6 1,164 1,170 Stock Options Exercised ..................... 35,142 5 491 496 Stock Redeemed .............................. (565,195) (71) (12,680) (12,751) ----------- -------- -------- --------- --------- --------- Balances, December 31, 2007 18,002,787 $ 2,250 $137,801 $ 202,750 $ (2,865) $ 339,936 =========== ======== ======== ========= ========= ========= See notes to consolidated financial statements. 45 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF CASH FLOWS ==================================================================================================================================== Year Ended December 31, (in thousands, except share data) 2007 2006 2005 ==================================================================================================================================== Operating Activities: Net Income ......................................................... $ 31,639 $ 30,198 $ 30,239 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Provision for Loan Losses ........................................ 8,507 6,258 8,354 Depreciation and Amortization..................................... 4,331 5,382 5,070 Share-based Compensation ......................................... 1,468 833 Tax Benefits from Stock Options Exercised ........................ (116) (139) Mortgage Loans Originated for Sale ............................... (123,051) (123,256) (86,122) Proceeds from Sales of Mortgage Loans ............................ 124,729 122,753 84,579 Net Change in: Interest Receivable .......................................... 943 (4,655) (2,372) Interest Payable ............................................. (1,001) 3,452 1,463 Other Adjustments ................................................ 2,165 (4,549) 5,283 --------- --------- --------- Net Cash Provided by Operating Activities .................... 49,614 36,277 46,494 --------- --------- --------- Investing Activities: Net Change in Interest-bearing Deposits ............................ (13,647) (2,536) 595 Purchases of Securities Available for Sale .................................... (69,536) (100,355) (97,861) Securities Held to Maturity ...................................... (8,466) Proceeds from Maturities of Securities Available for Sale .................................... 81,069 64,778 69,236 Securities Held to Maturity ...................................... 7,418 6,526 Proceeds from Sales of Securities Available for Sale .................................... 7,219 575 4,718 Proceeds from Sales of Mortgages ................................... Purchase of Federal Reserve and Federal Home Loan Bank stock ....... (1,559) (491) (342) Purchase of Bank-owned Life Insurance .............................. (4,500) (18,000) Net Change in Loans ................................................ (217,834) (240,080) (35,090) Net Cash Paid in Acquisition ........................................ (370) (59) (213) Other Adjustments .................................................. (4,143) (8,358) (6,233) --------- --------- --------- Net Cash Used by Investing Activities......................... (197,576) (298,000) (65,190) --------- --------- --------- 26,773 Cash Flows from Financing Activities: Net Change in: Demand and Savings Deposits ...................................... 65,035 133,591 (80,986) Certificates of Deposit and Other Time Deposits .................. 28,548 234,372 55,412 Receipt of Borrowings .............................................. 457,157 182,454 191,002 Repayment of Borrowings ............................................ (331,016) (249,927) (123,657) Cash Dividends ..................................................... (16,854) (16,899) (16,981) Stock Issued Under Employee Benefit Plans .......................... 787 857 914 Stock Issued Under Dividend Reinvestment and Stock Purchase Plan .......................................... 1,170 1,190 933 Stock Options Exercised ............................................ 496 1,228 2,174 Tax Benefits from Stock Options Exercised .......................... 116 139 Stock Redeemed ..................................................... (12,751) (5,690) (9,658) --------- --------- --------- Net Cash Provided by Financing Activities .................... 192,688 281,263 19,153 --------- --------- --------- Net Change in Cash and Cash Equivalents ............................... 44,726 19,540 457 Cash and Cash Equivalents, Beginning of Year .......................... 89,957 70,417 69,960 --------- --------- --------- Cash and Cash Equivalents, End of Year................................. $ 134,683 $ 89,957 $ 70,417 ========= ========= ========= Additional Cash Flows Information: Interest Paid ....................................................... $ 118,614 $ 95,059 $ 64,617 Income Tax Paid ..................................................... 12,206 14,385 16,775 See notes to consolidated financial statements. 46 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 1 NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of First Merchants Corporation ("Corporation"), and its wholly owned subsidiaries, First Merchants Bank, N.A. ("First Merchants"), First Merchants Bank of Central Indiana, N.A. ("Central Indiana"), Lafayette Bank and Trust Company, N.A. (“Lafayette”), and Commerce National Bank (“Commerce National”), (collectively the “Banks"), First Merchants Trust Company, National Association (“FMTC”), First Merchants Insurance Services, Inc. ("FMIS"), First Merchants Reinsurance Company ("FMRC") and Indiana Title Insurance Company (“ITIC”), conform to accounting principles generally accepted in the United States of America and reporting practices followed by the banking industry. On April 1, 2007, the Corporation combined five of its bank charters into one. Frances Slocum Bank & Trust Company, National Association, Decatur Bank & Trust Company, National Association, The First National Bank of Portland and United Communities National Bank combined with First Merchants Bank, N.A. Also on April 1, 2007, the name of The Madison Community Bank was changed to First Merchants Bank of Central Indiana, National Association. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Corporation is a financial holding company whose principal activity is the ownership and management of the Banks and operates in a single significant business segment. The Banks operate under national bank charters and provide full banking services. As national banks, the Banks are subject to the regulation of the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. The Banks generate commercial, mortgage, and consumer loans and receive deposits from customers located primarily in north-central and east-central Indiana and Butler, Franklin and Hamilton counties in Ohio. The Banks' loans are generally secured by specific items of collateral, including real property, consumer assets and business assets. CONSOLIDATION The consolidated financial statements include the accounts of the Corporation and all its subsidiaries, after elimination of all material intercompany transactions. INVESTMENT SECURITIES-Debt securities are classified as held to maturity when the Corporation has the positive intent and ability to hold the securities to maturity. Securities held to maturity are carried at amortized cost. Debt securities not classified as held to maturity are classified as available for sale. Securities available for sale are carried at fair value with unrealized gains and losses reported separately in accumulated other comprehensive income, net of tax. Amortization of premiums and accretion of discounts are recorded as interest income from securities. Realized gains and losses are recorded as net security gains (losses). Gains and losses on sales of securities are determined on the specific-identification method. Available-for-sale and held-to-maturity securities are reviewed quarterly for possible other-than-temporary impairment. The review includes an analysis of the facts and circumstances of each individual investment such as the length of time the fair value has been below cost, the expectation for that security’s performance, the creditworthiness of the issuer and the Corporation’s ability to hold the security to maturity. A decline in value that is considered to be other-than temporary is recorded as a loss within other operating income in the consolidated statements of income. LOANS HELD FOR SALE are carried at the lower of aggregate cost or market. Market is determined using the aggregate method. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income based on the difference between estimated sales proceeds and aggregate cost. LOANS held in the Corporation’s portfolio are carried at the principal amount outstanding. Certain nonaccrual and substantially delinquent loans may be considered to be impaired. A loan is impaired when, based on current information or events, it is probable that the Banks will be unable to collect all amounts due (principal and interest) according to the contractual terms of the loan agreement. In applying the provisions of Statement of Financial Accounting Standards ("SFAS") No. 114, the Corporation considers its investment in one-to-four family residential loans and consumer installment loans to be homogeneous and therefore excluded from separate identification for evaluation of impairment. Interest income is accrued on the principal balances of loans, except for installment loans with add-on interest, for which a method that 47 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 1 CONSOLIDATION continued approximates the level yield method is used. The accrual of interest on impaired loans is discontinued when, in management's opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed when considered uncollectable. Interest income is subsequently recognized only to the extent cash payments are received. Certain loan fees and direct costs are being deferred and amortized as an adjustment of yield on the loans. ALLOWANCE FOR LOAN LOSSES is maintained to absorb losses inherent in the loan portfolio and is based on ongoing, quarterly assessments of the probable losses inherent in the loan portfolio. The allowance is increased by the provision for loan losses, which is charged against current operating results. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The Corporation’s methodology for assessing the appropriateness of the allowance consists of three key elements – the determination of the appropriate reserves for specifically identified loans, historical losses, and economic, environmental or qualitative factors. Larger commercial loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropriate, reserves are allocated to individual loans based on management’s estimate of the borrower’s ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Corporation. Included in the review of individual loans are those that are impaired as provided in SFAS No. 114. Any allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or fair value of the underlying collateral. The Corporation evaluates the collectibility of both principal and interest when assessing the need for a loss accrual. Historical loss rates are applied to other commercial loans not subject to specific reserve allocations. Homogenous loans, such as consumer installment and residential mortgage loans, are not individually risk graded. Reserves are established for each pool of loans using loss rates based on a three-year average net charge-off history by loan category. Historical loss allocations for commercial and consumer loans may be adjusted for significant factors that, in management’s judgment, reflect the impact of any current conditions on loss recognition. Factors which management considers in the analysis include the effects of the national and local economies, trends in loan growth and charge-off rates, changes in mix, concentration of loans in specific industries, asset quality trends (delinquencies, charge offs and nonaccrual loans), risk management and loan administration, changes in the internal lending policies and credit standards, examination results from bank regulatory agencies and the Corporation’s internal loan review. An unallocated reserve, primarily based on the factors noted above, is maintained to recognize the imprecision in estimating and measuring loss when evaluating reserves for individual loans or pools of loans. Allowances on individual loans and historical loss allocations are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions. PREMISES AND EQUIPMENT are carried at cost net of accumulated depreciation. Depreciation is computed using the straight-line and declining balance methods based on the estimated useful lives of the assets. Maintenance and repairs are expensed as incurred, while major additions and improvements are capitalized. Gains and losses on dispositions are included in current operations. FEDERAL RESERVE AND FEDERAL HOME LOAN BANK STOCK are required investments for institutions that are members of the Federal Reserve Bank ("FRB") and Federal Home Loan Bank systems. The required investment in the common stock is based on a predetermined formula. INTANGIBLE ASSETS that are subject to amortization, including core deposit intangibles, are being amortized on both the straight-line and accelerated basis over 3 to 20 years. Intangible assets are periodically evaluated as to the recoverability of their carrying value. GOODWILL is maintained by applying the provisions of SFAS No. 142. Goodwill is reviewed for impairment annually in accordance with this statement with any loss recognized through the income statement, at that time. DERIVATIVE INSTRUMENTS are carried at the fair value of the derivatives reflects the estimated amounts that we would receive to terminate these contracts at the reporting date based upon pricing or valuation models applied to current market information. Interest rate floors are valued using the market standard methodology of discounting the future expected cash receipts that would occur if variable interest rates fell below the strike rate of the floors. The projected cash receipts on the floor are based on an expectation of future interest rates derived from observed market interest rate curves and volatilities. 48 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 1 CONSOLIDATION continued INCOME TAX in the consolidated statements of income includes deferred income tax provisions or benefits for all significant temporary differences in recognizing income and expenses for financial reporting and income tax purposes. The Corporation files consolidated income tax returns with its subsidiaries. The Corporation adopted the provisions of the Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109, on January 1, 2007. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. As a result of the implementation of FIN 48, the Corporation did not identify any uncertain tax positions that it believes should be recognized in the financial statements. The tax years still subject to examination by taxing authorities are years subsequent to 2003. STOCK OPTION AND RESTRICTED STOCK AWARD PLANS are maintained by the Corporation and are described more fully in Note 16. Prior to 2006, the Corporation accounted for these plans under the recognition and measurement principles of APB Opinion No. 25., Accounting for Stock Issued to Employees, and related Interpretations. Accordingly, in 2005 no stock-based employee compensation cost is reflected in net income, as all awards granted under these plans had an exercise price equal to the market value of the underlying common stock at the grant date. Effective January 1, 2006 the Corporation adopted the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123R, Share-Based Payment. The Corporation selected the modified prospective application. Accordingly, after January 1, 2006, the Corporation began expensing the fair value of stock awards granted, modified, repurchased or cancelled. The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based compensation in 2005. Year Ended December 31 2005 ========= Net Income, as Reported ...................... $30,239 Add: Total Stock-based Employee Compensation Cost Included in Reported Net Income, Net of Income Taxes ........................... Less: Total Stock-based Employee Compensation Cost Determined Under the Fair Value Based Method, Net of Income Taxes ............... (2,159) ------- Pro Forma Net Income $28,080 ======= Earnings per Share: Basic – as Reported ....................... $ 1.64 Basic – Pro Forma ......................... $ 1.52 Diluted – as Reported ..................... $ 1.63 Diluted – Pro Forma ....................... $ 1.51 EARNINGS PER SHARE have been computed based upon the weighted average common and common equivalent shares outstanding during each year. Certain reclassifications have been made to the 2006 financial statements to conform to the 2007 financial statement presentation. These reclassifications had no effect on net income. NOTE 2 BUSINESS COMBINATIONS Effective December 31, 2007, the Corporation acquired Oliver-Dorton Insurance of Muncie, Indiana, which has been merged into FMIS, a wholly owned subsidiary of the Corporation. The cash purchase price was $370,000. The acquisition was deemed to be an immaterial acquisition. Effective October 13, 2006, the Corporation acquired Armstrong Insurance, Inc. of Parker City, an Indiana corporation, which has merged into FMIS, a wholly owned subsidiary of the Corporation. The Corporation issued 77,307 shares of its common stock at a cost of $23.845 per share to complete the transaction. The acquisition was deemed to be an immaterial acquisition. 49 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 2 BUSINESS COMBINATIONS continued Effective September 1, 2005, the Corporation acquired Trustcorp Financial Services of Greenville, Inc., an Ohio corporation, which was merged into FMIS, a wholly owned subsidiary of the Corporation. The Corporation issued 16,762 shares of its common stock at a cost of $26.10 per share to complete the transaction. The acquisition was deemed to be an immaterial acquisition. NOTE 3 RESTRICTION ON CASH AND DUE FROM BANKS The Banks are required to maintain reserve funds in cash and/or on deposit with the Federal Reserve Bank. The reserve required at December 31, 2007, was $15,896,000. NOTE 4 INVESTMENT SECURITIES ============================================================================= GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE ============================================================================= Available for Sale at December 31, 2007 U.S. Treasury ............................... $ 1,501 $ 18 $ 1,519 U.S. Government-sponsored Agency Securities.. 67,793 240 $ 98 67,935 State and Municipal ......................... 150,744 2,324 156 152,912 Mortgage-backed Securities .................. 199,591 1,654 1,444 199,801 Corporate Obligations........ ............... 13,740 1,294 12,446 Marketable Equity Securities ................ 6,835 612 6,223 -------- -------- -------- -------- Total Available for Sale ................. 440,204 4,236 3,604 440,836 -------- -------- -------- -------- Held to maturity at December 31, 2007 State and Municipal ......................... 10,317 237 298 10,256 Mortgage-backed Securities .................. 14 14 -------- -------- -------- -------- Total Held to Maturity ................... 10,331 237 298 10,270 -------- -------- -------- -------- Total Investment Securities .............. $450,535 $ 4,473 $ 3,902 $451,106 ======== ======== ======== ======== Available for Sale at December 31, 2006 U.S. Treasury .......................................... $ 1,502 $ 1 $ 1,503 U.S. Government-sponsored Agency Securities ............ 87,193 69 $ 1,284 85,978 State and Municipal .................................... 168,262 2,251 892 169,621 Mortgage-backed Securities ............................. 195,228 600 3,983 191,845 Marketable Equity and Other Securities.................. 7,296 310 6,986 -------- -------- -------- -------- Total Available for Sale ............................ 459,481 2,921 6,469 455,933 -------- -------- -------- -------- Held to Maturity at December 31, 2006 State and Municipal .................................... 9,266 432 200 9,498 Mortgage-backed Securities ............................. 18 18 -------- -------- -------- -------- Total Held to Maturity .............................. 9,284 432 200 9,516 -------- -------- -------- -------- Total Investment Securities ......................... $468,765 $ 3,353 $ 6,669 $465,449 ======== ======== ======== ======== Certain investments in debt securities are reported in the financial statements at an amount less than their historical cost. The historical cost of these investments totaled $214,293,000 and $306,650,000 at December 31, 2007 and 2006, respectively. Total fair value of these investments was $210,391,000 and $299,984,000, which is approximately 46.6 and 64.5 percent of the Corporation's available-for-sale and held-to-maturity investment portfolio at December 31, 2007 and 2006, respectively. These declines primarily resulted from increases in market interest rates. Based on evaluation of available evidence, including recent changes in market interest rates, credit rating information and information obtained from regulatory filings, management believes the declines in fair value for these securities are temporary. Should the impairment of any of these securities become other than temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income in the period the other-than-temporary impairment is identified. 50 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 4 INVESTMENT SECURITIES continued The following tables show the Corporation’s gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2007 and 2006: Less than 12 12 Months or Total Months Longer ===================================================================== GROSS GROSS GROSS FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED VALUE LOSSES VALUE LOSSES VALUE LOSSES ===================================================================== Temporarily Impaired investment securities at December 31, 2007: U.S. Government-sponsored Agency Securities ............... $ 45,572 $ (98) $ 45,572 $ (98) State and Municipal ....................................... $ 858 $ (7) 60,996 (447) 61,854 (454) Mortgage-backed Securities ................................ 3,489 (30) 86,161 (1,414) 89,650 (1,444) Corporate Obligations ..................................... 12,415 (1,294) 12,415 (1,294) Marketable Equity Securities .............................. 900 (612) 900 (612) -------- ------- -------- ------- -------- -------- Total Temporarily Impaired Investment Securities ....... $ 16,762 $(1,331) $193,629 $(2,571) $210,391 $ (3,902) ======== ======= ======== ======= ======== ======== Less than 12 12 Months or Total Months Longer ===================================================================== GROSS GROSS GROSS FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED VALUE LOSSES VALUE LOSSES VALUE LOSSES ===================================================================== Temporarily Impaired Investment Securities at December 31, 2006: U.S. Government-sponsored Agency Securities ............... $ 1,576 $ (3) $ 71,702 $(1,281) $ 73,278 $ (1,284) State and Municipal ....................................... 9,608 (35) 81,841 (1,057) 91,449 (1,092) Mortgage-backed Securities ................................ 7,459 (20) 126,555 (3,963) 134,014 (3,983) Corporate Obligations .................................... 28 (6) 28 (6) Marketable Equity Securities .............................. 1,215 (304) 1,215 (304) -------- ------- -------- ------- -------- -------- Total Temporarily Impaired Investment Securities ....... $ 19,858 $ (362) $280,126 $(6,307) $299,984 $ (6,669) ======== ======= ======== ======= ======== ======== The amortized cost and fair value of securities available for sale and held to maturity at December 31, 2007, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. =================================================================================================================================== AVAILABLE FOR SALE HELD TO MATURITY AMORTIZED COST FAIR VALUE AMORTIZED COST FAIR VALUE =================================================================================================================================== Maturity Sistribution at December 31, 2007: Due in One Year or Less.......................................... $ 76,553 $ 76,456 $ 704 $ 705 Due After One Through Five Years ................................ 97,649 98,585 276 280 Due After Five Through Ten Years ................................ 38,253 39,470 810 801 Due After Ten Years ............................................. 21,323 20,301 8,527 8,470 -------- -------- -------- -------- 233,778 234,812 10,317 10,256 Mortgage-backed Securities ...................................... 199,591 199,801 11 11 Other Asset-backed Securities ................................... 3 3 Marketable Equity Securities .................................... 6,835 6,223 -------- -------- -------- -------- Totals ........................................................ $440,204 $440,836 $ 10,331 $ 10,270 Securities with a carrying value of approximately $191,470,000, 143,652,000 and $190,079,000 were pledged at December 31, 2007, 2006 and 2005 respectively to secure certain deposits and securities sold under repurchase agreements, and for other purposes as permitted or required by law. Proceeds from sales of securities available for sale during 2007, 2006 and 2005 were $7,219,000, $575,000 and $4,718,000 respectively. Gross gains of $0, $0 and $28,000 in 2007, 2006 and 2005, and gross losses of $0, $4,000, and $30,000 in 2007, 2006 and 2005 were realized on those sales. 51 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 5 LOANS AND ALLOWANCE 2007 2006 ================================== Loans at December 31: Commercial and Industrial Loans.............. $ 662,701 $ 537,305 Agricultural Production Financing and Other Loans to Farmers....... 114,324 100,098 Real Estate Loans: Construction............................... 165,425 169,491 Commercial and Farmland.................... 947,234 861,429 Residential................................ 744,627 749,921 Individuals' Loans for Household and Other Personal Expenditures.. 187,880 223,504 Tax-exempt Loans............................. 16,423 14,423 Lease Financing Receivables, Net of Unearned Income .................... 8,351 8,010 Other Loans.................................. 29,878 28,420 ---------- ---------- 2,786,843 2,692,601 Allowance for Loan Losses................... (28,228) (26,540) ---------- ---------- Total Loans........................ $2,848,615 $2,666,061 ========== ========== Residential Real Estate Loans Held for Sale at December 31, 2007 and 2006 were $3,735,000 and $5,413,000 respectively. 2007 2006 ================================== Allowance for Loan Losses Balance, January 1 ......................... $ 26,540 $ 25,188 Provision for Losses ....................... 8,507 6,258 Recoveries on Loans ........................ 1,738 1,604 Loans Charged Off .......................... (8,557) (6,510) ---------- ---------- Balance, December 31 ....................... $ 28,228 $ 26,540 ========== ========== Information on nonaccruing, contractually past due 90 days or more other than nonaccruing and restructured loans is summarized below: 2007 2006 ================================== Non-accrual Loans......................... $ 29,031 $ 17,926 Loans Contractually Past Due 90 Days or More Other Than Nonaccruing..... 3,578 2,870 Restructured Loans........................ 145 84 -------- -------- Total Non-performing Loans........... $ 32,754 $ 20,880 ======== ========= 52 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 5 LOANS AND ALLOWANCE continued Information on impaired loans is summarized below: 2007 2006 2005 ===================================================================================================================== As of, and for the Year Ending December 31: Impaired Loans with an Allowance .......................... $ 21,304 $ 17,291 $ 7,540 Impaired Loans for which the Discounted Cash Flows or Collateral Value Exceeds the Carrying Value of the Loan ............................ 65,645 43,029 44,840 ------- ------- ------- Total Impaired Loans ............................... $86,949 $60,320 $52,380 ======= ======= ======= Total Impaired Loans as a Percent of Total Loans ........................................ 3.02% 2.24% 2.13% Allowance for Impaired Loans (Included in the Corporation's Allowance for Loan Losses) .............. $ 6,034 $ 4,130 $ 2,824 Average Balance of Impaired Loans ......................... 103,272 66,139 44,790 Interest Income Recognized on Impaired Loans .............. 6,675 5,143 3,511 Cash Basis Interest Included Above ........................ 1,143 1,364 650 NOTE 6 PREMISES AND EQUIPMENT 2007 2006 ================================================================================ Cost at December 31: Land .......................................... $ 7,993 $ 7,767 Buildings and Leasehold Improvements .......... 47,853 37,791 Equipment ..................................... 40,455 46,895 -------- -------- Total Cost ................................ 96,301 92,453 Accumulated Depreciation and Amortization ..... (51,856) (50,060) -------- -------- Net ....................................... $ 44,445 $ 42,393 ======== ======== The Corporation is committed under various noncancelable lease contracts for certain subsidiary office facilities and equipment. Total lease expense for 2007, 2006 and 2005 was $2,477,000, $2,651,000 and $2,391,000, respectively. The future minimum rental commitments required under the operating leases in effect at December 31, 2007, expiring at various dates through the year 2016 are as follows for the years ending December 31: ==================================================== 2008 ................................ $1,708 2009 ................................ 1,385 2010 ................................ 1,178 2011 ................................ 953 2012 ................................ 600 After 2012 ........................... 73 ------ Total Future Minimum Obligations $5,897 ====== NOTE 7 GOODWILL The changes in the carrying amount of goodwill at December 31 are noted below. No impairment loss was recorded in 2007 and 2006. 2007 2006 ================================================================================ Balance, January 1 .............................. $ 123,168 $ 121,266 Goodwill Acquired ............................... 276 1,902 --------- --------- Balance, December 31 ............................ $ 123,444 $ 123,168 ========= ========= 53 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 8 CORE DEPOSIT AND OTHER INTANGIBLES The carrying basis and accumulated amortization of recognized core deposit and other intangibles at December 31 were: 2007 2006 ================================================================================ Gross Carrying Amount ........................... $ 32,126 $ 32,025 Accumulated Amortization ........................ (19,714) (16,555) --------- --------- Core Deposit and Other Intangibles ........... $ 12,412 $ 15,470 ========= ========= Amortization expense for the years ended December 31, 2007, 2006 and 2005, was $3,159,000, $3,066,000 and $3,102,000, respectively. Estimated amortization expense for each of the following five years is: ==================================================== 2008 ................................ $ 3,159 2009 ................................ 3,157 2010 ................................ 3,048 2011 ................................ 2,114 2012 ................................ 528 After 2012 .......................... 406 ------ $12,412 ====== NOTE 9 DEPOSITS 2007 2006 ================================================================================ Deposits at December 31: Demand Deposits ............................. $ 903,380 $ 883,294 Savings Deposits ............................ 552,380 507,431 Certificates and Other Time Deposits of $100,000 or more ....................... 495,630 431,068 Other Certificates and Time Deposits ........ 892,731 928,745 ---------- ---------- Total Deposits .......................... $2,844,121 $2,750,538 ========== ========== ===================================================== Certificates and Other Time Deposits Maturing in Years Ending December 31: 2008 ....................... $1,053,782 2009 ....................... 175,108 2010 ....................... 63,000 2011 ....................... 35,739 2012 ....................... 43,774 After 2012 ................. 16,958 ---------- $1,388,361 ========== Time deposits obtained through brokers were $239,019,000 and $256,632,000 at December 31, 2007 and 2006, respectively. 54 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 10 BORROWINGS 2007 2006 =================================================================================== Borrowings at December 31: Federal Funds Purchased ........................... $ 52,350 $ 56,150 Securities Sold Under Repurchase Agreements ....... 106,497 42,750 Federal Home Loan Bank Advances ................... 294,101 242,408 Subordinated Debentures, Revolving Credit Lines and Term Loans ............................ 115,826 99,456 -------- -------- Total Borrowings .............................. $568,774 $440,764 ======== ======== Securities sold under repurchase agreements consist of obligations of the Banks to other parties. The obligations are secured by U.S. Treasury, U.S. Government-sponsored agency security obligations and corporate asset-backed securities. The maximum amount of outstanding agreements at any month-end during 2007 and 2006 totaled $128,023,000 and $98,765,000 respectively, and the average of such agreements totaled $85,853,000 and $73,818,000 during 2007 and 2006 respectively. Maturities of securities sold under repurchase agreements; Federal Home Loan Bank advances; and subordinated debentures, revolving credit lines and term loans as of December 31, 2007, are as follows: SUBORDINATED DEBENTURES SECURITIES SOLD UNDER FEDERAL HOME LOAN REVOLVING CREDIT LINES REPURCHASE AGREEMENTS BANK ADVANCES AND TERM LOANS ================================================================================================================================== AMOUNT AMOUNT AMOUNT ================================================================================================================================== Maturities in Years Ending December 31: 2008 .............. $ 72,247 $108,398 $ 25,000 2009 .............. 53,351 2010 .............. 10,000 46,080 2011 .............. 18,944 2012 .............. 14,250 51,679 After 2012 ........ 10,000 15,649 90,826 -------- -------- -------- Total ...... $106,497 $294,101 $115,826 ======== ======== ======== The terms of a security agreement with the FHLB require the Corporation to pledge, as collateral for advances, qualifying first mortgage loans and all otherwise unpledged investment securities in an amount equal to at least 145 percent of these advances. Advances, with interest rates from 2.36 to 6.84 percent, are subject to restrictions or penalties in the event of prepayment. The total available remaining borrowing capacity from the FHLB at December 31, 2007, was $18,487,000. Subordinated Debentures, Revolving Credit Lines and Term Loans. Three borrowings were outstanding on December 31, 2007, for $115,826,000. • • First Merchants Capital Trust II. The subordinated debenture, entered into on July 2, 2007, for $56,702,000 will mature on September 15, 2037. The Corporation may redeem the debenture no earlier than September 15, 2012, subject to the prior approval of the Federal Reserve, as required by law or regulation. Interest is fixed at 6.495 percent for the period from the date of issuance through September 15, 2012, and thereafter, at an annual floating rate equal to the three-month LIBOR plus 1.56 percent, reset quarterly. Interest is payable in March, June, September and December of each year. First Merchants Capital Trust II is a wholly owned subsidiary of the Corporation. CNBC Statutory Trust I. As part of the March 1, 2003, acquisition of CNBC Bancorp, the Corporation assumed $4,124,000 of a junior subordinated debenture entered into on February 22, 2001. The subordinated debenture of $4,124,000 will mature on February 22, 2031. Interest is fixed at 10.20 percent and payable on February 22 and August 22 of each year. The Corporation may redeem the debenture, in whole or in part, at its option commencing February 22, 2011, at a redemption price of 105.10 percent of the outstanding principal amount and, thereafter, at a premium which declines annually. On or after February 22, 2021, the securities may be redeemed at face value with prior approval of the Board of Governors of the Federal Reserve System. CNBC Statutory Trust I is a wholly owned subsidiary of the Corporation. 55 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 10 BORROWINGS continued • LaSalle Bank, N.A. A Loan and Subordinated Debenture Loan Agreement (“LaSalle Agreement”) was entered into with LaSalle Bank, N.A. on March 25, 2003 and later amended as of September 5, 2007. The LaSalle Agreement includes three credit facilities: o o o The Term Loan of $5,000,000 matures on March 7, 2014. Interest is calculated at a floating rate equal to the lender's base rate or LIBOR plus 1.00 percent. The Term Loan is secured by 100 percent of the common stock of First Merchants. The Agreement contains several restrictive covenants, including the maintenance of various capital adequacy levels, asset quality and profitability ratios, and certain restrictions on dividends and other indebtedness. The Revolving Loan had a balance of $25,000,000 at December 31, 2007. Interest is payable quarterly based on a floating rate equal to the lender’s base rate or LIBOR plus 1.00 percent. Principal and interest are due on or before March 5, 2008. The total principal amount outstanding at any one time may not exceed $25,000,000. The Revolving Loan is secured by 100 percent of the common stock of First Merchants. The Agreement contains several restrictive covenants, including the maintenance of various capital adequacy levels, asset quality and profitability ratios, and certain restrictions on dividends and other indebtedness. The Subordinated Debenture of $25,000,000 matures on March 7, 2014. Interest is calculated at a floating rate equal to the lender’s base rate or LIBOR plus 1.25 percent. The Subordinated Debenture is treated as Tier 2 Capital for regulatory capital purposes and is unconditionally guaranteed by the Corporation. The Corporation redeemed its subordinated debentures payable to First Merchants Capital Trust I during 2007. The aggregate redemption price was the principal amount of $54,832,000 plus any accrued but unpaid interest. The redemption of the debentures was immediately followed by the redemption by First Merchants Capital Trust I of its outstanding common and preferred securities at their $25 liquidation value, plus any accrued but unpaid distributions. Subordinated Debentures, Revolving Credit Lines and Term Loans. Three borrowings were outstanding on December 31, 2006, for $99,456,000. • • First Merchants Capital Trust I. The subordinated debenture, entered into on April 12, 2002, for $54,832,000 will mature on June 20, 2032. The Corporation may redeem the debenture no earlier than June 30, 2007, subject to the prior approval of the Federal Reserve, as required by law or regulation. Interest is fixed at 8.75 percent and payable on March 31, June 30, September 30 and December 31 of each year. CNBC Statutory Trust I. As part of the March 1, 2003, acquisition of CNBC Bancorp, the Corporation assumed $4,124,000 of a junior subordinated debenture entered into on February 22, 2001. The subordinated debenture of $4,124,000 will mature on February 22, 2031. Interest is fixed at 10.20 percent and payable on February 22 and August 22 of each year. The Corporation may redeem the debenture, in whole or in part, at its option commencing February 22, 2011, at a redemption price of 105.10 percent of the outstanding principal amount and, thereafter, at a premium which declines annually. On or after February 22, 2021, the securities may be redeemed at face value with prior approval of the Board of Governors of the Federal Reserve System. • LaSalle Bank, N.A. A Loan and Subordinated Debenture Loan Agreement (“LaSalle Agreement”) was entered into with LaSalle Bank, N.A. on March 25, 2003 and later amended as of March 7, 2006. The LaSalle Agreement includes three credit facilities: o The Term Loan of $5,000,000 matures on March 7, 2012. Interest is calculated at a floating rate equal to the lender's prime rate or LIBOR plus 1.00 percent. The Term Loan is secured by 100 percent of the common stock of First Merchants. The Agreement contains several restrictive covenants, including the maintenance of various capital adequacy levels, asset quality and profitability ratios, and certain restrictions on dividends and other indebtedness. 56 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 10 BORROWINGS continued o o The Revolving Loan had a balance of $10,500,000 at December 31, 2006. Interest is payable quarterly based on LIBOR plus 1 percent. Principal and interest are due on or before March 6,2007. The total principal amount outstanding at any one time may not exceed $20,000,000. The Revolving Loan is secured by 100 percent of the common stock of First Merchants. The Agreement contains several restrictive covenants, including the maintenance of various capital adequacy levels, asset quality and profitability ratios, and certain restrictions on dividends and other indebtedness. The Subordinated Debenture of $25,000,000 matures on March 7, 2012. Interest is calculated at a floating rate equal to, at the Corporation’s option, either the lender’s prime rate or LIBOR plus 1.50 percent. The Subordinated Debenture is treated as Tier 2 Capital for regulatory capital purposes. NOTE 11 LOAN SERVICING Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The loans are serviced primarily for the Federal Home Loan Mortgage Corporation, and the unpaid balances totaled $115,618,000, $98,538,000 and $107,730,000 at December 31, 2007, 2006 and 2005 respectively the amount of capitalized servicing assets is considered immaterial. NOTE 12 INCOME TAX 2007 2006 2005 ================================================================================================================================= Income Tax Expense for the Year Ended December 31: Currently Payable: Federal ................................................................ $ 13,343 $ 13,192 $ 14,814 State .................................................................. 162 1,415 2,231 Deferred: Federal ................................................................ (1,664) (1,785) (3,248) State .................................................................. (498) (627) (501) -------- -------- -------- Total Income Tax Expense ............................................ $ 11,343 $ 12,195 $ 13,296 ======== ======== ======== Reconciliation of Federal Statutory to Actual Tax Expense: Federal Statutory Income Tax at 35% .................................... $ 15,043 $ 14,837 $ 15,158 Tax-exempt Interest .................................................... (2,259) (2,215) (2,204) Effect of State Income Taxes ........................................... (220) 475 1,115 Earnings on Life Insurance ............................................. (1,064) (594) (452) Tax Credits ............................................................ (348) (391) (395) Other .................................................................. 191 83 74 -------- -------- -------- Actual Tax Expense ................................................. $ 11,343 $ 12,195 $ 13,296 ======== ======== ======== Tax expense (benefit) applicable to security gains and losses for the years ended December 31, 2007, 2006 and 2005, was $0, $(2,000) and $(1,000), respectively. 57 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 12 INCOME TAX continued A cumulative net deferred tax asset is included in other assets in the consolidated balance sheets. The components of the net asset are as follows: 2007 2006 ====================================================================================================================== Deferred Tax Asset at December 31: Assets: Differences in Accounting for Loan Losses ............................. $11,086 $10,641 Deferred Compensation ................................................. 3,841 3,078 Difference in Accounting for Pensions and Other Employee Benefits ......................................... 3,071 5,442 State Income Tax ...................................................... 156 187 Net Unrealized Loss on Securities Available for Sale................... 1,241 Other ................................................................. 322 399 ------ ------ Total Assets ...................................................... 18,476 20,988 ------ ------ Liabilities: Differences in Depreciation Methods ................................... 3,508 3,114 Differences in Accounting for Loans and Securities .................... 3,889 4,974 Differences in Accounting for Loan Fees ............................... 399 534 Net Unrealized Gain on Securities Available for Sale................... 220 Other ................................................................. 2,344 2,381 ------ ------ Total Liabilities ................................................. 10,360 11,003 ------ ------ Net Deferred Tax Asset ............................................ $ 8,116 $ 9,985 ====== ====== NOTE 13 COMMITMENTS AND CONTINGENT LIABILITIES In the normal course of business there are outstanding commitments and contingent liabilities, such as commitments to extend credit and standby letters of credit, which are not included in the accompanying financial statements. The Corporation's exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Banks use the same credit policies in making such commitments as they do for instruments that are included in the consolidated balance sheets. Financial instruments whose contract amount represents credit risk as of December 31, were as follows: 2007 2006 ======== ======== Commitments to Extend Credit $747,070 $681,462 Standby Letters of Credit 25,431 23,286 Commitments to extend credit are agreements to lend to a customer, as long as there is no violation of any condition established in the contract. 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. The Banks evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Banks upon extension of credit, is based on management's credit evaluation. Collateral held varies, but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties. Standby letters of credit are conditional commitments issued by the Banks to guarantee the performance of a customer to a third party. The Corporation and subsidiaries are also subject to claims and lawsuits, which arise primarily in the ordinary course of business. It is the opinion of management that the disposition or ultimate resolution of such claims and lawsuits will not have a material adverse effect on the consolidated financial position of the Corporation. 58 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 14 STOCKHOLDERS' EQUITY National banking laws restrict the maximum amount of dividends that a bank may pay in any calendar year. National banks are limited to the bank’s retained net income (as defined) for the current year plus those for the previous two years. The amount at December 31, 2007, available for 2008 dividends from First Merchants, Central Indiana, Lafayette, Commerce National, FMTC and FMIS to the Corporation totaled $18,719,000, $1,877,000, $1,039,000, $8,313,000, $520,000 and $9,616,000, respectively. Total stockholders' equity for all subsidiaries at December 31, 2007, was $445,104,000 of which $405,020,000 was restricted from dividend distribution to the Corporation. The Corporation has a Dividend Reinvestment and Stock Purchase Plan, enabling stockholders to elect to have their cash dividends on all shares held automatically reinvested in additional shares of the Corporation’s common stock. In addition, stockholders may elect to make optional cash payments up to an aggregate of $2,500 per quarter for the purchase of additional shares of common stock. The stock is credited to participant accounts at fair market value. Dividends are reinvested on a quarterly basis. NOTE 15 REGULATORY CAPITAL The Corporation and Banks are subject to various regulatory capital requirements administered by the federal banking agencies and are assigned to a capital category. The assigned capital category is largely determined by three ratios that are calculated according to the regulations: total risk adjusted capital, Tier 1 capital, and Tier 1 leverage ratios. The ratios are intended to measure capital relative to assets and credit risk associated with those assets and off-balance sheet exposures of the entity. The capital category assigned to an entity can also be affected by qualitative judgments made by regulatory agencies about the risk inherent in the entity's activities that are not part of the calculated ratios. There are five capital categories defined in the regulations, ranging from well capitalized to critically undercapitalized. Classification of a bank in any of the undercapitalized categories can result in actions by regulators that could have a material effect on a bank's operations. At December 31, 2007, the management of the Corporation believes that it meets all capital adequacy requirements to which it is subject. The most recent notifications from the regulatory agencies categorized the Corporation and Banks as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Banks must maintain a minimum total capital to risk-weighted assets, Tier I capital to risk-weighted assets and Tier I capital to average assets of 10 percent, 6 percent and 5 percent, respectively. There have been no conditions or events since that notification that management believes have changed this categorization. 59 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 15 REGULATORY CAPITAL continued Actual and required capital amounts and ratios are listed below. ===================================================================================================================================== 2007 2006 REQUIRED FOR REQUIRED FOR ACTUAL ADEQUATE CAPITAL1 ACTUAL ADEQUATE CAPITAL1 AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO ===================================================================================================================================== December 31 Total Capital1,2,3(to Risk-weighted Assets) Consolidated ...................... $312,080 10.55% $236,636 8.00% $299,353 11.09% $215,906 8.00% First Merchants ................... 169,678 11.07 122,567 8.00 77,072 10.46 58,965 8.00 Central Indiana.................... 29,268 11.72 19,984 8.00 28,541 11.06 20,637 8.00 United Communities ................ 27,723 11.21 19,790 8.00 First National .................... 10,881 11.13 7,820 8.00 Decatur ........................... 12,200 11.06 8,828 8.00 Frances Slocum .................... 20,016 11.87 13,488 8.00 Lafayette ......................... 79,692 11.46 55,646 8.00 79,106 11.60 54,539 8.00 Commerce National ................. 52,353 10.76 38,922 8.00 46,997 11.28 33,320 8.00 Tier I Capital1,2,3 (to Risk-weighted Assets) Consolidated ...................... $258,918 8.75% $118,318 4.00% $247,813 9.18% $107,953 4.00% First Merchants ................... 154,624 10.09 61,284 4.00 69,957 9.45 29,482 4.00 Central Indiana.................... 26,669 10.68 9,992 4.00 26,036 10.09 10,318 4.00 United Communities ................ 25,201 10.19 9,895 4.00 First National .................... 10,126 10.36 3,910 4.00 Decatur ........................... 11,261 10.20 4,414 4.00 Frances Slocum..................... 17,918 10.63 6,744 4.00 Lafayette ......................... 73,437 10.56 27,823 4.00 72,646 10.66 27,269 4.00 Commerce National ................. 48,099 9.89 19,461 4.00 43,149 10.36 16,660 4.00 Tier I Capital1,2,3 (to Average Assets) Consolidated ...................... $258,918 7.19% $144,000 4.00% $247,813 7.37% $134,443 4.00% First Merchants ................... 154,624 8.10 76,293 4.00 69,657 7.33 38,005 4.00 Central Indiana.................... 26,669 8.91 11,966 4.00 26,036 8.63 12,068 4.00 United Communities ................ 25,201 7.91 12,747 4.00 First National .................... 10,126 8.04 5,040 4.00 Decatur ........................... 11,261 7,31 6,162 4.00 Frances Slocum..................... 17,918 9.08 7,895 4.00 Lafayette ......................... 73,437 8.01 36,669 4.00 72,646 7.99 36,385 4.00 Commerce National ................. 48,099 9.11 21,119 4.00 43,149 8.99 19,203 4.00 NOTE 16 SHARE-BASED COMPENSATION Stock options and restricted stock awards ("RSAs"), which are non-vested shares, have been issued to directors, officers and other management employees under the Corporation's 1994 Stock Option Plan and The 1999 Long-term Equity Incentive Plan. The stock options, which have a ten-year life, become 100 percent vested ranging from three months to two years and are fully exercisable when vested. Option exercise prices equal the Corporation's common stock closing price on NASDAQ on the date of grant. RSAs provide for the issuance of shares of the Corporation's common stock at no cost to the holder and generally vest after three years. The RSAs only vest if the employee is actively employed by the Corporation on the vesting date. The Corporation's 2004 Employee Stock Purchase Plan ("ESPP") provides eligible employees of the Corporation and its subsidiaries an opportunity to purchase shares of common stock of the Corporation through annual offerings financed by payroll deductions. The price of the stock to be paid by the employees may not be less than 85 percent of the lesser of the fair market value of the Corporation's common stock at the beginning or at the end of the offering period. Common stock purchases are made annually and are paid through advance payroll deductions of up to 20 percent of eligible compensation. SFAS 123(R) required the Corporation to begin recording compensation expense in 2006 related to unvested share-based awards outstanding as of December 31, 2005, by recognizing the un-amortized grant date fair value of these awards over the remaining service periods of those awards, with no change in historical reported fair values and earnings. Awards granted after December 31, 2005 are valued at fair value in accordance with provisions of SFAS 123(R) and are recognized on a straight-line basis over the service periods of each award. To complete the exercise of vested stock options, RSA's and ESPP options, the Corporation generally issues new shares from its authorized but unissued share pool. Share-based 1 As defined by regulatory agencies 2 Effective April 1, 2007, United Communities, First National, Decatur and Frances Slocum were merged into First Merchants Bank, N.A. 3 Effective April 1, 2007, Madison’s name was changed to First Merchants Bank of Central Indiana, National Association. 60 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 16 SHARE-BASED COMPENSATION continued compensation for the years ended December 31, 2007 and 2006 totaled $1,468,000 and $833,000, respectively, and has been recognized as a component of salaries and benefits expense in the accompanying Consolidated Condensed Statements of Income. Prior to 2006, the Corporation accounted for share-based compensation in accordance with APB 25 using the intrinsic value method, which did not require that compensation expense be recognized for the Corporation's stock and ESPP options. However, under APB 25, the Corporation was required to record compensation expense over the vesting period for the value of RSAs granted, if any. The Corporation provided pro forma disclosure amounts in accordance with SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" (SFAS No. 148), as if the fair value method defined by SFAS No. 123 had been applied to its share-based compensation. The Corporation's net income and net income per share for the period ended December 31, 2005 would have been reduced if compensation expense related to stock and ESPP options had been recorded in the financial statements, based on fair value at the grant dates. The estimated fair value of the stock options granted during 2007, 2006 and 2005 was calculated using a Black Scholes options pricing model. The following summarizes the assumptions used in the Black Scholes model: 2007 2006 2005 ---- ---- ---- Risk-free Interest Rate ................................. 4.67% 4.59% 4.05% Expected Price Volatility ............................... 29.76% 29.84% 30.20% Dividend Yield .......................................... 3.64% 3.54% 3.56% Forfeiture Rate ......................................... 5.00% 4.00% 4.00% Weighted-average Expected Life, Until Exercise .......... 5.99 years 5.75 years 8.50 years The Black Scholes model incorporates assumptions to value share-based awards. The risk-free rate of interest, for periods equal to the expected life of the option, is based on a zero-coupon U.S. government instrument over a similar contractual term of the equity instrument. Expected price volatility is based on historical volatility of the Corporation's common stock. In addition, the Corporation generally uses historical information to determine the dividend yield and weighted-average expected life of the options, until exercise. Separate groups of employees that have similar historical exercise behavior with regard to option exercise timing and forfeiture rates are considered separately for valuation and attribution purposes. Share-based compensation expense recognized in the Consolidated Condensed Statements of Income is based on awards ultimately expected to vest and is reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods, if actual forfeitures differ from those estimates. Pre-vesting forfeitures were estimated to be approximately 5 percent for the year ended December 31, 2007, based on historical experience. In the Corporation's pro forma disclosures required under SFAS 123(R) for the periods prior to fiscal 2006, the Corporation accounted for forfeitures as they occurred. As a result of adopting SFAS 123(R), net income of the Corporation for the year ended December 31, 2007 and 2006 were $1,124,000 and $656,000, respectively, lower (net of $344,000 and $177,000 in tax benefits), than if it had continued to account for share-based compensation under APB 25. The impact on both basic and diluted earnings per share for the year ended December 31, 2007 and 2006 were $.06 and $.04 per share. 61 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 16 SHARE-BASED COMPENSATION continued The following table summarizes the components of the Corporation's share-based compensation awards recorded as expense. Components of the share-based compensation: Year Ended December 31, 2007 ----------------- Stock and ESPP Options: Pre-tax Compensation Expense ...................... $ 602 Income Tax Benefit ................................ (41) ----------------- Stock and ESPP Options Expense, Net of Income........ $ 561 ================= Restricted Stock Awards: Pre-tax Compensation Expense ...................... $ 866 Income Tax Benefit ................................ (303) ----------------- Restricted Stock Awards Expense, Net of Tax ......... $ 563 ================= Total Share-based Compensation: Pre-tax Compensation Expense ...................... $ 1,468 Income Tax Benefit ................................ (344) ----------------- Total Share-based Compensation Expense, Net of Tax... $ 1,124 ================= Year Ended December 31, 2006 ----------------- $ 449 (42) ----------------- $ 407 ================= $ 384 (135) ----------------- $ 249 ================= $ 833 (177) ----------------- $ 656 ================= As of December 31, 2007, unrecognized compensation expense related to stock options, RSAs and ESPP options totaling $221,000, $1,320,000 and $92,000, respectively, is expected to be recognized over weighted-average periods of .61, 1.67 and .5 years, respectively. Stock option activity under the Corporation's stock option plans as of December 31, 2007 and changes during the year ended December 31, 2007 were as follows: Weighted- Average Weighted- Remaining Number Average Contractual Aggregate of Exercise Term Intrinsic Shares Price (in Years) Value ---------- ------------ ----------- ---------- Outstanding at January 1, 2007 .................. 1,067,247 $ 23.87 Granted ......................................... 75,968 26.00 Exercised ....................................... (48,609) 18.11 Cancelled ....................................... (40,176) 23.68 ---------- Outstanding at December 31, 2007 ................ 1,054,430 $ 24.30 5.33 $568,511 ========== Vested and Expected to Vest at December 31, 2007. 1,042,511 $ 24.28 5.29 $568,511 Exercisable at December 31, 2007 ................ 924,467 $ 24.12 4.86 $568,511 The weighted-average grant date fair value was $5.85, $6.22 and $6.93 for stock options granted during the year ended December 31, 2007, 2006 and 2005, respectively. The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Corporation's closing stock price on the last trading day of 2007 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their stock options on the last trading day of 2007. The amount of aggregate intrinsic value will change based on the fair market value of the Corporation's common stock. The aggregate intrinsic value of stock options exercised during the years ended December 31, 2007, 2006 and 2005 were $250,185, $665,000 and $903,000, respectively. Exercise of options during these same periods resulted in cash receipts of $496,000, $1,228,000 and $1,347,000, respectively. The Corporation recognized a tax benefit of approximately $116,000 for the year ended December 31, 2007, related to the exercise of employee stock options and has been recorded as an increase to additional paid-in capital. 62 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 16 SHARE-BASED COMPENSATION continued The following table summarizes information on unvested restricted stock awards outstanding as of December 31, 2007: Number of Grant-Date Shares Fair Value ---------- ---------- Unvested RSAs at January 1, 2007 ........... 55,000 $ 27.83 Granted .................................... 57,775 26.07 Forfeited .................................. 6,306 25.78 Vested ..................................... 8,442 25.56 ---------- Unvested RSAs at December 31, 2007 ......... 98,027 $ 27.12 ========== ======== The grant date fair value of ESPP options was estimated at the beginning of the July 1, 2007 offering period and approximates $184,000. The ESPP options vested during the twelve-month period ending June 30, 2008. At December 31, 2007, total unrecognized compensation expense related to unvested ESPP options was $92,000, which is expected to be recognized over a six-month period ending June 30, 2008. NOTE 17 PENSION AND OTHER POST RETIREMENT BENEFIT PLANS The Corporation's defined-benefit pension plans cover substantially all of the Corporation's employees. On December 31, 2006 the Corporation adopted the recognition provision of SFAS No. 158 Employers’ Accounting for Defined Benefit, Pension and other Post-Retirement Plans. The benefits are based primarily on years of service and employees' pay near retirement. Contributions are intended to provide not only for benefits attributed to service-to-date, but also for those expected to be earned in the future. The table below sets forth the plans' funded status and amounts recognized in the consolidated balance sheet at December 31, using measurement dates of September 30, 2007 and 2006. December 31 2007 2006 ===================================================================================== Change in Benefit Obligation Benefit Obligation at Beginning of Year ............ $ 58,078 $ 55,484 Service Cost ....................................... 671 688 Interest Cost ...................................... 3,146 2,985 Actuarial (Gain)/Loss .............................. (1,640) 1,303 Benefits Paid ...................................... (2,755) (2,382) -------- -------- Benefit Obligation at End of Year .................. 57,500 58,078 -------- -------- Change in Plan Assets Fair Value of Plan Assets at Beginning of Year ..... 41,591 39,913 Actual Return on Plan Assets ....................... 6,563 3,243 Employer Contributions ............................. 853 817 Benefits Paid ...................................... (2,755) (2,382) -------- -------- End of Year ........................................ 46,252 41,591 -------- -------- Funded Status at End of Year ............................ $ 11,248 $ 16,487 ======== ======== Assets and Liabilities Recognized in the Balance Sheets: Deferred Tax Assets ................................ $ 2,804 $ 4,654 Liabilities ........................................ $ 11,248 $ 16,487 Amounts Recognized in Accumulated Other Comprehensive Income Not Yet Recognized as Components of Net Periodic Benefit Cost Consist of: Net Loss (Gain) .................................... $ 4,089 $ 6,701 Prior Service Cost (Credit) ........................ 118 34 -------- -------- $ 4,207 $ 6,735 ======== ======== In January 2005, the Board of Directors of the Corporation approved the curtailment of the accumulation of defined benefits for future services provided by certain participants in the First Merchants Corporation Retirement Pension Plan (the "Plan"). Employees of the Corporation and certain of its subsidiaries who are participants in the Plan were notified that, on and after March 1, 2005, no additional pension benefits will be earned by employees who have not both attained the age of fifty-five (55) and accrued at least ten (10) years of "Vesting Service". As a result of this action, the Corporation incurred a $1,630,000 pension curtailment loss to record previously unrecognized prior service costs in accordance with SFAS No. 88, 63 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 17 PENSION AND OTHER POST RETIREMENT BENEFIT PLANS continued "Employers' Accounting for Settlements and Curtailments of Defined Benefit Plans and for Termination Benefits." This loss was recognized and recorded by the Corporation in 2005. The accumulated benefit obligation for all defined benefit plans was $56,739,000 and $51,732,000 at December 31, 2007 and 2006, respectively. Information for pension plans with an accumulated benefit obligation in excess of plan assets: December 31 2007 2006 ===================================================================================== Projected Benefit Obligation ....................... $ 57,500 $ 58,078 ======== ======== Accumulated Benefit Obligation ..................... $ 51,770 $ 56,583 ======== ======== Fair Value of Plan Assets .......................... $ 46,252 $ 41,591 ======== ======== Components of net periodic pension cost: December 31 2007 2006 ===================================================================================== Service Cost ....................................... $ 671 $ 688 Interest Cost ...................................... 3,146 2,985 Expected Return on Plan Assets...................... (3,164) (2,913) Amortization of Prior Service Costs ................ 25 26 Amortization of Net (Gain) Loss .................... 527 445 -------- -------- Net Periodic Pension Cost .......................... $ 1,205 $ 1,231 ======== ======== Other changes in plan assets and benefit obligations recognized in other comprehensive income: ========================================================================================= Net Periodic Pension Cost .............................................. $ 1,205 Defined Benefit Pension Plans, Net of Income Tax Expense of ($1,475) Net Gain Arising During Period ...................................... 2,725 Prior Service Cost Arising During Period ............................ 30 Amortization of Prior Service Cost .................................. (15) December 31, 2007 -------- Total Recognized in Other Comprehensive Income ...................... 2,740 ------- Total Recognized in NPPC and OCI ....................................... $ 3,945 ======= The estimated net loss and transition obligation for the defined benefit pension plans that will be amortized from accumulated other comprehensive income into net periodic pension cost over the next fiscal year are: ========================================================================================== Amortization of Net Loss (Gain) ......................... $ 152 16 Amortization of Prior Service Cost ...................... --------- $ 168 ========= Total ............................................... Significant assumptions include: December 31 2007 2006 ===================================================================================== Weighted-average Assumptions Used to Determine Benefit Obligation: Discount Rate ...................................... 5.50% 5.50% Rate of Compensation Increase ...................... 3.50% 3.50% Weighted-average Assumptions Used to Determine Benefit Cost: Discount Rate ...................................... 5.50% 5.50% Expected Return on Plan Assets ..................... 7.75% 7.50% Rate of Compensation Increase ...................... 3.52% 4.00% At September 30, 2007 and 2006, the Corporation based its estimate of the expected long-term rate of return on analysis of the historical returns of the plans and current market information available. The plans' investment strategies are to provide for preservation of capital with an emphasis on long-term growth 64 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 17 PENSION AND OTHER POST RETIREMENT BENEFIT PLANS continued without undue exposure to risk. The assets of the plans' are invested in accordance with the plans' Investment Policy Statement, subject to strict compliance with ERISA and any other applicable statutes. The plans' risk management practices include quarterly evaluations of investment managers, including reviews of compliance with investment manager guidelines and restrictions; ability to exceed performance objectives; adherence to the investment philosophy and style; and ability to exceed the performance of other investment managers. The evaluations are reviewed by management with appropriate follow-up and actions taken, as deemed necessary. The Investment Policy Statement generally allows investments in cash and cash equivalents, real estate, fixed income debt securities and equity securities, and specifically prohibits investments in derivatives, options, futures, private placements, short selling, non-marketable securities and purchases of non-investment grade bonds. At December 31, 2007, the maturities of the plans' debt securities ranged from 18 days to 8.7 years, with a weighted average maturity of 3.2 years. At December 31, 2006, the maturities of the plans' debt securities ranged from 1 day to 10.4 years, with a weighted average maturity of 3.0 years. The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid as of December 31, 2007. The Corporation plans to contribute as least $386,000 to the plans in 2008. ====================================================== 2008 ................................ $ 2,672 2009 ................................ 2,777 2010 ................................ 2,990 2011 ................................ 3,207 2012 ................................ 3,401 2013 and After ....................... 18,340 Plan assets are re-balanced quarterly. At December 31, 2007 and 2006, plan assets by category are as follows: December 31 2007 2006 ============================================================================== Equity Securities ................................ 65% 66% Debt Securities .................................. 32% 32% Other ............................................ 3% 2% -------- -------- 100% 100% ======== ======== The following table reflects the adjustments recorded during 2006 in accordance with the adoption of the recognition and disclosure requirement of SFAS No. 158: Before After Application of Application of Statement 158 Adjustments Statement 158 ======================================================================================================= Other Assets ................................. $ 22,281 $ 1,377 $ 23,658 Total Assets ................................. 3,553,493 1,377 3,554,870 Other Liabilities ............................ 23,486 3,431 26,917 Total Liabilities ............................ 3,224,114 3,431 3,227,545 Accumulated Other Comprehensive Loss ......... (7,341) (2,064) (9,405) Total Stockholders' Equity ................... 329,389 (2,064) 327,325 The First Merchants Corporation Retirement and Income Savings Plan (the "Savings Plan"), a Section 401(k) qualified defined contribution plan, was amended on March 1, 2005 to provide enhanced retirement benefits, including employer and matching contributions, for eligible employees of the Corporation and its subsidiaries. The Corporation matches employees' contributions primarily at the rate of 50 percent for the first 6 percent of base salary contributed by participants. Beginning in 2005, employees who have completed 1,000 hours of service and are an active employee on the last day of the year receive an additional retirement contribution after year-end. The amount of a participant's retirement contribution varies from 2 to 7 percent of salary based upon years of service. Full vesting occurs after 5 years of service. The Corporation’s expense for the Savings Plan was $2,454,000 for 2007, $2,026,000 for 2006 and $2,052,000 for 2005. The Corporation maintains post-retirement benefit plans that provide health insurance benefits to retirees. The plans allow retirees to be carried under the Corporation's health insurance plan, generally from ages 55 to 65. The retirees pay most of the premiums due for their coverage, with amounts paid by retirees ranging from 70 to 100 percent of the premiums payable. The accrued benefits payable under the plans totaled $1,317,000 and $1,089,000 at December 31, 2007 and 2006. Post-retirement plan expense totaled $171,000, $127,000 and $120,000 for the years ending December 31, 2007, 2006 and 2005, respectively. 65 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 18 NET INCOME PER SHARE ===================================================================================================================================================== Year Ended December 31, 2007 2006 2005 ---------------------------------------------------------------------------------------------------------------------------------- WEIGHTED-AVERAGE PER SHARE WEIGHTED-AVERAGE PER SHARE WEIGHTED-AVERAGE PER SHARE INCOME SHARES AMOUNT INCOME SHARES AMOUNT INCOME SHARES AMOUNT ============================================================================================================================================== Basic Net Income Per Share: Net Income Available to Common Stockholders .......... $31,639 18,249,919 $1.73 $30,198 18,383,074 $1.64 $30,239 18,484,832 $1.64 ===== ===== ===== Effect of Dilutive Stock Options.. 64,843 83,679 110,863 ------- ---------- ------- ---------- ------- ---------- Diluted Net Income Per Share: Net Income Available to Common Stockholders and Assumed Conversions ...... $31,639 18,313,964 $1.73 $30,198 18,466,753 $1.64 $30,239 18,595,695 $1.63 ======= ========== ===== ======= ========== ===== ======= ========== ===== Options to purchase 831,795, 590,736, and 214,840 shares of common stock with weighted average exercise prices of $25.67, $26.21 and $26.81 at December 31, 2007, 2006 and 2005, respectively, were excluded from the computation of diluted net income per share because the options exercise price was greater than the average market price of the common stock. NOTE 19 FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instrument: CASH AND CASH EQUIVALENTS The fair value of cash and cash equivalents approximates carrying value. INTEREST-BEARING TIME DEPOSITS The fair value of interest-bearing time deposits approximates carrying value. INVESTMENT SECURITIES Fair values are based on quoted market prices. MORTGAGE LOANS HELD FOR SALE The fair value of mortgages held for sale approximates carrying values. LOANS For both short-term loans and variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair value for other loans is estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. FEDERAL RESERVE AND FEDERAL HOME LOAN BANK STOCK The fair value of FRB and FHLB stock is based on the price at which it may be resold to the FRB and FHLB. INTEREST RECEIVABLE/PAYABLE The fair values of interest receivable/payable approximate carrying values. DEPOSITS The fair values of noninterest-bearing demand accounts, interest-bearing demand accounts and savings deposits are equal to the amount payable on demand at the balance sheet date. The carrying amounts for variable rate, fixed-term certificates of deposit approximate their fair values at the balance sheet date. Fair values for fixed-rate certificates of deposit and other time deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on such time deposits. BORROWINGS The fair value of borrowings is estimated using a discounted cash flow calculation, based on current rates for similar debt, except for short-term and adjustable rate borrowing arrangements. At December 31, the fair value for these instruments approximates carrying value. DERIVATIVE INSTRUMENTS The fair value of the derivatives reflects the estimated amounts that we would receive to terminate these contracts at the reporting date based upon pricing or valuation models applied to current market information. Interest rate floors are valued using the market standard methodology of discounting the future expected cash receipts that would occur if variable interest rates fell below the strike rate of the floors. The projected cash receipts on the floor are based on an expectation of future interest rates derived from observed market interest rate curves and volatilities. 66 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 19 FAIR VALUES OF FINANCIAL INSTRUMENTS continued OFF-BALANCE SHEET COMMITMENTS Loan commitments and letters-of-credit generally have short-term, variable-rate features and contain clauses which limit the Banks' exposure to changes in customer credit quality. Accordingly, their carrying values, which are immaterial at the respective balance sheet dates, are reasonable estimates of fair value. The estimated fair values of the Corporation’s financial instruments are as follows: 2007 2006 ======================================================================================================================================= CARRYING FAIR CARRYING FAIR AMOUNT VALUE AMOUNT VALUE ======================================================================================================================================= Assets at December 31: Cash and Due from Banks .................................... $ 134,683 $ 134,683 $ 89,957 $ 89,957 Interest-bearing Time Deposits ............................. 24,931 24,931 11,284 11,284 Investment Securities Available for Sale ................... 440,836 440,836 455,933 455,933 Investment Securities Held to Maturity ..................... 10,331 10,270 9,284 9,516 Mortgage Loans Held for Sale ............................... 3,735 3,735 5,413 5,413 Loans ...................................................... 2,848,615 2,846,625 2,666,061 2,649,916 FRB and FHLB Stock ......................................... 25,250 25,250 23,691 23,691 Interest Receivable ........................................ 23,402 23,402 24,345 24,345 Interest Rate Floors ....................................... 2,001 2,001 428 428 Liabilities at December 31: Deposits ................................................... $2,844,121 $2,731,895 $2,750,538 $2,661,866 Borrowings: Federal Funds Purchased ................................ 52,350 52,350 56,150 56,150 Securities Sold Under Repurchase Agreements ............ 106,497 106,497 42,750 42,750 FHLB Advances .......................................... 294,101 298,574 242,408 242,954 Subordinated Debentures, Revolving Credit Lines and Term Loans ................................. 115,826 121,177 99,456 112,966 Interest Payable ........................................... 8,325 8,325 9,326 9,326 NOTE 20 CONDENSED FINANCIAL INFORMATION (parent company only) Presented below is condensed financial information as to financial position, results of operations, and cash flows of the Corporation: CONDENSED BALANCE SHEETS December 31, 2007 2006 ================================================================================ Assets Cash .............................................. $ 8,192 $ 6,122 Investment in Subsidiaries ........................ 445,104 417,287 Goodwill .......................................... 448 448 Other Assets ...................................... 12,282 15,425 -------- -------- Total Assets ................................... $466,026 $439,282 ======== ======== Liabilities Borrowings ........................................ $115,826 $ 99,456 Other Liabilities ................................. 10,264 12,501 -------- -------- Total Liabilities .............................. 126,090 111,957 Stockholders' Equity ................................. 339,936 327,325 -------- -------- Total Liabilities and Stockholders' Equity ..... $466,026 $439,282 ======== ======== 67 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 20 CONDENSED FINANCIAL INFORMATION (parent company only) continued CONDENSED STATEMENTS OF INCOME December 31, 2007 2006 2005 =================================================================================================================================== Income Dividends from Subsidiaries ................................................ $ 20,979 $ 33,919 $ 30,930 Administrative Services Fees from Subsidiaries.............................. 17,670 15,104 13,823 Other Income ............................................................... 102 240 644 -------- -------- -------- Total Income ............................................................ 38,750 49,263 45,397 -------- -------- -------- Expenses Amortization of Core Deposit Intangibles and Fair Value Adjustments ................................................ 11 11 11 Interest Expense............................................................ 7,750 8,124 7,432 Salaries and Employee Benefits.............................................. 16,111 13,934 12,500 Net Occupancy Expenses...................................................... 1,198 1,232 1,294 Equipment Expenses.......................................................... 3,772 4,210 3,418 Telephone Expenses.......................................................... 915 1,108 1,181 Postage and Courier Expenses................................................ 1,797 1,658 1,528 Other Expenses.............................................................. 5,898 2,548 2,394 -------- -------- -------- Total Expenses .......................................................... 37,452 32,825 29,758 -------- -------- -------- Income Before Income Tax Benefit and Equity in Undistributed Income of Subsidiaries ....................................... 1,298 16,438 15,639 Income Tax Benefit ...................................................... 7,355 6,771 5,404 -------- -------- -------- Income Before Equity in Undistributed Income of Subsidiaries ................. 8,653 23,209 21,043 Equity in Undistributed (Distributions in Excess of) Income of Subsidiaries ................................................... 22,986 6,989 9,196 -------- -------- -------- Net Income ................................................................... $ 31,639 $ 30,198 $ 30,239 ======== ======== ======== CONDENSED STATEMENTS OF CASH FLOWS Year Ended December 31, ===================================================================================================================== 2007 2006 2005 ===================================================================================================================== Operating Activities: Net Income ........................................................ $ 31,639 $ 30,198 $ 30,239 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Amortization .................................................... 11 11 11 Share-based Compensation ........................................ 723 41 Distributions in Excess of (Equity in Undistributed) Income of Subsidiaries ............... ........................ (22,986) (6,989) (9,196) Net Change in: Other Assets ................................................. 3,143 (3,166) (2,220) Other Liabilities ............................................ (2,237) 5,923 1,680 -------- -------- -------- Net Cash Provided by Operating Activities ................. 10,293 26,018 20,514 -------- -------- -------- Investing Activities - Investment in Subsidiaries .................... 2,559 840 (2,884) -------- -------- -------- Net Cash Provided (Used) by Investing Activities .......... 2,559 840 (2,884) -------- -------- -------- Financing Activities: Cash Dividends .................................................... (16,854) (16,951) (16,981) Borrowings......................................................... 73,202 3,750 9,833 Repayment of Borrowings ........................................... (56,832) (8,250) (3,083) Stock Issued Under Employee Benefit Plans ......................... 787 857 914 Stock Issued Under Dividend Reinvestment and Stock Purchase Plan ......................................... 1,170 1,190 933 Stock Options Exercised ........................................... 496 1,228 2,174 Stock Redeemed .................................................... (12,751) (5,690) (9,658) Other ............................................................. 381 -------- -------- -------- Net Cash Used by Financing Activities ..................... (10,782) (23,485) (15,868) -------- -------- -------- Net Change in Cash ................................................... 2,070 3,373 1,762 Cash, Beginning of Year .............................................. 6,122 2,749 987 -------- -------- -------- Cash, End of Year .................................................... $ 8,192 $ 6,122 $ 2,749 ======== ======== ======== 68 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 21 QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following table sets forth certain quarterly results for the years ended December 31, 2007 and 2006: ----------------------------------------------------------------------------------------------------------------------------------- AVERAGE SHARES OUTSTANDING NET INCOME PER SHARE QUARTER INTEREST INTEREST NET INTEREST PROVISION FOR NET -------------------------- -------------------- ENDED INCOME EXPENSE INCOME LOAN LOSSES INCOME BASIC DILUTED BASIC DILUTED 2007: March ............ $ 55,241 $ 28,166 $ 27,075 $ 1,599 $ 7,771 18,410,958 18,495,926 $ .42 $ .42 June ............. 57,008 29,393 27,615 1,648 6,208 18,290,918 18,368,513 .34 .34 September......... 59,157 30,622 28,535 2,810 8,350 18,221,467 18,276,180 .46 .46 December.......... 59,327 29,432 29,895 2,450 9,310 18,080,281 18,137,667 .51 .51 ---------- ---------- ----------- -------- -------- ----- ----- $ 230,733 $ 117,613 $ 113,120 $ 8,507 $ 31,639 18,249,919 18,313,964 $1.73 $1.73 ========== ========== =========== ======== ======== ===== ===== 2006: March ............ $ 48,062 $ 20,473 $ 27,589 $ 1,726 $ 7,509 18,425,047 18,532,136 $ .41 $ .41 June ............. 51,047 23,281 27,766 1,729 7,291 18,385,298 18,463,278 .39 .39 September......... 54,325 26,701 27,624 1,558 7,739 18,317,558 18,380,631 .42 .42 December.......... 55,172 28,056 27,116 1,245 7,659 18,405,330 18,497,507 .42 .42 ---------- ---------- ----------- -------- -------- ----- ----- $ 208,606 $ 98,511 $ 110,095 $ 6,258 $ 30,198 18,383,074 18,466,753 $1.64 $1.64 ========== ========== =========== ======== ======== ===== ===== NOTE 22 DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), as amended and interpreted, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. As required by SFAS 133, the Corporation records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and the resulting designation. Derivatives used to hedge the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives used to hedge the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. To qualify for hedge accounting, the Corporation must comply with the detailed rules and strict documentation requirements at the inception of the hedge, and hedge effectiveness is assessed at inception and periodically throughout the life of each hedging relationship. Hedge ineffectiveness, if any, is measured periodically throughout the life of the hedging relationship. The Corporation’s objective in using derivatives is to add stability to interest income and to manage its exposure to changes in interest rates. To accomplish this objective, the Corporation uses interest rate floors to protect against movements in interest rates below the floors’ strike rates over the life of the agreements. The interest rate floors have notional amounts of $50,000,000, $100,000,000, and $100,000,000 with corresponding strike rates of 6.0%, 7.0% and 7.5%, respectively. All of the floors have maturity dates of August 1, 2009. During 2007, the floors were used to hedge the variable cash flows associated with existing variable-rate loan assets that are based on the prime rate (Prime). For accounting purposes, the floors are designated as a cash flow hedge of the overall changes in cash flows on the first Prime- based interest payments received by the Corporation each calendar month during the term of the hedges that, in aggregate for each period, are interest payments on principal from specified portfolios equal to the notional amount of the floors. For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income (outside of earnings) and subsequently reclassified to earnings ("interest income on loans") when the hedged transaction affects earnings. Ineffectiveness resulting from the hedging relationship, if any, is recorded as a gain or loss in earnings as part of non-interest income. Based on the Corporation's assessments both at inception and throughout the life of the hedging relationship, it is probable that sufficient Prime-based interest receipts will exist through the maturity dates of the floors. The Corporation uses the “Hypothetical Derivative Method” described in Statement 133 Implementation Issue No. G20, “Cash Flow Hedges: Assessing and Measuring the Effectiveness of a Purchased Option Used in a Cash Flow Hedge,” for quarterly prospective and retrospective assessments of hedge effectiveness, as well as for measurements of hedge ineffectiveness. The effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income (outside of earnings) and subsequently reclassified to earnings (“interest income on loans”) when the hedged transactions affect earnings. Ineffectiveness resulting from the hedge is recorded as a gain or loss in the consolidated statement of income as part of non-interest income. The Corporation also monitors the risk of counterparty default on an ongoing basis. 69 PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (table dollar amounts in thousands, except share data) NOTE 22 DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES continued Prepayments in hedged loan portfolios are treated in a manner consistent with the guidance in Statement 133 Implementation Issue No. G25, “Cash Flow hedges: Using the First-Payments-Received Technique in Hedging the Variable Interest Payments on a Group of Non-Benchmark-Rate-Based Loans,” which allows the designated forecasted transactions to be the variable, Prime-rate-based interest payments on a rolling portfolio of prepayable interest-bearing loans using the first-payments-received technique, thereby allowing interest payments from loans that prepay to be replaced with interest payments from new loan originations. As of December 31, 2007, no derivatives were designated as fair value hedges or hedges of net investments in foreign operations. Additionally, the Corporation does not use derivatives for trading or speculative purposes. For the years ended December 31, 2007 and 2006, the interest rate floors designated as cash flow hedges had a fair value of $2,001,000 and $428,000, respectively, which were included in “Other Assets”. The change in net unrealized gains/losses on cash flow hedges reported in the consolidated statements of changes in shareholders’ equity was a net of tax gain of $1,057,000 during 2007, and a loss of $125,000 during 2006. For the year ended December 31, 2007, the Corporation recognized a gain of $64,000 for hedge ineffectiveness due to mismatches in the terms of the floor and the hedged loans, which is reported in other income in the consolidated statements of income. Amounts reported in accumulated other comprehensive income related to the interest rate floor will be reclassified to interest income as interest payments are received on the Corporation’s variable-rate assets. The change in net unrealized gains/losses on cash flow hedges reflects a reclassification of $48,000 of net unrealized gains and $38,000 of net unrealized losses from accumulated other comprehensive income to interest income during 2007 and 2006, respectively. During 2008, the Corporation estimates that an additional $787,000 will be reclassified. Interest rate floors are valued using market standard methodologies that incorporate implied forward interest rates and implied volatility as inputs. The fair value of each floor is obtained by summing the values of each individual floorlet - which are monthly European-style options on the daily-weighted-average Prime rate. The fair value of each floorlet is calculated using the Black-Scholes Model. NOTE 23 ACCOUNTING MATTERS In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting standards, and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We do not expect that the adoption of SFAS No. 157 will have a material impact on our financial condition or results of operations. The Corporation adopted the provisions of the Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109, on January 1, 2007. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. As a result of the implementation of FIN 48, the Corporation did not identify any uncertain tax positions that it believes should be recognized in the financial statements. The tax years still subject to examination by taxing authorities are years subsequent to 2003. In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities; including an Amendment of FASB Statement No. 115" (SFAS 159). SFAS 159 permits entities with an irrevocable option to report most financial assets and liabilities at fair value, with subsequent changes in fair value reported in earnings. The election can be applied on an instrument-by-instrument basis. The statement establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. The provisions of FAS 159 are effective for the fiscal year beginning January 1, 2008. The Corporation does not expect the adoption of SFAS No. 159 to have a material impact on the operations of the Corporation. 70 PART II: ITEM 9., ITEM 9A. AND ITEM 9B. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. In connection with its audits for the two most recent fiscal years ended December 31, 2007, there have been no disagreements with the Corporation's independent registered public accounting firm on any matter of accounting principles or practices, financial statement disclosure or audit scope or procedure, nor have there been any changes in accountants. ITEM 9A. CONTROLS AND PROCEDURES At the end of the period covered by this report (the "Evaluation Date"), the Corporation carried out an evaluation, under the supervision and with the participation of the Corporation's management, including the Corporation's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Rule 13a-15(b) and 15d-15(b) of the Securities Exchange Act of 1934 ("Exchange Act"). Based upon that evaluation, the Corporation's Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, the Corporation's disclosure controls and procedures are effective. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in Corporation reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management of the Corporation is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. The Corporation's internal control over financial reporting is designed to provide reasonable assurance to the Corporation's management and board of directors regarding the preparation and fair presentation of published financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Accordingly, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Management assessed the effectiveness of the Corporation's internal control over financial reporting as of December 31, 2007. In making this assessment, management used the criteria set forth in "Internal Control - Integrated Framework" issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on this assessment, management has determined that the Corporation's internal control over financial reporting as of December 31, 2007 is effective based on the specified criteria. There have been no changes in the Corporation's internal controls over financial reporting identified in connection with the evaluation referenced above that occurred during the Corporation's last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Corporation's internal control over financial reporting. 71 PART II: ITEM 9., ITEM 9A. AND ITEM 9B. REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Audit Committee, Board of Directors and Stockholders First Merchants Corporation Muncie, Indiana We have audited First Merchants Corporation's internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, First Merchants Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (OSO). We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of First Merchants Corporation and our report dated February 8, 2008, expressed an unqualified opinion thereon. Indianapolis, Indiana February 8, 2008 ITEM 9B. OTHER INFORMATION None 72 PART III: ITEM 10., ITEM 11., ITEM 12., ITEM 13. AND ITEM 14. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information in the Corporation's Proxy Statement dated March 19, 2008 furnished to its stockholders in connection with an annual meeting to be held April 29, 2008 (the "2008 Proxy Statement"), under the captions "INFORMATION REGARDING DIRECTORS", "COMMITTEES OF THE BOARD" and "SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE", is expressly incorporated herein by reference. The information required under this item relating to executive officers is set forth in Part I, "Supplemental Information - Executive Officers of the Registrant" on this Annual Report on Form 10-K. The Corporation has adopted a Code of Ethics that applies to its Chief Executive Officer, Chief Operating Officer, Chief Financial Officer, Controller and Treasurer. It is part of the Corporation's Code of Business Conduct, which applies to all employees and directors of the Corporation and its affiliates. A copy of the Code of Business Conduct may be obtained, free of charge, by writing to First Merchants Corporation at 200 East Jackson Street, Muncie, IN 47305. In addition, the Code of Ethics is maintained on the Corporation's website, which can be accessed at http://www.firstmerchants.com. ITEM 11. EXECUTIVE COMPENSATION The information in the Corporation's 2008 Proxy Statement, under the captions, "COMPENSATION OF DIRECTORS", "COMPENSATION OF EXECUTIVE OFFICERS", "COMMITTEES OF THE BOARD-Compensation and Human Resources Committee Interlocks and Insider Participation" and "COMMITTEES OF THE BOARD-Compensation and Human Resources Committee Report" is expressly incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Corporation's 2008 Proxy Statement, under the captions, “SECURITY OWNERSHIP OF BENEFICIAL OWNERS AND MANAGEMENT – Securities Ownership of Certain Beneficial Owners” and “SECURITY OWNERSHIP OF BENEFICIAL OWNERS AND MANAGEMENT – Security Ownership of Directors and Executive Officers”, is expressly incorporated herein by reference. The information required under this item relating to equity compensation plans is set forth in Part II, Item 5 under the table entitled "Equity Compensation Plan Information" on this Annual Report on Form 10-K. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information in the Corporation's 2008 Proxy Statement, under the captions, “SECURITY OWNERSHIP OF BENEFICIAL OWNERS AND MANAGEMENT – Securities Ownership of Certain Beneficial Owners," and “TRANSACTIONS WITH RELATED PERSONS”, is expressly incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information in the Corporation's 2008 Proxy Statement, under the caption "INDEPENDENT AUDITOR", is expressly incorporated herein by reference. 73 PART IV: ITEM 15. FINANCIAL STATEMENT SCHEDULES AND EXHIBITS PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL INFORMATION This Annual Report to Shareholders intentionally omits (i) the list of financial statements, financial statement schedules and exhibits required to be set forth under Item 15 of the Corporation’s 2007 Annual Report on Form 10-K, (ii) the signatures required on the Corporation’s 2007 Annual Report on Form 10-K and (iii) the exhibits required to be filed as part of the Corporation’s 2007 Annual Report on Form 10-K. A complete copy of the Corporation’s 2007 Annual Report on Form 10-K may be obtained as provided on page 5 and 6 hereof. 74 ﬁ rst merchants corpor ation market area c o r p o r a t e p r o f i l e First Merchants Corporation is a ﬁ nancial services company focused on building deep, lifelong client relationships. Headquartered in Muncie, Indiana, with four bank subsidiaries, a trust company and a multi-line insurance company, we deliver superior personalized ﬁ nancial solutions to consumer and closely held commercial clients in diverse community markets. With 66 locations in eighteen Indiana and three Ohio counties, we provide a full range of personal and business services including ﬁ nancing, mortgages, cash ﬂ ow management services and deposit solutions. ■ ﬁ rst merchants bank, n.a. ﬁ rst m Serves Ada Serves Adams, Delaware, Fayette, Hamilton, Henry, Howard, Jay, Marion, Miami, Randolph, Union, Wabash, Wayne Counties in Indiana, Marion M and Butler Ohio. ■ lafaye lafayette bank & trust, n.a. Serves Tip Serves Tippecanoe, Carroll, Jasper and White Counties. a n n u a l m e e t i n g ■ ﬁ rst merchants bank of centr al indiana, n.a. ﬁ rst m The annual meeting of stockholders of First Merchants Corporation will be held… Serves Ma Serves Madison County. ■ comme commerce national bank, n.a. Serves Fra Serves Franklin and Hamilton Counties in Ohio. ■ ﬁ rst merchants trust company ﬁ rst m Tuesday, April 29, 2007 (cid:129) 3:30 pm One of the One of the largest trust companies in the State of Indiana, provides c u l t u r e s t a t e m e n t We are a team of associates who support and expect superior results from our company and ourselves. Accountability and execution are the foundations of our success. c o r e v a l u e s client satisfaction: Focus on the client in all that we do. teamwork: Teams make better decisions. local decisions: Make decisions locally – stay close to the client. integrity: Maintain the highest standards with clients, associates, Horizon Convention Center 401 South High Street Muncie, Indiana 47305 a full com a full complement of trust and investment services. communities and stakeholders. ■ ﬁ rst merchants insur ance services ﬁ rst m Offers an e Offers an extensive line of commercial insurance products complemented quality: by persona by personal insurance and employee beneﬁ t plans. Provide predictable superior execution. ﬁ nancial highlights to our shareholders partnership proﬁ le investor summary fmc board of directors 1 2 4 6 7 afﬁ liate board of directors 8 ﬁ nancial review 9 ■ co corpor ate headquarters Firs First Merchants Corporation 200 East Jackson Street Muncie, IN 47305 765.747.1500 www.ﬁ rstmerchants.com st■ stock symbol: nasdaq: fr me people: Respect and value people as our competitive advantage. ﬁ nancial performance: Operate proﬁ table lines of business to beneﬁ t our stakeholders. The greater part of progress is the desire to progress. o u r m i s s i o n To deliver superior, personalized ﬁ nancial solutions to consumer and closely held commercial clients, in diverse community markets, by providing sound advice and products that exceed expectations. o u r v i s i o n A ﬁ nancial services company focused on building deep, lifelong client relationships and providing maximum shareholder value. We provide an environment where customers can bank with their neighbors, realizing that our business begins and ends with people. ■ corpor corporate headquarters First Merc First Merchants Corporation 200 East Jackson Street Muncie, Indiana 47305 765.747.1500 — seneca www.ﬁ rstmerchants.com a na na na n n un un un u a la la la l r rrr e pe pe pp o r t 2 0 0 7 a n n u a l r e p o r t 2 0 0 7 www.ﬁ rstmerchants.com

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