a n n u a l r e p o r t 2 0 0 8
p r e p a r e d t o m e e t t o d a y ’ s c h a l l e n g e s
a n n u a l r e p o r t 2 0 0 8
aBout first Merchants
first Merchants corporation
Market area
annual Meeting
The annual meeting of stockholders
of First Merchants Corporation
will be held…
Wednesday, May 6, 2009 | 3:30 pm
Horizon Convention Center
401 South High Street
Muncie, Indiana 47305
First Merchants Corporation is the largest financial services holding
company located in Central Indiana. With 80 locations in 24 Indiana
and 3 Ohio counties, we provide our customers with broad financial
services delivered locally by bankers who are known and trusted in
their communities. We offer consumer banking, mortgage banking,
business banking, cash management services, wealth management
and insurance.
Subsidiaries of the company include:
• first Merchants Bank, n.a.
Serves Adams, Delaware, Fayette, Hamilton, Henry, Howard,
Jay, Marion, Miami, Randolph, Union, Wabash, Wayne Counties
in Indiana, and Butler County in Ohio.
• lafayette Bank & trust, n.a.
Serves Carroll, Clinton, Jasper, Montgomery, Tippecanoe
and White Counties.
• first Merchants Bank of central indiana, n.a.
Serves Brown, Hendricks, Johnson, Madison and Morgan Counties.
• commerce national Bank
Serves Franklin and Hamilton Counties in Ohio.
• first Merchants trust company, n.a.
One of the largest trust companies in the State of Indiana,
provides a full complement of trust and investment services.
• first Merchants insurance services
Offers an extensive line of commercial insurance products
complemented by personal insurance and employee
benefit packages.
to our shareholders
fMc Board of Directors
affiliate Board of Directors
financial review
1
3
4
5
corporate heaDquarters
First Merchants Corporation
200 East Jackson Street
Muncie, IN 47305
765.747.1500
www.firstmerchants.com
stock syMBol: nasDaq: frMe
p r e p a r e d t o m e e t t o d a y ’ s c h a l l e n g e s
To Our Shareholders:
It has been a very long time since our country has faced the kind of economic turmoil
we are currently experiencing; and First Merchants, while strong, is certainly not
immune to the difficult market conditions that exist today. With consumers spending
more carefully and less, our customers are facing significant business challenges.
As complex and uncertain as the banking environment has become, First Merchants
is pleased to have earned more than $20 million in net income in 2008, while building
its allowance for loan loss, recognizing the negative economic trends nationally and in
the Midwest. Our solid financial performance is testimony to an exceptionally focused,
committed and hard-working team.
Looking ahead, we are far from complacent about conditions in the U.S. and foreign
markets. The actions taken by your management team this year to draw on our strengths
As complex and uncertain
will give us the ability to navigate through the current disruption. Our brand, people and
as the banking environment
continued investment in our infrastructure will enable First Merchants to face the future
with confidence.
has become, First Merchants
Our community banking model and customer-centric approach is rooted in building trusted
is pleased to have earned
relationships that are not easily shaken, and backed by the financial resources to meet
our stakeholders’ needs. This combination allows us to deliver scalable financial solutions
with personalized service by experienced local financial professionals. We are not certain
how long, how deep, or how wide this recession will run; but we are confident that these
more than $20 million in
net income in 2008, while
strengths, leveraged by our talented, dedicated team, forge a company that has and will
building its allowance for loan
continue to stand the test of time.
loss, recognizing the negative
economic trends nationally
and in the Midwest.
• We are intently focused on proactively managing credit issues
using a multi-faceted approach.
We have reorganized our risk and credit structures internally to ensure that we have
the right talent and infrastructure in place to oversee both short and long- term issues.
Additionally, we have conducted deep reviews of our commercial loan portfolio
to identify weakness. Resources have been focused on managing those
relationships to minimize loss wherever possible, and manage loss
when imminent. Our community bank model offers us an edge in
our ability to know our customers and closely monitor their situations.
We manage our credit risk by setting sound credit policies for
underwriting new business, while monitoring and reviewing
the performance of our loan portfolio. Interest rate and market risks
inherent in our asset and liability balances are managed within
prudent ranges, while ensuring adequate liquidity and funding.
We maintain strong capital levels to provide for future growth.
Charles E. Schalliol, Chairman of the Board and
Michael C. Rechin, President & Chief Executive Officer
1
a n n u a l r e p o r t 2 0 0 8
• Our capital position enables us to aggressively manage
the balance sheet and loan portfolios.
As you know, First Merchants chose to participate in the Capital Purchase Program offered
through the U.S. Department of Treasury. While our stakeholders hold varied views around
public policy such as TARP, EESA and CPP, we have weighed those considerations carefully.
The decision to participate in the Capital Purchase Program was based on our desire to add
We continue to maintain leading
the lowest cost capital in order to support continued economic growth in Central Indiana
market positions in deposits in
opportunities support the markets where our customers and employees live and work.
and Ohio. Extending credit renewals and new credit for appropriately structured lending
many communities within
our banking footprint.
• Our deposit growth and liquidity remain strong.
Total deposits in 2008 grew by $220 million. Our responsive delivery model provides
customers a place to feel safe depositing their money. We believe the continued growth
These valued relationships
in deposits demonstrates a vote of confidence in our organization.
are core to our continued
The acquisition of Lincoln Bancorp in 2008 aligns with our strategic vision to expand the
growth and ability to serve the
First Merchants’ footprint where emerging opportunities and markets exist. With locations
in Johnson, Hendricks, Brown, Morgan, Montgomery and Clinton counties, we have the
community markets in which
opportunity to drive growth in some of Indiana’s largest growing counties and communities.
your company was built.
Lincoln Bank has a solid community banking reputation that has been established over
their long history, and mirrors the First Merchants’ culture of partnership with both our
customers and communities. With convenience as an intended benefit, First Merchants
Corporation, the largest financial services holding company in Central Indiana, will serve
customers in 24 Indiana and 3 Ohio counties.
We remain confident that
our people, strategies, capital,
We continue to maintain leading market positions in deposits in many communities within
our banking footprint. These valued relationships are core to our continued growth and
ability to serve the community markets in which your company was built.
First Merchants Corporation’s management team is focused on five objectives in 2009,
liquidity, and commitment to
including asset quality, capital and liquidity management, net interest margin management,
endure the current environment
will prove successful in the
expense management and the success of the Lincoln Bank integration. We remain confident
that our people, strategies, capital, liquidity, and commitment to endure the current
environment will prove successful in the short and long-term time horizon.
short and long-term time horizon.
• Our commitment to you.
I want to personally thank you as a valued shareholder for your commitment to
First Merchants. We have certainly enjoyed success over many years, and believe
that our future is bright and strong!
2
Sincerely,
Michael C. Rechin
President and Chief Executive Officer
f i r s t m e r c h a n t s c o r p o r a t i o n b o a r d & e x e c u t i v e o f f i c e r s
bOArd OF direcTOrS
execuTive OFFicerS
• charles e. schalliol
• Michael c. rechin
Chairman of the Board
Baker & Daniels, LLP
Of Counsel
First Merchants Corporation
President
Chief Executive Officer
• thoMas B. clark
Jarden Corporation
Chairman of the Board
President
Chief Executive Officer (retired)
• Michael l. cox
• roDerick english
• Dr. Jo ann M. gora
First Merchants Corporation
President
Chief Executive Officer (retired)
The James Monroe Group, LLC
President
Chief Executive Officer
Ball State University
President
• WilliaM l. hoy
Columbus Sign Company
Chief Executive Officer
• Barry J. huDson
First National Bank
Chairman of the Board (retired)
• terry l. Walker
Muncie Power Products, Inc.
Chairman of the Board
Chief Executive Director
• Jean l. WoJtoWicz
Cambridge Capital
Management Corp.
President
Chief Executive Officer
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
Michael c. rechin
President
Chief Executive Officer
Mark k. hardwick
Executive Vice President
Chief Financial Officer
Michael J. stewart
Executive Vice President
Chief Banking Officer
Jami l. Bradshaw
Senior Vice President
Chief Accounting Officer
robert r. connors
Senior Vice President
Chief Information Officer
kimberly J. ellington
Senior Vice President
Human Resources Director
Jeffrey B. lorentson
Senior Vice President
Chief Risk Officer
David W. spade
Senior Vice President
Chief Credit Officer
bOArd cOMMiTTeeS
executive coMMittee
terry l. Walker, chairperson
Barry J. hudson
Michael c. rechin
charles e. schalliol
auDit coMMittee
Jean l. Wojtowicz, chairperson
thomas B. clark
William l. hoy
terry l. Walker
coMpensation &
huMan resources coMMittee
charles e. schalliol, chairperson
thomas B. clark
roderick english
noMinating/
governance coMMittee
thomas B. clark, chairperson
Jo ann M. gora
charles e. schalliol
Jean l. Wojtowicz
pension & retireMent
incoMe & savings plan
aDMinistrative coMMittee
kimberly J. ellington, plan administrator
Jami l. Bradshaw
Michael c. rechin
3
f i r s t m e r c h a n t s c o r p o r a t i o n a f f i l i a t e s b o a r d s o f d i r e c t o r s
arthur W. Jasen
B. Walter & Co., Inc.
President
Mark a. kaehr
R & K Incinerator
President
eric J. kelly
Masonry Services, Inc.
President
Dr. Bonnie r. Maitlen
Lee Lecht Harrison
Senior Vice President
James a. Meinerding
First Merchants Bank
President
Chief Executive Officer
Jon h. Moll
DeFur Voran, LLP
Partner
gerald s. paul
Medreco, Inc.
President
robert M. pearson
Wabash County REMC
Chief Executive Officer
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
ronald k. fauquher
Chairman of the Board
Ontario Systems, LLC
Senior Vice President
Dennis a. Bieberich
First Merchants Bank
Senior Executive Officer
kevan B. Biggs
Ideal Suburban Homes, Inc.
Chief Executive Officer
thomas e. chalfant
Chalfant Farms, Inc.
Vice President
richard a. Daniels
McCullough-Hyde
Memorial Hospital
President
Chief Executive Officer (retired)
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 Officer
Mark k. hardwick
First Merchants Corporation
Executive Vice President
Chief Financial Officer
John W. hartmeyer
Al Pete Meats, Inc.
Chief Executive Officer
• First Merchants bank of central indiana
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 Officer
george r. likens
Chairman of the Board
Farmer
Michael l. Baker
First Merchants Bank
of Central Indiana
President
Chief Executive Officer
Dr. James l. edwards
Anderson University
President
Jeffrey a. Jenness
Board of Pensions
Church of God
Executive Secretary
Joseph r. kilmer
Attorney at Law
4
• commerce National bank
• Lafayette bank & Trust company
• First Merchants Trust company
thomas D. Mcauliffe
Commerce National Bank
Chairman of the Board
Jameson crane, Jr.
Crane Group Co.
Vice President
rhonda J. DeMuth
TDCI, Inc.
Chief Executive Officer
William l. hoy
Columbus Sign Company
Chief Executive Officer
clark kellogg
CBS Sports
Basketball Analyst
John a. romelfanger
H & S Forest Products, Inc.
Chief Executive Officer
John W. royer
Kohr, Royer, Griffith, Inc. (KRG)
President
Mark c. ryan
New Albany Board of Education
Board Member
David l. Winks
Capital Lighting, Inc.
Vice President
Jeffrey l. kessler
Chairman of the Board
Stall & Kessler Diamond Center
Co-Owner
tony s. albrecht
Lafayette Bank & Trust Company
President
Chief Executive Officer
Jason J. Bricker
Kirby Risk Corporation
Executive Vice President
Chief Financial Officer
Joann Brouillette
Demeter LP
Managing Partner
kelly v. Busch
KVB Broadcasting
Managing General Partner
Joseph B. hornett
Purdue Research Foundation
Senior Vice President
Treasurer
Mark e. howard
Howard & Sons
President
gary J. lehman
Fairfield Manufacturing Company, Inc.
President
Chief Executive Officer
eric p. Meister
GTE North, Inc.
Central Division Manager (retired)
Michael c. rechin
First Merchants Corporation
President
Chief Executive Officer
• Lincoln bank
Jerry r. holifield
Chairman of the Board
Plainfield Community Schools
Superintendent (retired)
lester n. Bergum, Jr.
Robison, Robison, Bergum & Johnson
Attorney at Law
Partner
Dennis W. Dawes
Hendricks Regional Health
President
Jerry r. engle
Lincoln Bank
President
Chief Executive Officer
W. thomas harmon
Town and Country Homecenter, Inc.
Co-Owner
r. J. Mcconnell
Bose McKinney & Evans, LLP
Attorney at Law
Partner
David e. Mansfield
The Excel Group
Vice President (retired)
patrick a. sherman, cpa
Sherman & Armbruster, LLP
Partner
Jon h. Moll
Chairman of the Board
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 Officer
terri e. Matchett
First Merchants Trust Company
President
Chief Executive Officer
Michael c. rechin
First Merchants Corporation
President
Chief Executive Officer
• First Merchants
insurance Group
Mark k. hardwick
Chairman of the Board
First Merchants Corporation
Executive Vice President
Chief Financial Officer
Michael D. gilbert
First Merchants Insurance Services
Senior Vice President
James a. Meinerding
First Merchants Bank
President
Chief Executive Officer
Michael c. rechin
First Merchants Corporation
President
Chief Executive Officer
curt l. stephenson
First Merchants Insurance Services
President
Chief Executive Officer
• First Merchants
reinsurance co., LTd.
Mark k. hardwick
Chairman of the Board
First Merchants Corporation
Executive Vice President
Chief Financial Officer
Jami l. Bradshaw
Secretary and Treasurer
First Merchants Corporation
Senior Vice President
Chief Accounting Officer
Michael c. rechin
Director
First Merchants Corporation
President
Chief Executive Officer
UNITED STATES
UNITED STATES
UNITED STATES
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
SECURITIES AND EXCHANGE COMMISSION
SECURITIES AND EXCHANGE COMMISSION
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, 2008
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
FIRST MERCHANTS CORPORATION
FIRST MERCHANTS CORPORATION
FIRST MERCHANTS CORPORATION
(Exact name of registrant as specified in its charter)
1544218
Indiana 35----1544218
Indiana 35
1544218
1544218
Indiana 35
Indiana 35
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
200 East Jackson
200 East Jackson
200 East Jackson
200 East Jackson
47305----2814281428142814
47305
47305
47305
Muncie, Indiana
Muncie, Indiana
Muncie, Indiana
Muncie, Indiana
(Zip Code)
(Address of principal executive offices)
(765) 747----1500150015001500
Registrant's telephone number, including area code: (765) 747
(765) 747
(765) 747
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
Common Stock, $.125 stated value per share
Common Stock, $.125 stated value per share
Common Stock, $.125 stated value per share
(Title of class)
(Title of class)
(Title of class)
(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. [ ]
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 $330,723,000 as of the last business day of the registrant's most recently completed second fiscal quarter (June 30, 2008).
As of February 27, 2009 there were 21,178,488 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 May 6, 2009
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
5
23
27
28
28
28
29
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 33
44
Quantitative and Qualitative Disclosure about Market Risk
Financial Statements and Supplementary Data
45
Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure
Controls and Procedures
Other Information
82
82
83
30
32
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
84
84
84
84
84
85
Item 15.
Exhibits and Financial Statement Schedules
2
FIVE-YEAR SUMMARY OF SELECTED FINANCIAL DATA
==================================================================================================================================
(Dollars in Thousands, except share data) 2008 2007 2006 2005 2004
==================================================================================================================================
Operations
Net Interest Income
Fully Taxable Equivalent (FTE) Basis .............. $ 133,083 $ 117,247 $ 114,076 $ 114,907 $ 108,986
Less Tax Equivalent Adjustment ......................... 3,699 4,127 3,981 3,778 3,597
---------- ---------- ---------- ---------- ----------
Net Interest Income .................................... 129,384 113,120 110,095 111,129 105,389
Provision for Loan Losses .............................. 28,238 8,507 6,258 8,354 5,705
---------- ---------- ---------- ---------- ----------
Net Interest Income
After Provision for Loan Losses ................... 101,146 104,613 103,837 102,775 99,684
Total Other Income ..................................... 36,367 40,551 34,613 34,717 34,554
Total Other Expenses ................................... 108,792 102,182 93,057 93,957 91,642
---------- ---------- ---------- ---------- ----------
Income Before Income Tax Expense .................. 28,721 42,982 42,393 43,535 42,596
Income Tax Expense ..................................... 8,083 11,343 12,195 13,296 13,185
---------- ---------- ---------- ---------- ----------
Net Income ............................................. $ 20,638 $ 31,639 $ 30,198 $ 30,239 $ 29,411
========== ========== ========== ========== ==========
Per Share Data 1
Basic Net Income ....................................... $ 1.14 $ 1.73 $ 1.64 $ 1.64 $ 1.59
Diluted Net Income ..................................... 1.14 1.73 1.64 1.63 1.58
Cash Dividends Paid .................................... .92 .92 .92 .92 .92
December 31 Book Value ................................. 18.69 18.88 17.75 17.02 16.93
December 31 Market Value (Bid Price) ................... 22.21 27.84 27.19 26.00 28.30
Average Balances 2
Total Assets ........................................... $3,811,166 $3,639,772 $3,371,386 $3,179,464 $3,109,104
Total Loans 3
........................................... 3,002,628 2,794,824 2,569,847 2,434,134 2,369,017
Total Deposits ......................................... 2,902,902 2,752,443 2,568,070 2,418,752 2,365,306
Securities Sold Under Repurchase Agreements
(long-term portion) ............................... 34,250 23,813 181
Total Federal Home Loan Bank Advances .................. 237,791 259,463 234,629 227,311 225,375
Total Subordinated Debentures, Revolving
Credit Lines and Term Loans ...................... 107,752 104,680 99,456 106,811 96,230
Total Stockholders' Equity ............................. 349,594 330,786 319,519 315,525 310,004
Year-end Balances 2
Total Assets ........................................... $4,784,155 $3,782,087 $3,554,870 $3,237,079 $3,191,668
Total Loans 3
........................................... 3,726,247 2,880,578 2,698,014 2,462,337 2,431,418
Total Deposits ......................................... 3,718,811 2,884,121 2,750,538 2,382,576 2,408,150
Securities Sold Under Repurchase Agreements
(long-term portion) .............................. 34,250 34,250 320
Total Federal Home Loan Bank Advances .................. 360,217 294,101 242,408 247,865 223,663
Total Subordinated Debentures, Revolving
Credit Lines and Term Loans ...................... 135,826 115,826 83,956 103,956 97,206
Total Stockholders' Equity ............................. 395,903 339,936 327,325 313,396 314,603
Financial Ratios
Return on Average Assets ............................... .54% .87% .90% .95% .95%
Return on Average Stockholders' Equity ................. 5.90 9.56 9.45 9.58 9.49
Average Earning Assets to Total Assets 2
................ 72.39 90.15 91.15 90.93 90.28
Allowance for Loan Losses as % of Total Loans .......... 1.33 .98 .99 1.02 .93
Dividend Payout Ratio .................................. 80.70 53.18 56.10 56.44 58.23
Average Stockholders' Equity to Average Assets ......... 9.17 9.09 9.48 9.92 9.97
Tax Equivalent Yield on Earning Assets ................ 6.44 7.10 6.92 6.26 5.72
Cost of Supporting Liabilities ......................... 2.60 3.55 3.21 2.29 1.84
Net Interest Margin on Earning Assets .................. 3.84 3.55 3.71 3.97 3.88
1 Restated for all stock dividends and stock splits.
2 On December 31, 2008, the corporation acquired 100 percent of the outstanding stock of Lincoln Bancorp, the holding company of Lincoln Bank,
which is located in Plainfield, Indiana. Lincoln Bank is a state chartered bank with branches in central Indiana. Lincoln Bancorp was merged
into the Corporation and Lincoln Bank maintained its bank charter as a subsidiary of the Corporation. The Corporation issued approximately
3,040,415 shares of its common stock at a cost of $19.78 per share and approximately $16.8 million in cash to complete the transaction. As a
result of the acquisition, the Corporation has an opportunity to increase its customer base and continue to increase its market share. The
purchase had a recorded acquisition price of $77,290,000, including investments of $122,093,000; loans of $628,277,000, premises and equipment
of $15,624,000; other assets of $86,091,000; deposits of $655,370,000; other liabilities of $136,280,000 and goodwill of $19,813,000.
Additionally, core deposit intangibles totaling $12,461,000 were recognized and will be amortized over ten years. The combination was
accounted for under the purchase method of accounting. All assets and liabilities were recorded at their fair values as of December 31, 2008.
The purchase accounting adjustments are being amortized over the life of the respective asset or liability.
3 Includes loans held for sale.
3
FORWARD-LOOKING STATEMENTS
First Merchants Corporation (the “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
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 Global Select Market System under the symbol
FRME and was organized in September 1982. Since its organization, the Corporation has grown to include five
affiliate banks with eighty-two locations in twenty-four 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:
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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;
Commerce National Bank (“Commerce”) in Franklin and Hamilton counties in Ohio; and
Lincoln Bank (“Lincoln”) in Brown, Clinton, Hamilton, Hendricks, Johnson, Montgomery and Morgan
counties.
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.
In addition, the Corporation operates First Merchants Reinsurance Co. Ltd. (“FMRC”), a small life
reinsurance company whose primary business includes 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. FMRC 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 company
also issues guaranteed asset protection contracts, which are limited to the amount of the loan on these
guaranteed asset protection contracts and are issued on loans up to a maximum of $50,000. The total self-
insurance exposure for all contracts as of December 31, 2008 totaled $19.1 million.
All inter-company transactions are eliminated during the preparation of consolidated financial statements.
On December 31, 2008, the Corporation acquired Lincoln Bancorp, parent company of Lincoln Bank, through a
merger of Lincoln Bancorp into the Corporation. Lincoln Bank adds seventeen Indiana banking locations in
the Indianapolis area. The banking locations are in Avon, Bargersville, Brownsburg, Crawfordsville,
Frankfort, Franklin, Greenwood, Mooresville, Morgantown, Nashville, Plainfield and Trafalgar. Lincoln also
has two loan production offices located in Carmel and Greenwood, Indiana.
On December 31, 2008, the Corporation sold its interest in Indiana Title Insurance Company, LLC, a full
service title insurance agency.
As of December 31, 2008, the Corporation had consolidated assets of $4.8 billion, consolidated deposits of
$3.7 billion and stockholders' equity of $396 million. The Corporation is presently engaged in conducting
commercial banking business through the offices of its five banking subsidiaries. As of December 31, 2008,
the Corporation and its subsidiaries had 1,367 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 the reinsurance of credit life, accident, and health insurance.
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PART I: ITEM 1. BUSINESS
GENERAL continued
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. 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. Cynthia 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 percent 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.
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PART I: ITEM 1. BUSINESS
CAPITAL ADEQUACY GUIDELINES FOR BANK HOLDING COMPANIES
The BHC Act does not place territorial restrictions on such non-banking related activities. 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 percent (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.
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 percent 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 percent above the stated minimum.
The following are the Corporation's regulatory capital ratios as of December 31, 2008:
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Regulatory Minimum
Corporation Requirement
=============================================================================
Tier 1 Capital: 7.71% 4.0%
(to Risk-weighted Assets)
Total Capital: 10.24% 8.0%
BANK REGULATION
Four 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.
Lincoln is an Indiana commercial bank, subject to examination by the Indiana Department of Financial
Institutions (“IDFI”) and the Federal Deposit Insurance Corporation (“FDIC”). The IDFI and the FDIC
regulate or monitor virtually all areas of Lincoln’s operations. Lincoln must undergo regular on-site
examinations by the FDIC and IDFI and must submit periodic reports to the FDIC and the IDFI. The
Corporation plans to merge Lincoln with Central Indiana under the Central Indiana charter and has applied
to the OCC for approval of the merger.
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 percent. 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 percent 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 percent plus an additional 1 to 2 percent.
All of the Corporation's affiliate banks exceed the minimum risk-based capital guidelines of the OCC as of
December 31, 2008.
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PART I: ITEM 1. BUSINESS
FDIC IMPROVEMENT ACT OF 1991
The 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
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, 2008, four of the five bank subsidiaries of the Corporation were "well capitalized"
based on the "prompt corrective action" ratios and deadlines described above. Lincoln was not considered
well capitalized at December 31, 2008. However, on February 20, 2009, the Corporation added $30 million in
capital to Lincoln, which returned them to well capitalized status. It should be noted 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.
PARTICPATION IN THE CPP UNDER EESA
In response to the ongoing financial crisis affecting the banking system and financial markets, the
Emergency Economic Stabilization Act of 2008 (“EESA”) was signed into law on October 3, 2008, which
established the Troubled Assets Relief Program (“TARP”). As part of TARP, the United States Department of
the Treasury (the “Treasury”) established the Capital Purchase Program (“CPP”) to provide up to $700
billion of funding to eligible financial institutions through the purchase of mortgages, mortgage-backed
securities, capital stock and other financial instruments for the purpose of stabilizing and providing
liquidity to the U.S. financial markets.
On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law by
President Obama. ARRA includes a wide variety of programs intended to stimulate the economy and provide for
extensive infrastructure, energy, health, and education needs. In addition, ARRA imposes certain new
executive compensation and corporate expenditure limits on all current and future TARP recipients,
including the Corporation, until the institution has repaid the Treasury, which is now permitted under ARRA
without penalty and without the need to raise new capital, subject to the Treasury’s consultation with the
recipient’s appropriate regulatory agency.
On February 20, 2009, First Merchants completed the sale to the Treasury of $116.0 million of newly issued
First Merchants non-voting preferred shares as part of the CPP enacted as part of the TARP, under the ESSA.
The Treasury has certain supervisory and oversight duties and responsibilities under EESA and the CPP and,
pursuant to the terms of a Letter Agreement and a Securities Purchase Agreement – Standard Terms attached
thereto (collectively, the “Securities Purchase Agreement”), the Treasury is empowered to unilaterally
amend any provision of the Securities Purchase Agreement with First Merchants to the extent required to
comply with any changes in applicable federal statutes.
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.
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PART I: ITEM 1. BUSINESS
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, 2008, the
Corporation's affiliate banks had a total of $42,856,000 retained net profits available for 2009 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
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
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PART I: ITEM 1. BUSINESS
USA PATRIOT ACT continued
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:
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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;
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.
It also 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
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PART I: ITEM 1. BUSINESS
ADDITIONAL MATTERS Continued
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.
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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:
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Interest Interest Interest
Average Income/ Average Average Income/ Average Average Income/ Average
(Dollars in Thousands) Balance Balance Rate Balance Balance Rate Balance Balance Rate
================================================================================================================================
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2008 2007 2006
Assets:
Federal Funds Sold ............ $ 2,604 $ 28 1.1% $ 3,308 $ 172 5.2% $ 6,983 $ 373 5.3%
Interest-bearing Deposits...... 22,576 755 3.3 10,580 582 5.5 7,831 500 6.4
Federal Reserve and
Federal Home Loan Bank Stock. 25,425 1,391 5.5 24,221 1,299 5.4 23,473 1,256 5.4
Securities: 1
Taxable ....................... 259,013 12,046 4.7 300,854 13,744 4.6 289,692 12,316 4.3
Tax-exempt 2
................... 151,231 9,009 6.0 175,152 10,074 5.8 175,072 10,100 5.8
---------- -------- ---------- -------- ---------- --------
Total Securities............. 410,244 21,055 5.1 476,006 23,818 5.0 464,764 22,416 4.8
Mortgage Loans Held for Sale..... 3,614 268 7.4 6,107 549 9.0 4,620 176 3.8
Loans: 3
Commercial .................... 2,248,255 149,988 6.7 1,955,750 151,158 7.7 1,704,026 128,888 7.6
Real Estate Mortgage........... 355,540 22,357 6.3 412,008 26,288 6.4 441,407 27,813 6.3
Installment ................... 371,813 25,771 6.9 400,191 29,276 7.3 405,006 29,891 7.4
Tax-exempt 2
................... 23,406 1,558 6.7 20,768 1,718 8.3 14,788 1,274 8.6
---------- -------- ---------- -------- ---------- --------
Total Loans ................. 3,002,628 199,942 6.7 2,794,824 208,989 7.5 2,569,847 188,042 7.3
---------- -------- ---------- -------- ---------- --------
Total Earning Assets......... 3,463,477 223,172 6.4 3,308,939 234,860 7.1 3,072,898 212,587 6.9
---------- -------- ---------- -------- ---------- --------
Net Unrealized Gain (Loss) on Securities
Available for Sale........... 1,383 (3,624) (7,353)
Allowance for Loan Losses........ (32,383) (27,495) (26,443)
Cash and Due from Banks.......... 75,553 64,571 58,305
Premises and Equipment .......... 44,601 43,945 40,227
Other Assets .................... 258,535 253,436 233,752
--------- --------- ---------
Total Assets ................ $3,811,166 $3,639,772 $3,371,386
========== ========== ==========
Liabilities:
Interest-bearing Deposits:
NOW Accounts ................ $ 527,993 5,526 1.0% $ 490,908 11,034 2.2% $ 396,477 $ 6,065 1.5%
Money Market Deposit Accounts 276,579 3,954 1.4 246,706 7,648 3.1 251,746 7,551 3.0
Savings Deposits ............ 274,320 2,075 0.8 264,134 4,604 1.7 259,052 3,927 1.5
Certificates and Other
Time Deposits ............. 1,445,843 56,026 3.9 1,407,151 66,635 4.7 1,333,408 56,771 4.3
---------- -------- ---------- -------- ---------- --------
Total Interest-bearing
Deposits..................... 2,524,735 67,581 2.7 2,408,899 89,921 3.7 2,240,683 74,314 3.3
Borrowings ...................... 528,397 22,508 4.3 515,562 27,692 5.4 445,806 24,197 5.4
---------- -------- ---------- -------- ---------- --------
Total Interest-bearing
Liabilities................. 3,053,132 90,089 3.0 2,924,461 117,613 4.0 2,686,489 98,511 3.7
Noninterest-bearing Deposits..... 378,167 343,544 327,387
Other Liabilities ............... 30,273 40,981 37,991
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Total Liabilities............ 3,461,572 3,308,986 3,051,867
Stockholders' Equity ............ 349,594 330,786 319,519
---------- -------- ---------- ------- ---------- --------
Total Liabilities and
Stockholders' Equity........ $3,811,166 90,089 2.6 $3,639,772 117,613 3.6 $3,371,386 98,511 3.2
========== -------- ========== -------- ========== --------
Net Interest Income ......... $133,083 $117,247 $114,076
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Net Interest Margin.......... 3.8% 3.5% 3.7%
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 2008, 2007 and 2006.
Those totals equal $3,699, $4,127, and $3,981, respectively.
3 Nonaccruing loans have been included in the average balances.
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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
================================================================================================================================
2008 Compared to 2007 2007 Compared to 2006
Volume Rate Total Volume Rate Total
======== ======== ======= ======== ======== =======
Interest Income:
Federal Funds Sold ............... $ (30) $ (114) $ (144) $ (298) $ 97 $ (201)
Interest-bearing Deposits ........ 468 (295) 173 200 (118) 82
Federal Reserve and Federal
Home Loan Bank Stock ........... 65 27 92 40 3 43
Securities ....................... (3,362) 599 (2,763) 550 852 1,402
Mortgage Loans Held for Sale ..... (197) (84) (281) 71 302 373
Loans ............................ 15,017 (23,782) (8,765) 16,640 3,934 20,574
-------- --------- --------- -------- --------- ---------
Totals ........................... 11,961 (23,649) (11,688) 17,203 5,070 22,273
-------- --------- --------- -------- --------- ---------
Interest Expense:
NOW Accounts ..................... 778 (6,286) (5,508) 1,673 3,296 4,969
Money Market Deposit
Accounts........................ 835 (4,529) (3,694) (153) 250 97
Savings Deposits.................. 171 (2,700) (2,529) 78 599 677
Certificates and Other
Time Deposits................... 1,788 (12,397) (10,609) 3,256 6,608 9,864
Borrowings........................ 674 (5,858) (5,184) 3,749 (254) 3,495
-------- --------- --------- -------- --------- ---------
Totals.......................... 4,246 (31,770) (27,524) 8,603 10,499 19,102
-------- --------- --------- -------- --------- ---------
Change in Net Interest
Income (Fully Taxable
Equivalent Basis)................ $ 7,715 $ 8,121 $ 15,836 $ 8,600 $ (5,429) $ 3,171
======== ========= ======== =========
Tax Equivalent Adjustment
Using Marginal Rate
of 35% for 2008, 2007,
and 2006.......................... 428 (146)
---------- ----------
Change in Net Interest
Income........................... $ 16,264 $ 3,025
========= ==========
INVESTMENT SECURITIES
The Corporation’s management has evaluated all securities with unrealized losses for other than temporary
impairment as of December 31, 2008. The evaluations are based on the nature of the securities, the extent
and duration of the loss and the intent and ability of the Corporation to hold these securities either to
maturity or through the expected recovery period.
The current unrealized losses are primarily concentrated within trust preferred securities held by the
Corporation. The Corporation holds ten trust preferred pool securities and four single issuer securities.
Such investments have an amortized cost of $18.8 million and a fair value of $9.8, which is only 2 percent
of the Corporation’s entire investment portfolio. On all but one small pool investment, the Corporation
utilized broker quotes to determine their fair value.
The Corporation utilizes a third party for portfolio accounting services, including market value input.
The Corporation has obtained an understanding of what inputs are being used by the vendor in pricing our
portfolio and how the vendor was classifying these securities based upon these inputs. From these
discussions, the Corporation’s management is comfortable the classifications are proper. The Corporation
has gained trust in the data for two reasons: (a) independent spot testing of the data is conducted by the
Corporation through obtaining market quotes from various brokers on a periodic basis and (b) actual gains
or loss resulting from the sale of certain securities has proven the data to be accurate over time.
13
PART I: ITEM 1. BUSINESS
INVESTMENT SECURITIES continued
The fair values of the investments have been impacted by the recent market conditions which have caused
risk and liquidity premiums to increase resulting in a significant decline in the fair value of the
Corporation’s trust preferred securities, or the value the Corporation could realize if it were forced to
immediately sell the securities into the secondary market. Management has determined that (a) the drop in
market value is primarily a result of illiquidity in the current market rather than poor performance, and
(b) there has not been an adverse change in future cash flows of the securities.
The Corporation has the intent and ability to hold these, and all other, investment securities until the
fair value is recovered, which may be maturity, and therefore, does not consider them, with one exception,
to be other-than-temporarily impaired at December 31, 2008. The one exception is a smaller trust preferred
pool that has been deemed other than temporarily impaired, due to a higher rate of defaults and deferrals
from the underlying banks in the pool and collateral position. A $1.2 million loss was included in the
earnings for 2008 establishing a new cost basis of $770,000.
During 2008, the Corporation owned shares of a series of preferred stock issued by the Federal Home Loan
Mortgage Corporation (“FHLMC”). On September 7, 2008, the Federal Housing Finance Agency (“FHFA”) was
appointed as conservator of FHLMC, and the U.S. Treasury Department disclosed that it had entered into a
Senior Preferred Stock Purchase Agreement with FHLMC, contemplating an investment of up to $100 billion.
The senior preferred stock has a liquidation preference senior to all FHLMC stock, including the series of
preferred stock held by the Corporation. In addition, the terms of the senior preferred stock prohibit
FHLMC from declaring or paying any dividend or making any other distribution with respect to any stock
other than the senior preferred stock without the consent of the U.S. Treasury Department. In connection
with the appointment of the FHFA as conservator, the FHFA announced that it was eliminating the payment of
all future dividends on all FHLMC stock, including dividends on the series of preferred stock that the
Corporation owns. After assessing these events, during the third quarter of 2008, the Corporation recorded
an other-than-temporary impairment write-down of $1,458,000 related to its investments in the preferred
securities issued by FHLMC. The investment was sold during the fourth quarter of 2008 triggering an
additional $47,000 loss.
14
PART I: ITEM 1. BUSINESS
INVESTMENT SECURITIES continued
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, 2008
U.S. Government-sponsored Agency Securities.. $ 15,451 $ 218 $ 15,669
State and Municipal ......................... 156,426
3,220 $ 107 159,539
Mortgage-backed Securities .................. 265,820 4,472 215 270,077
Corporate Obligations........ ............... 19,822 8,978 10,844
3,507
Marketable Equity Securities ................ 3,507
-------- -------- -------- --------
Total Available for Sale ................. 461,026 7,910 9,300 459,636
-------- -------- -------- --------
Held to Maturity at December 31, 2008
1 11,674
U.S. Treasury ............................... 11,675
State and Municipal ......................... 10,666 93 264 10,495
Mortgage-backed Securities .................. 7
7
-------- -------- -------- --------
Total Held to Maturity ................... 22,348 93 265 22,176
-------- -------- -------- --------
Total Investment Securities .............. $483,374 $ 8,003 $ 9,565 $481,812
======== ======== ======== ========
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
======== ======== ======== ========
15
PART I: ITEM 1. BUSINESS
INVESTMENT SECURITIES continued
====================================================================================================================
(Dollars in Thousands)
Cost Yield Cost Yield Cost Yield
====================================================================================================================
2008
2007 2006
Federal Reserve and Federal Home Loan
Bank Stock at December 31:
Federal Reserve Bank Stock .................... $ 9,276 6.0% $ 9,223 6.0% $ 9,091 6.0%
Federal Home Loan Bank Stock .................. 25,043 4.3 16,027 4.3 14,600 4.3
------- ------- -------
Total ..................................... $34,319 4.7% $25,250 4.9% $23,691 4.9%
======= ======= =======
----- ----- -----
The fair value of Federal Reserve and Federal Home Loan Bank stock approximates cost.
There were no issuers included in our investment security portfolio at December 31, 2008, 2007 or 2006
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, 2008 were:
Securities available for sale December 31, 2008:
================================================================================================================================
Within 1 Year 1-5 Years 5-10 Years
(Dollars in Thousands) Amount Yield1 Amount Yield1 Amount Yield1
================================================================================================================================
U.S. Government-sponsored Agency Securities.. $ 8,088 4.8% $ 7,482 3.9% $ 99 4.8%
State and Municipal.......................... 22,858 4.7 67,861 5.7 35,219 6.5
Corporate Obligations ....................... 1,034 5.0
------- -------- -------
Total.................................... $30,946 4.7% $ 76,377 5.5% $35,318 6.5%
======= ======== =======
Marketable Equity
and Mortgage -
Due After Ten Years Backed Securities Total
------------------- ----------------------- -----
Amount Yield1 Amount Yield1 Amount Yield1
------ ------ ------ ------ ------ ------
U.S. Government-sponsored
Agency Securities................. $ 15,669 4.3%
State and Municipal.................. $ 33,601 7.3% 159,539 6.1
Marketable Equity Securities......... $ 3,507 4.1% 3,507 4.1
Corporate Obligations ............... 9,810 3.3 10,844 3.5
Mortgage-backed Securities........... 253,325 5.5 253,325 5.5
Other Asset Backed Securities………………..
4.0 16,752 4.0
-------- --------- --------
Total............................ $ 43,411 6.4% $ 273,584 5.4% $459,636 5.5%
======== ========= ========
16,752
Securities held to maturity at December 31, 2008:
===========================================================================================================================
Within 1 Year 1-5 Years 5-10 Years
(Dollars in Thousands) Amount Yield1 Amount Yield1 Amount Yield1
===========================================================================================================================
U.S. Treasury........................ $ 11,675 0.0%
State and Municipal.................. 1,456 5.5 $ 435 7.0% $ 3,990 5.9%
-------- --------- ---------
Total............................ $ 13,131 0.6% $ 435 7.0% $ 3,990 5.9%
======== ========= =========
Mortgage-Backed
Due After Ten Years Securities Total
===================== ================= =======
Amount Yield1 Amount Yield1 Amount Yield1
------ ------ ------- ----- ------- ------
U.S. Treasury........................ $ 11,675 0.0%
State and Municipal.................. $ 4,785 8.1% 10,666 6.9
Other Asset-backed Securities........ $ 7 8.4% 7 8.4
------- --------- --------
Total............................ $ 4,785 8.1% $ 7 8.4% $ 22,348 3.3%
======= ========= =========
1 Interest yields on state and municipal securities are presented on a fully taxable equivalent basis using a 35% tax rate.
16
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, 2008 and 2007:
====================================================================================================================================
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, 2008:
U.S. Treasury........................
U.S. Government-sponsored Agency Securities ...............
State and Municipal ....................................... 10,274 (124) $ 3,582 $ (247) 13,856 (371)
Mortgage-backed Securities ................................ 13,315 (47) 11,755 (168) 25,070 (215)
Corporate Obligations ..................................... 7,302 (69) 2,741 (8,909) 10,043 (8,978)
Marketable Equity Securities ..............................
-------- ------ ------- ------- ------- --------
Total Temporarily Impaired Investment Securities ....... $ 42,265 $ (241) $18,078 $(9,324) $60,343 $ (9,565)
======== ====== ======= ======= ======= ========
$ 11,374 $ (1) $11,374 $ (1)
---------
---------------------------------------------------------------------
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, 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)
======== ======= ======== ======= ======== ========
LOAN PORTFOLIO
TYPES OF LOANS
====================================================================================================================================
(Dollars in Thousands) 2008 2007 2006 2005 2004
====================================================================================================================================
Loans at December 31:
Commercial and Industrial Loans.............. $ 904,646 $ 662,701 $ 537,305 $ 461,102 $ 451,227
Agricultural Production
Financing and Other Loans to Farmers....... 135,099 114,324 100,098 95,130 98,902
Real Estate Loans:
Construction............................... 252,487 165,425 169,491 174,783 164,738
Commercial and Farmland.................... 1,202,372 947,234 861,429 734,865 709,163
Residential................................ 956,245 744,627 749,921 751,217 761,163
Individuals' Loans for
Household and Other Personal Expenditures.. 201,632 187,880 223,504 200,139 198,532
Tax-exempt Loans............................. 28,070 16,423 14,423 8,263 8,203
Lease Financing Receivables,
Net of Unearned Income .................... 8,996 8,351 8,010 8,713 11,311
Other Loans.................................. 32,405 29,878 28,420 23,215 24,812
---------- ---------- ---------- ---------- ----------
Allowance for Loan Losses................... (49,543) (28,228) (26,540) (25,188) (22,548)
---------- ---------- ---------- ---------- ----------
Total Loans............................. $3,672,409 $2,848,615 $2,666,061 $2,432,239 $2,405,503
========== ========== ========== ========== ==========
3,721,952 2,876,843 2,692,601 2,457,427 2,428,501
Residential Real Estate Loans Held for Sale at December 31, 2008, 2007, 2006, 2005 and 2004 were
$4,295,000, $3,735,000, $5,413,000, $4,910,000, and $3,367,000, respectively.
17
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,
2008. 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................ $ 465,929 $ 321,246 $ 117,471 $ 904,646
Agricultural Production Financing
and Other Loans to Farmers................... 97,335 32,362 5,402 135,099
Real Estate - Construction..................... 162,326 82,166 7,995 252,487
Real Estate - Commercial and Farmland.......... 372,301 590,368 239,703 1,202,372
Tax-exempt Loans............................... 8,363 11,386 8,321 28,070
Other Loans.................................... 16,125 13,297 2,983 32,405
---------- --------- -------- ----------
Total.................................... $1,122,379 $1,050,825 $ 381,875 $2,555,079
========== ========== ========= ==========
==========================================
Maturing Maturing
1 - 5 Over
Years 5 Years
==========================================
Loans Maturing After One Year with:
Fixed Rate.............................. $ 385,767 $ 277,585
Variable Rate........................... 665,058 104,290
------------- ------------
Total................................. $ 1,050,825 $ 381,875
============= ============
NONACCRUING, CONTRACTUALLY PAST DUE 90 DAYS OR MORE OTHER THAN NONACCRUING AND RESTRUCTURED LOANS
=====================================================================================================================================
(Dollars in Thousands) 2008 2007
=====================================================================================================================================
2006
2005
2004
Non-accrual Loans......................... $ 87,546 $ 29,031 $ 17,926
Loans Contractually Past Due 90
Days or More Other Than Nonaccruing..... 5,982 3,578 2,870 3,965 1,907
Restructured Loans........................ 130 145 84 310 2,019
------- -------- -------- -------- --------
Total Non-performing Loans........... $93,658 $ 32,754 $ 20,880 $ 14,305 $ 19,281
======= ======== ======== ======== ========
$ 10,030
$ 15,355
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. Lincoln accounted for $35,839,000 of the increase
in non-performing loans.
Restructured loans are loans for which the contractual interest rate has been reduced or other concessions
are granted to the borrower, because of 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 $997,000 for the year ended December 31, 2008, was recognized on the nonaccruing and
restructured loans listed in the table above, whereas interest income of $4,056,000 would have been
recognized under their original loan terms.
Potential problem loans:
Management has identified certain other loans totaling $132,391,000 as of December 31, 2008, not included
in the table above, or the impaired loan table in the footnotes to the consolidated financial statements,
about which there are concerns as to the borrowers' ability to comply with present repayment terms. For
the Corporation, all classified 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 central, 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.
18
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) 2008 2007 2006 2005 2004
==============================================================================================================================
Allowance for Loan Losses:
Balance at January1 .................... $ 28,228 $ 26,540 $ 25,188 $ 22,548 $ 25,493
Charge offs:
Commercial and Industrial1 ........... 9,449 2,403 1,369 3,763 7,455
Real Estate Mortgage2 ............... 10,142 4,309 3,613 2,117 1,588
Individuals' Loans for Household and
Other Personal Expenditures,
Including Other Loans................ 3,035 1,845 1,528 1,864 1,858
-------- -------- -------- -------- --------
Total Charge offs.................... 22,626 8,557 6,510 7,744 10,901
-------- -------- -------- -------- --------
Recoveries:
Commercial and Industrial3 ............ 3,401 551 291 1,283 1,629
Real Estate Mortgage4 ................. 2,621 750 863 122 161
Individuals' Loans For Household and
Other Personal Expenditures,
Including Other Loans................ 1,002 437 450 625 461
-------- -------- -------- -------- --------
Total Recoveries..................... 7,024 1,738 1,604 2,030 2,251
-------- -------- -------- -------- --------
Net Charge offs.......................... 15,602 6,819 4,906 5,714 8,650
-------- -------- -------- -------- --------
Provisions for Loan Losses............... 28,238 8,507 6,258 8,354 5,705
Allowance Acquired in Acquisition........ 8,679
-------- -------- -------- -------- --------
Balance at December 31................... $49,543 $28,228 $26,540 $25,188 $22,548
======== ======== ======== ======== ========
Ratio of Net Charge offs During the
Period to Average Loans
Outstanding During the Period.......... .52% .24% .19% .23% .37%
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.
19
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.
====================================================================================================================
2008 2007
(Dollars in Thousands)
====================================================================================================================
Amount Percent Amount Percent
1.................. $ 20,709 36.0% $ 9,598 34.1%
2....................... 22,195 58.6 12,561 58.8
Balance at December 31:
Commercial and Industrial
Real Estate Mortgage
Individuals' Loans for Household and
Other Personal Expenditures,
Including Other Loans..................... 6,539 5.4 5,969 7.1
Unallocated................................. 100 N/A 100 N/A
-------- ------ -------- ------
Totals...................................... $ 49,543 100.0% $ 28,228 100.0%
======== ====== ======== ======
2006 2005
------------------------- -------------------------
Amount Percent Amount Percent
-------- -------- -------- --------
.................. $ 9,598 31.0% $ 7,430 30.9%
2....................... 12,479 60.5 13,149 60.6
Balance at December 31:
Commercial and Industrial1
Real Estate Mortgage
Individuals' Loans for Household and
Other Personal Expenditures,
Including Other Loans..................... 4,363 8.5 4,509 8.5
Unallocated................................. 100 N/A 100 N/A
-------- ------ -------- ------
Totals...................................... $ 26,540 100.0% $ 25,188 100.0%
======== ====== ======== ======
2004
-------------------------
Amount Percent
-------- --------
Balance at December 31:
Commercial and industrial1
.................. $ 16,821 30.9%
2....................... 1,916 60.9
Real estate mortgage
Individuals' Loans for Household and
Other Personal Expenditures,
Including Other Loans..................... 3,711 8.5
Unallocated. .... .......................... 100 N/A
-------- ------
Totals...................................... $ 22,548 100.0%
======== ======
At December 31, 2008, 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 respective 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.
20
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 classified loans, including
substandard, doubtful and loss credits, are included in the impaired loan total. The fair value for
impaired loans is measured based on the value of the collateral securing those loans and is determined
using several methods. The fair value of real estate is generally determined based on appraisals by
qualified licensed appraisers. The appraisers typically determine the value of the real estate by
utilizing an income or market valuation approach. If an appraisal is not available, the fair value may be
determined by using a cash flow analysis. Fair value on other collateral such as business assets is
typically valued by using the financial information such as financial statements and aging reports provided
by the borrower and is discounted as considered appropriate. Information on impaired loans is summarized
below:
=======================================================================================================================
(Dollars in Thousands) 2008 2007 2006
=======================================================================================================================
As of, and for the Year Ending December 31:
Impaired Loans With an Allowance............................ $ 25,397 $ 21,304 $ 17,291
Impaired Loans for which the Discounted
Cash Flows or Collateral Value Exceeds the
Carrying Value of the Loan................................ 180,729 65,645 43,029
------------ ------------ ------------
Total Impaired Loans.................................. $ 206,126 $ 86,949 $ 60,320
============ ============ ============
Total Impaired Loans as a Percent of Total Loans.............. 5.53% 3.02% 2.24%
Allowance for Impaired Loans (Included in the
Corporation's Allowance for Loan Losses).................. $ 9,790 $ 6,034 $ 4,130
Average Balance of Impaired Loans........................... 229,608 103,272 66,139
Interest Income Recognized on Impaired Loans................ 8,078 6,675 5,143
Cash Basis Interest Included Above.......................... 997 1,143 1,364
Lincoln accounted for $56,107,000 of the increase in impaired loans, which were at their fair value on the
acquisition date of December 31, 2009.
21
PART I: ITEM 1. BUSINESS
DEPOSITS
The average balances, interest income and expense and average rates on deposits for the years ended
December 2008, 2007 and 2006 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, 2008, 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.......... $190,738 $108,604 $108,982 $137,757 $546,081
Percent ....................... 35% 20% 20% 25% 100%
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 Annual Report on Form 10-K.
SHORT-TERM BORROWINGS
=============================================================================================
(Dollars in Thousands) 2008 2007 2006
=============================================================================================
Balance at December 31:
Securities Sold Under Repurchase
Agreements (Short-term Portion).................. $ 88,061 $ 72,247 $ 42,750
Federal Funds Purchased............................ 52,350 56,150
-------- -------- --------
Total Short-term Borrowings................ $ 88,061 $124,597 $ 98,900
======== ======== ========
Securities sold under repurchase agreements are borrowings maturing within one year and are secured by U.S.
Treasury and U.S. Government Sponsored Enterprise obligations.
Pertinent information with respect to short-term borrowings is summarized below:
=============================================================================================
(Dollars in Thousands) 2008 2007 2006
=============================================================================================
Weighted Average Interest Rate on Outstanding
Balance at December 31:
Securities Sold Under Repurchase
Agreements (Short-term Portion).............. 0.3% 3.7% 4.4%
Total Short-term Borrowings..................... 0.3 3.9 4.9
Weighted Average Interest Rate During the Year:
Securities Sold Under Repurchase
Agreements(Short-term Portion)............... 1.7% 4.3% 4.4%
Total Short-term Borrowings..................... 2.1 4.9 4.6
Highest Amount Outstanding at Any Month End
During the Year:
Securities Sold Under Repurchase
Agreements (Short-term Portion).............. $ 88,061 $ 98,735 $ 98,765
Total Short-term Borrowings..................... 239,416 226,894 219,337
Average Amount Outstanding During the Year:
Securities Sold Under Repurchase
Agreements (Short-term Portion).............. $ 65,590 $ 62,040 $ 73,818
Total Short-term Borrowings..................... 139,545 127,345 109,577
22
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 current banking crisis, including the Enactment of EESA and ARRA, may significantly affect our
financial condition, results of operations, liquidity or stock price.
The capital and credit markets have been experiencing volatility and disruption for more than a year. In
recent months, the volatility and disruption has reached unprecedented levels. In some cases, the markets
have produced downward pressure on stock prices and credit availability for certain issuers seemingly
without regard to those issuers’ underlying financial strength.
EESA, which established TARP, was signed into law in October 2008. As part of TARP, the Treasury
established the CPP to provide up to $700 billion of funding to eligible financial institutions through the
purchase of capital stock and other financial instruments for the purpose of stabilizing and providing
liquidity to the U.S. financial markets. Then, on February 17, 2009, President Obama signed ARRA, as a
sweeping economic recovery package intended to stimulate the economy and provide for broad infrastructure,
energy, health, and education needs. There can be no assurance as to the actual impact that EESA or its
programs, including the CPP, and ARRA or its programs, will have on the national economy or financial
markets. The failure of these significant legislative measures to help stabilize the financial markets and
a continuation or worsening of current financial market conditions could materially and adversely affect
our business, financial condition, results of operations, access to credit or the trading price of our
common shares.
There have been numerous actions undertaken in connection with or following EESA and ARRA by the Federal
Reserve Board, Congress, the Treasury, the FDIC, the SEC and others in efforts to address the current
liquidity and credit crisis in the financial industry that followed the sub-prime mortgage market meltdown
which began in 2007. These measures include homeowner relief that encourages loan restructuring and
modification; the establishment of significant liquidity and credit facilities for financial institutions
and investment banks; the lowering of the federal funds rate; emergency action against short selling
practices; a temporary guaranty program for money market funds; the establishment of a commercial paper
funding facility to provide back-stop liquidity to commercial paper issuers; and coordinated international
efforts to address illiquidity and other weaknesses in the banking sector. The purpose of these legislative
and regulatory actions is to help stabilize the U.S. banking system. EESA, ARRA and the other regulatory
initiatives described above may not have their desired effects. If the volatility in the markets continues
and economic conditions fail to improve or worsen, our business, financial condition and results of
operations could be materially and adversely affected.
•
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, a
prolonged economic downturn, continued increase in unemployment, or other events that affect household
and/or corporate incomes could result in further deterioration of credit quality, an increase 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
23
PART I: ITEM 1A. AND ITEM 1B.
INDUSTRY RISK FACTORS continued
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.
•
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 of 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.
In connection with recent economic developments, many financial institutions, including the Corporation,
have experienced unusual and significant declines in the performance of their loan portfolios, and the
values of real estate collateral supporting many loans have declined. If current trends in the housing and
real estate markets continue, we expect that loan delinquencies and credit losses may increase. Although
the Corporation believes its underwriting and loan review procedures are appropriate for the various kinds
of loans it makes, the Corporation’s results of operations and financial condition will be adversely
affected in the event the quality of its loan portfolio deteriorates. As of December 31, 2008, the
Corporation had $93,658,000 in non-performing loans and an additional $49,543,000 in allowance for loan
losses.
24
PART I: ITEM 1A. AND ITEM 1B.
CORPORATION RISK FACTORS continued
•
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.
•
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
25
PART I: ITEM 1A. AND ITEM 1B.
CORPORATION RISK FACTORS continued
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.
•
A write-down of all or part of the Corporation’s goodwill could materially reduce its net income
and net worth.
At December 31, 2008, the Corporation had over $143 million of goodwill recorded on its consolidated
balance sheet. Under SFAS No. 142, “Goodwill and Other Intangible Assets," the Corporation is required to
evaluate goodwill for impairment on an annual basis, as well as on an interim basis, if events or changes
indicate that the asset may be impaired. An impairment loss must be recognized for any excess of carrying
value over the "fair value" of goodwill. "Fair value" is determined 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 result in material write-downs of
goodwill and recording of impairment losses. Such a write-down could materially reduce the
Corporation's net income and overall net worth. The Corporation also cannot predict the occurrence of
certain future events that might adversely affect the fair value of goodwill. Such events include, but are
not limited to, strategic decisions made in response to economic and competitive conditions, the effect of
the economic environment on the Corporation’s customer base, or a material negative change in its
relationship with significant customers.
•
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.
•
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
26
PART I: ITEM 1A. AND ITEM 1B.
CORPORATION RISK FACTORS continued
of any divestitures required by regulatory authorities in acquisitions or business combinations may be
greater than expected.
•
The Corporation may not be able to pay dividends in the future in accordance with past practice.
The Corporation has traditionally paid a quarterly dividend to common stockholders. The payment of
dividends is subject to legal and regulatory restrictions. Any payment of dividends in the future will
depend, in large part, on the Corporation’s earnings, capital requirements, financial condition and other
factors considered relevant by the Corporation’s Board of Directors. Additionally, due to our participation
in the CPP, we may not increase our dividend for three years from the date of the Agreement without the
consent of the U.S. Treasury, unless the preferred shares sold to the U.S. Treasury have been redeemed in
whole or transferred to a third party which is not an affiliate of the Corporation.
•
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.
27
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 eighty-two banking offices operated by the Corporation's affiliate
banks, fifty-five are owned by the respective banks and twenty-seven 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, 2008
was $59,641,000.
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 2008 to a vote of security holders, through the
solicitation of proxies or otherwise.
28
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, 50, President and Chief Executive Officer, Corporation
Chief Executive Officer of the Corporation since April 2007; Chief Operating Officer, Corporation from
November 2005 to April 2007; Executive Vice President, Corporate Banking National City Bank from 1995 to
November 2005.
Mark K. Hardwick, 38, 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.
Michael J. Stewart, 43, Executive Vice President and Chief Banking Officer, Corporation
Executive Vice President and Chief Banking Officer of the Corporation since February 2008; Executive Vice
President, Director of Large Corporate Commercial Banking from December 2006 to February 2008 for National
City Corp; Executive Vice President and Chief Credit Officer for National City Bank of Indiana from
December 2002 to December 2006.
Jami L. Bradshaw, 46, 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, 59, 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, 49, 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, 45, 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, 56, 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; Executive Vice President
Commercial Banking Division of First Merchants Bank from 2005 to December 2006; Executive Vice President
and Northern Division Chief Credit Officer of Old National Bank from 2001 to 2005.
29
PART II: ITEM 5. AND ITEM 6.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, 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, 2003 and tracks it through December 31, 2008.
Total Return Performance
First Merchants Corporation
Russell 2000
Russell 2000 Financial Services
180
160
140
120
100
80
60
e
u
l
a
V
x
e
d
n
I
12/31/03
12/31/04
12/31/05
12/31/06
12/31/07
12/31/08
First Merchants Corporation
Russell 2000
Russell 2000 Financial Services
100.00
100.00
100.00
115.05
118.33
121.10
109.48
123.72
123.76
118.74
146.44
147.83
99.35
144.15
122.96
105.35
95.44
91.75
12/31/03
12/31/04
12/31/05 12/31/06
12/31/07
12/31/08
The stock price performance included in this graph is not necessarily indicative of future stock price
performance.
30
PART II: ITEM 5. AND ITEM 6.
STOCK INFORMATION
================================================================================================================================
PRICE PER SHARE
QUARTER HIGH LOW DIVIDENDS DECLARED1
================================================================================================================================
2008 2007 2008 2007 2008 2007
-------------------------- --------------------------- ---------------------------
First Quarter ............. $ 30.00 $ 27.46 $ 18.76 $ 22.75 $ .23 $ .23
Second Quarter ............. 29.98 25.00 18.15 21.51 .23 .23
Third Quarter .............. 27.40 24.95 16.58 18.30 .23 .23
Fourth Quarter ............. 22.87 23.44 16.17 19.92 .23 .23
The table above lists per share prices and dividend payments during 2008 and 2007. Prices are as reported
by the National Association of Securities Dealers Automated Quotation – Global Select 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 Global Select 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 27, 2009, the number of shares outstanding was 21,178,488. There were
8,405 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, 2008, 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, 2008 0 $ 0 0 0
November 1-30, 2008 902
December 1-31, 2008 1982 18.28 0 0
21.17 0 0
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 The shares were purchased in connection with the exercise of certain outstanding stock options.
31
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, 2008.
========================================================================================================================
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 921 214 $ 24.80 226,8151
Equity Compensation Plans Not
Approved by Stockholders2 30 108 21.50
----------------------- -------------------- -----------------------------
Total 951 322 $ 24.70 226,8151
======================= ==================== =============================
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.
32
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 Annual Report on 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 Statement of Financial Accounting Standards (“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 central, 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-
33
PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES continued
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.
Pension. The Corporation provides pension benefits to its employees. Its accounting policies related to
pensions and other postretirement benefits reflect the guidance in SFAS No. 158 “Employers’ Accounting for
Defined Benefit Pension and Other Postretirement Plans”. 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. Various statistical and other factors, which attempt to anticipate
future events, are used in calculating the expense and liabilities related to the plans. Key factors
include assumptions on the expected rates of return on plan assets, discount rates, expected rates of
salary increases and health care costs and trends. The Corporation considers market conditions, including
changes in investment returns and interest rates in making these assumptions. The primary assumptions used
in determining the Corporation’s pension and postretirement benefit obligations and related expenses are
presented in Note 16 “Employee Benefit Plans” in the Annual Report for the specific assumptions used by the
Corporation.
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.
Under SFAS No. 142, “Goodwill and Other Intangible Assets”, the Corporation is required to evaluate
goodwill for impairment on an annual basis, as well as on an interim basis, if events or changes indicate
that the asset may be impaired, indicating that the carrying value may not be recoverable. The Corporation
has elected to test for goodwill impairment as of September 30 of each year. 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.
The Corporation cannot predict the occurrence of certain future events that might adversely affect the
reported value of goodwill. Such events include, but are not limited to, strategic decisions made in
response to economic and competitive conditions, the effect of the economic environment on the
Corporation’s customer base, or a material negative change in its relationship with significant customers.
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.
34
PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS - 2008
As of December 31, 2008 total assets equaled $4.8 billion, an increase of $1 billion from December 31,
2007. Loans and investments, the Corporation’s primary earning assets, totaled $4.2 billion, an increase of
$876 million over the prior year. Loans accounted for $846 million of the increase as investment securities
increased by $31 million. Of the $876 million increase, the addition of Lincoln accounted for $637 million
in loans and $122 million in investments. During 2007 and 2008, 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.
Net income for 2008 totaled $20.6 million, a decrease of $11 million from 2007. Diluted earnings per share
totaled $1.14, a decline of $.59 from the 2007 total of $1.73. Net interest margin expanded by 29 basis
points from 3.55 percent in 2007 to 3.84 percent in 2008. As a result, net-interest income increased by
$16.3 million, or 14.4 percent. Net interest margin remained strong even during the fourth quarter as the
Federal Reserve Board lowered the target Fed Funds rate to just 25 basis points. Aggressive deposit
pricing and the use of interest rate floors on over $360 million of the Corporation’s prime rate indexed
loans helped preserve the Corporation’s net interest margin.
Provision expense totaled $28.2 million in 2008, an increase of $19.7 million over the prior. The increase
in provision expense exceeded the expansion of net interest income by $3.4 million.
Non-interest income decreased $4.2 million in 2008. Income from changes in the cash surrender value of
bank owned life insurance (BOLI) declined by $3.9 million. During the fourth quarter the Corporation
recorded a loss of $2.1 million due to declines in market value below the stable value wrap. BOLI losses
are not tax deductible resulting in a $3.9 million decrease in net income. On December 18, 2008,
management changed the investment elections under the separate account policy structure to more
conservative investments. The Corporation also recorded an other than temporary loss of $1.5 million on
Federal Home Loan Mortgage Corporation preferred stock. The Corporation has no additional equity exposure
to FHLMC and FNMA and no remaining exposure to private label mortgage backed investment securities.
Additionally, the Corporation recorded an other than temporary loss of $1.2 million of its $15.5 million
original book balance trust preferred pooled investment exposure. The loss is attributable to a Trapeza IV
pool, the only pool deemed to be other-than-temporarily impaired as of year-end. The remaining $13.5
million of exposure to trust preferred pools is diversified among eight FTN PreTsl investments.
Total non-interest expenses for the year increased by $6.6 million or 6.5 percent as salary and benefit
expense increased by $4.2 million. The remaining increases in other expense include an increase of $1.8
million in other real estate expense and $860,000 of professional services related to loan workouts.
First Merchants also sold the assets of Indiana Title Insurance Company, LLC resulting in a $560,000 loss
during the month of December.
Return on equity was 5.90 percent in 2008, 9.56 percent in 2007 and 9.45 percent in 2006. Return on assets
totaled .54 percent in 2008, .87 percent in 2007 and .90 percent in 2006. 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.
RESULTS OF OPERATIONS – 2007 and 2006
As of December 31, 2007 total assets equaled $3.8 billion, an increase of $227.2 million from December 31,
2006. Loans and investments, the Corporation’s primary earning assets, increased by $168.5 million, 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.
Net income for 2007 totaled $31.6 million, an increase of $1.4 million, 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. These factors and others are discussed within
the respective sections of Management’s Discussion and Analysis of Financial condition and Results of
Operations.
35
PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CAPITAL
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. The Corporation’s regulatory capital fell slightly below the
regulatory “well capitalized” standard at December 31, 2008.
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
7.73 percent and 7.19 percent at December 31, 2008 and 2007, respectively.
At December 31, 2008, the Corporation had a Tier I risk-based capital ratio of 7.71 percent and total risk-
based capital ratio of 10.24 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 decrease in the Corporation’s regulatory capital ratios for the year is primarily attributable to two
factors. The first factor of note is the decline in First Merchants other comprehensive income resulting
from investment security write-downs under SFAS 115 totaling $1.3 million during the year. The second
factor is a combination of items related to the Lincoln Bancorp acquisition. The Corporation used cash of
$16.8 million as part of the $77.3 million purchase price resulting in increased common equity of $60.1
million to acquire an $876 million institution. Additionally, as a result of the acquisition, First
Merchants added $32.3 million of intangibles from the closing of Lincoln Bancorp.
The Corporation’s GAAP capital ratio, defined as total stockholders’ equity to total assets, equaled 8.27
percent as of December 31, 2008, down from 8.99 percent in 2007.
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 5.01 percent as of December 31, 2008, down from 5.72
percent in 2007.
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.
========================================================================================
December 31,
(Dollars in Thousands) 2008 2007
========================================================================================
Average Goodwill..................................... $ 124,403 $ 123,191
Average Core Deposit Intangible (CDI)................ 11,388 13,868
Average Deferred Tax on CDI.......................... (2,867) (3,659)
---------- ----------
Intangible Adjustment.............................. $ 132,924 $ 133,400
========== ==========
Average Stockholders’ Equity (GAAP Capital).......... $ 349,594 $ 330,786
Intangible Adjustment................................ (132,924) (133,400)
---------- ----------
Average Tangible Capital........................... $ 216,670 $ 197,386
========== ==========
Average Assets....................................... $3,811,166 $3,639,772
Intangible Adjustment................................ (132,924) (133,400)
---------- ----------
Average Tangible Assets............................ $3,678,242 $3,506,372
========== ==========
Net Income........................................... $ 20,638 $ 31,539
CDI Amortization, Net of Tax......................... 1,919 1,919
---------- ----------
Tangible Net Income................................ $ 22,557 $ 33,558
========== ==========
Diluted Earnings Per Share........................... $ 1.14 $ 1.73
Diluted Tangible Earnings Per Share.................. $ 1.24 $ 1.83
Return on Average GAAP Capital....................... 5.90% 9.56%
Return on Average Tangible Capital................... 10.41% 17.00%
Return on Average Assets............................. 0.54% 0.87%
Return on Average Tangible Assets.................... 0.61% 0.96%
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
36
PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ASSET QUALITY/PROVISION FOR LOAN LOSSES continued
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)
In connection with recent economic developments, many financial institutions, including the Corporation,
have experienced unusual and significant declines in the performance of their loan portfolios, and the
values of real estate collateral supporting many loans have declined. If current trends in the housing and
real estate markets continue, we expect that loan delinquencies and credit losses may increase. Although
the Corporation believes its underwriting and loan review procedures are appropriate for the various kinds
of loans it makes, the Corporation’s results of operations and financial condition will be adversely
affected in the event the quality of its loan portfolio deteriorates.
At December 31, 2008, non-performing loans totaled $93,658,000, an increase of $60,904,000, of which the
addition of Lincoln at December 31 accounted for $35,839,000 of the increase. Loans 90 days past due other
than non-accrual and restructured loans increased by $2,404,000. The amount of non-accrual loans totaled
$87,546,000 at December 31, 2008 and Lincoln accounted for $33,669,000 of non-accrual loans. 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, 2008, impaired loans totaled $206,126,000, an increase of $119,177,000 from year-end 2007.
Lincoln accounted for $56,107,000 of the increase in impaired loans, which were at their fair value on the
acquisition date of December 31, 2009. At December 31, 2008, a specific allowance for losses was not
deemed necessary for impaired loans totaling $180,729,000, but a specific allowance of $9,790,000 was
recorded for the remaining balance of impaired loans of $25,397,000 and is included in the Corporation’s
allowance for loan losses. The average balance of impaired loans for 2008 was $229,608,000. 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 classified
loans, including substandard, doubtful and loss credits, are included in the impaired loan total.
In 2008, total net charge-offs were $15,602,000, an increase of $8,873,000 from 2007 of $6,819,000. Net
charge-offs included commercial and residential real estate of $7,521,000, commercial and industrial of
$6,048,000 and individual loans for household and other personal expenditures, including other loans of
$2,033,000.
Commercial construction and land development loans were $252,487,000 at December 31, 2008, an increase of
$87,062,000 from December 31, 2007. The addition of Lincoln at December 31 accounted for $66,907,000 of
the increase. Construction and land development represents 63.8 percent of total capital and 6.8 percent
of total loans. Management continues to closely monitor this portfolio for existing projects, as well as
being very selective with additional exposure to this industry.
At December 31, 2008, the allowance for loan losses was $49,543,000, an increase of $21,315,000 from year-
end 2007. As a percent of loans, the allowance was 1.33 percent at December 31, 2008 and .98 percent at
December 31, 2007. Management believes that the allowance for loan losses is adequate to cover losses
inherent in the loan portfolio at December 31, 2008. 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 provision for loan losses in 2008 was $28,238,000, an increase of $19,731,000 from $8,507,000, in 2007,
reflecting an increase of 46 basis points in net charge offs during the year.
37
PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ASSET QUALITY/PROVISION FOR LOAN LOSSES continued
The provision for loan losses in 2007 was $8,507,000, an increase of $2,249,000 from $6,258,000, in 2006,
reflecting an increase of 5 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) 2008 2007
================================================================================
Non-accrual Loans .............................. $87,546 $29,031
Loans Contractually
Past Due 90 Days or More
Other than Non-accruing ..................... 5,982 3,578
Restructured Loans ............................. 130 145
------- -------
Total ....................................... $93,658 $32,754
======= =======
The table below represents loan loss experience for the years indicated.
========================================================================================================
(Dollars in Thousands) 2008 2007 2006
========================================================================================================
Allowance for Loan Losses:
Balance at January 1 .................................. $28,228 $26,540 $25,188
------- ------- -------
Charge offs ............................................ 22,626 8,557 6,510
Recoveries ............................................ 7,024 1,738 1,604
------- ------- -------
Net charge offs ........................................ 15,602 6,819 4,906
Provision for Loan Losses ............................. 28,238 8,507 6,258
Allowance Acquired in Acquisition....................... 8,679
------- ------- -------
Balance at December 31 ................................ $49,543 $28,228 $26,540
======= ======= =======
Ratio of Net Charge offs During the Period to
Average Loans Outstanding During the Period .......... .52% .24% .19%
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 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, 2008, total borrowings from the FHLB were $360,217,000. 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, 2008, was $95,214,000. At December 31, 2008, the
revolving line of credit with LaSalle Bank had a balance of $20,000,000 with $5,000,000 remaining borrowing
capacity.
On February 20, 2009, First Merchants completed the sale to the Treasury of $116.0 million of newly issued
First Merchants non-voting preferred shares as part of the CPP enacted as part of the TARP, under the ESSA.
The Treasury has certain supervisory and oversight duties and responsibilities under EESA and the CPP and,
pursuant to the terms of a Letter Agreement and a Securities Purchase Agreement – Standard Terms attached
thereto (collectively, the “Securities Purchase Agreement”), the Treasury is empowered to unilaterally
amend any provision of the Securities Purchase Agreement with First Merchants to the extent required to
comply with any changes in applicable federal statutes.
38
PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
LIQUIDITY continued
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 $459,636,000 at December 31, 2008, an increase of $18,800,000, or 4.3
percent over December 31, 2007. 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 $13,131,000 at December 31, 2008. 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, 2008 are as
follows:
===================================================================================
At December 31,
(Dollars in Thousands)
===================================================================================
2008
Amounts of Commitments:
Loan Commitments to Extend Credit ...............................
Standby Letters of Credit .......................................
$ 794,240
31,194
----------
$ 825,434
==========
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.
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, 2008 are as follows:
========================================================================================================
2014 and
(Dollars in Thousands) 2009 2010 2011 2012 2013 after Total
========================================================================================================
Operating Leases $ 2,010 $ 1,844 $ 1,647 $ 1,104 $ 461 $ 677 $ 7,743
Federal Funds Purchased
Securities Sold Under
Repurchase Agreements 88,061 10,000 14,250 10,000 122,311
Federal Home Loan Bank Advances 137,015 86,183 32,163 72,097 7,756 25,003 360,217
Subordinated Debentures,
Revolving Credit Lines and
Term Loans 20,000 115,826 135,826
-------- ------- ------- ------- -------- -------- --------
Total $247,086 $98,027 $33,810 $87,451 $ 8,217 $151,506 $626,097
======== ======= ======= ======= ======== ======== ========
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 constructed, presented and
monitored quarterly.
39
PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK continued
Management believes that the Corporation's liquidity and interest sensitivity position at December 31,
2008, 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, 2008.
===================================================================================================================================
At December 31, 2008
(Dollars in Thousands) 1-180 DAYS 181-365 DAYS 1-5 YEARS BEYOND 5 YEARS TOTAL
===================================================================================================================================
Rate-Sensitive Assets:
Federal Funds Sold....................................... $ 66,237 $ 66,237
Interest-bearing Deposits ............................... 38,823 38,823
Investment Securities ................................... 61,040 $ 67,712 $ 245,718 $ 107,514 481,984
Loans ................................................... 1,806,018 484,436 1,270,494 165,299 3,726,247
Federal Reserve and Federal Home Loan Bank Stock ........ 34,319 34,319
---------- ---------- ---------- ---------- ----------
Total Rate-sensitive Assets ........................ 1,972,118 552,148 1,550,531 272,813 4,347,610
---------- ---------- ---------- ---------- ----------
Rate-Sensitive Liabilities:
Interest-bearing Deposits ............................... 2,193,749 399,526 651,874 13,143 3,258,292
Securities Sold Under Repurchase Agreements ............. 88,061 24,250 10,000 122,311
Federal Home Loan Bank Advances ......................... 97,630 49,633 202,795 10,159 360,217
Subordinated Debentures, Revolving Credit
Lines and Term Loans ................................. 64,926 10,074 60,826 135,826
---------- ---------- ---------- ---------- ----------
Total Rate-sensitive Liabilities ................... 2,444,366 459,233 939,745 33,302 3,876,646
---------- ---------- ---------- ---------- ----------
Interest Rate Sensitivity Gap by Period .................... $ (472,248) $ 92,915 $ 610,786 $ 239,511
Cumulative Rate Sensitivity Gap ............................ (472,248) (379,333) 231,453 470,964
Cumulative Rate Sensitivity Gap Ratio
at December 31, 2008 .................................... 80.7% 86.9% 106.0% 112.1%
at December 31, 2007 .................................... 71.1% 82.3% 112.3% 111.2%
The Corporation had a cumulative negative gap of $379,333,000 in the one-year horizon at December 31, 2008, 7.9 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.
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 200 basis points and falling 100 basis points scenarios below, as of December 31,
2008, 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 the current rate environment, many
driver rates are at or near historical lows, thus total rate movements (beginning point minus ending point)
to each of the various driver rates utilized by management have the following results:
====================================================================================
Driver Rates RISING (200 basis points) FALLING (100 basis points)
====================================================================================
Prime 200
Federal Funds 200
One-Year CMT 200
Three-Year CMT 200
Five-Year CMT
200
CD's 200
FHLB Advances 200
0
0
(6)
(24)
(24)
(96)
(30)
40
PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK continued
Results for the base, rising 200 basis points, and falling 100 basis points interest rate scenarios are
listed below based upon the Corporation’s rate sensitive assets and liabilities at December 31, 2008. 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.
================================================================================================================================
RISING (200 basis points) FALLING (100 basis points)
BASE
================================================================================================================================
Net Interest Income (Dollars in Thousands)
$154,398
$144,038
$145,606
Variance from Base $ 10,359
Percent of Change from Base
7.19%
$ 1,568
1.09%
The comparative rising 200 basis points and falling 200 basis points scenarios below, as of December 31,
2007, 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 (200 basis points) FALLING (200 basis points)
=====================================================================================
Prime 200
Federal Funds 200
One-Year CMT 200
Two-Year CMT
200
CD's 200
FHLB Advances 200
(200)
(200)
(200)
(193)
(200)
(200)
Results for the base, rising 200 basis points, and falling 200 basis points 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 (200 Basis Points) FALLING (200 Basis Points)
==============================================================================================================================
Net Interest Income (Dollars in Thousands)
$120,089 $116,063
$117,693
Variance from Base $ 2,396
Percent of Change from Base 2.0% (1.4)%
$ (1,630)
EARNING ASSETS
The following table presents the earning asset mix as of December 31, 2008, and December 31, 2007.
Earnings assets increased by $965,684,000. Loans increased by $845,109,000, of which $626,058,000 of the
increase was related to the addition of Lincoln on December 31, 2008. Of the remaining increase of
$219,051,000, the largest loan segments that increased were in commercial and industrial of $197,236,000
and commercial and farmland real estate of $31,609,000. The largest loan category that decreased was in
loans to individuals. This category decreased as management strategically reduced its indirect lending
function, our lowest yielding loan category.
Investments increased by $30,817,000. The addition of Lincoln on December 31, 2008, brought an investment
portfolio of $122,093,000. The decrease in the portfolio of $91,276,000 during the period was related to a
strategic decision to reinvest investment portfolio maturities in higher yielding loans.
=========================================================================================
(Dollars in Thousands) December 31,
=========================================================================================
2008 2007
-------- --------
Federal Funds Sold................................... $ 66,237 $ 495
Interest-bearing Time Deposits....................... 38,823 24,931
Investment Securities Available for Sale ............ 459,636 440,836
Investment Securities Held to Maturity............... 22,348 10,331
Mortgage Loans Held for Sale ........................ 4,295 3,735
Loans................................................ 3,721,952 2,876,843
Federal Reserve and Federal Home Loan Bank Stock..... 34,319 25,250
--------- ---------
Total ........................................... $4,347,610 $3,382,421
========= =========
41
PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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, 2008 and 2007.
===================================================================================
(Dollars in Thousands) December 31,
===================================================================================
2008 2007
---------- ----------
Deposits ........................................ $3,718,811 $2,844,121
Federal Funds Purchased.......................... 52,350
Securities Sold Under Repurchase Agreements...... 122,311 106,497
Federal Home Loan Bank Advances ................. 360,217 294,101
Subordinated Debentures, Revolving Credit Lines
and Term Loans................................ 135,826 115,826
---------- ----------
$4,337,165 $3,412,895
========== ==========
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 2008.
In 2008, asset yields decreased 66 basis points on a fully taxable equivalent basis (FTE) and interest cost
decreased 95 basis points, resulting in a 29 basis point increase in the interest margin compared to 2007.
The decrease in interest income and interest expense was primarily a result of seven federal funds rate
decreases of approximately 350 basis points by the Federal Open Market Committee during this period.
Growth in earning assets produced a positive volume variance of $7,715,000 (FTE), and a declining interest
rate environment produced a positive rate variance of $8,549,000 (FTE), resulting in an increase of
$16,264,000 in net interest income.
In 2007, asset yields increased 18 basis points (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 $8,665,000 (FTE), while interest
rate compression produced a negative rate variance of $5,640,000 (FTE), resulting in an increase of
$3,025,000 in net interest income.
==============================================================================================
(Dollars in Thousands) December 31,
==============================================================================================
2008 2007 2006
------ ------ ------
Net Interest Income................................... $ 129,384 $ 113,120 $ 110,095
FTE Adjustment........................................ $ 3,699 $ 4,127 $ 3,981
Net Interest Income
on a Fully Taxable Equivalent Basis................. $ 133,083 $ 117,247 $ 114,076
Average Earning Assets................................ $3,463,477 $3,308,939 $3,072,898
Interest Income (FTE) as a Percent
of Average Earning Assets........................... 6.44% 7.10% 6.92%
Interest Expense as a Percent
of Average Earning Assets........................... 2.60% 3.55% 3.21%
Net Interest Income (FTE) as a Percent
of Average Earning Assets........................... 3.84% 3.55% 3.71%
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.
42
PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 2008 amounted to $36,367,000, a 10.3 percent decrease from 2007. The change in other
income from 2008 to 2007 was primarily attributable to fluctuations within the following other income
items:
•
•
•
•
•
Insurance commissions increased $711,000 from 2007 due to the purchase of an insurance agency in
April 2008.
Service Charges increased $581,000 from the same period in 2007 due to increased fees.
Fees related to derivative hedge agreements were $510,000. No such fees were collected in 2007.
Other than temporary impairments of $2,682,000 were recognized on FHLMC Preferred Stock and Trust
Preferred Securities held in the investment portfolio. This was offset by approximately $599,000
in net gains from the sale of various investment securities.
Earnings on bank-owned life insurance decreased $3,918,000 from the same period in 2007 as
discussed in “RESULTS OF OPERATIONS” section of Management’s Discussion and Analysis of Financial
Condition and Results of Operations.
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 EXPENSES
Other expenses represent non-interest operating expenses of the Corporation. Total other expenses for 2008
were $108,792,000, an increase of $6,610,000 or 6.5 percent from 2007. The change in other expenses from
2008 to 2007 was primarily attributable to fluctuations within the following other expense items:
•
•
•
•
Salary and employee benefits grew $4,163,000, or 7.1 percent, due to staff additions and normal
salary increases. Approximately $451,000 of the increase is due to share-based compensation
expense recorded in 2008.
Expenses related to other real estate owned and repossessed assets were $1,809,000 higher in 2008
than in the same period of 2007.
Premises expenses were $1,064,000 higher than the same period in 2007 primarily due to higher real
estate taxes and fees paid to a third-party property management company.
On December 31, 2008, the Corporation sold its interest in Indiana Title Insurance Company, LLC,
for a loss of $560,000.
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.
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.
Other expenses increased $1,129,000 primarily due to integration expenses related to bank
combinations and name changes.
43
PART II: ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INCOME TAXES
Income tax expense totaled $8,083,000 for 2008, which is a decrease of $3,260,000 from 2007. The effective
tax rates for the periods ending December 31, 2008, 2007 and 2006 were 28.1 percent, 26.4 percent and 28.8
percent, respectively. The Corporation’s federal statutory income tax rate is 35 percent and its state tax
rate varies from 0 to 8.5 percent depending on the state in which the subsidiary company is domiciled. The
effective tax rate is lower than the blended effective statutory federal and state rates primarily due to
the Corporation’s income on tax exempt securities and loans, income generated by the subsidiaries domiciled
in a state with no state or local income tax, income tax credits generated from investments in affordable
housing projects, 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 and loan volume. 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).
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.
44
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, 2008 and 2007, 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, 2008. 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, 2008 and 2007, and the
results of its operations and its cash flows for each of the years in the three-year period ended December
31, 2008, in conformity with accounting principles generally accepted in the Unites States of America.
As discussed in Note 19, the Company changed its method of accounting for fair value measurements in
accordance with Statement of Financial Accounting Standards No. 157 in 2008.
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,
2008, 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 March 16, 2009, expressed
an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
Indianapolis, Indiana
March 16, 2009
45
PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data) December 31,
===================================================================================================================================
2008 2007
===================================================================================================================================
Assets
Cash and Cash Equivalents
Cash and Due From Banks ....................................................... $ 84,249 $ 134,188
Federal Funds Sold............................................................. 66,237 495
----------- -----------
Total Cash and Cash Equivalents.............................................. 150,486 134,683
Interest-bearing Time Deposits ................................................... 38,823 24,931
Investment Securities
Available for Sale ............................................................ 459,636 440,836
Held to Maturity (Fair Value of $22,176 and $10,270)........................... 22,348 10,331
----------- -----------
Total Investment Securities ................................................. 481,984 451,167
Mortgage Loans Held for Sale ..................................................... 4,295 3,735
Loans, Net of Allowance for Loan Losses of $49,543 and $28,228.................... 3,672,409 2,848,615
Premises and Equipment ........................................................... 59,641 44,445
Federal Reserve and Federal Home Loan Bank Stock ................................. 34,319 25,250
Interest Receivable .............................................................. 23,976 23,402
Core Deposit Intangibles ........................................................ 22,492 12,412
Goodwill.......................................................................... 143,482 123,444
Cash Value of Life Insurance...................................................... 93,222 70,970
Other Real Estate Owned........................................................... 18,458 2,573
Other Assets ..................................................................... 40,568 16,460
----------- -----------
Total Assets ................................................................ $ 4,784,155 $ 3,782,087
=========== ===========
Liabilities
Deposits
Noninterest-bearing ........................................................... $ 460,519 $ 370,397
Interest-bearing .............................................................. 3,258,292 2,473,724
----------- -----------
Total Deposits .............................................................. 3,718,811 2,844,121
Borrowings
Fed Funds Purchased............................................................ 52,350
Securities Sold Under Repurchase Agreements.................................... 122,311 106,497
Federal Home Loan Bank Advances................................................ 360,217 294,101
Subordinated Debentures, Revolving Credit Lines and Term Loans................. 135,826 115,826
----------- -----------
Total Borrowings............................................................. 618,354 568,774
Interest Payable ................................................................. 8,844 8,325
Other Liabilities ................................................................ 42,243 20,931
----------- -----------
Total Liabilities ........................................................... 4,388,252 3,442,151
----------- -----------
Commitments and Contingent Liabilities
Stockholders' Equity
Preferred Stock, No-par Value
Authorized and Unissued -- 500,000 Shares
Cumulative Preferred Stock, $1,000 Par Value:
Authorized -- 600 Shares
Isssued and Outstanding -- 125 Shares 125
Common Stock, $.125 Stated Value
Authorized -- 50,000,000 Shares
Issued and Outstanding – 21,178,123 and 18,002,787 Shares .................... 2,647 2,250
Additional Paid-in Capital ....................................................... 202,299 137,801
Retained Earnings ................................................................ 206,496 202,750
Accumulated Other Comprehensive Loss ............................................. (15,664) (2,865)
----------- -----------
Total Stockholders' Equity .................................................. 395,903 339,936
----------- -----------
Total Liabilities and Stockholders' Equity .................................. $ 4,784,155 $ 3,782,087
=========== ===========
See notes to consolidated financial statements.
46
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,
===================================================================================================================================
2008 2007 2006
===================================================================================================================================
Interest Income
Loans Receivable
Taxable ............................................................. $198,385 $207,268 $186,768
Tax Exempt .......................................................... 1,013 1,120 828
Investment Securities
Taxable ............................................................. 12,046 13,744 12,316
Tax Exempt .......................................................... 5,855 6,548 6,565
Federal Funds Sold .................................................... 28 172 373
Deposits with Financial Institutions .................................. 755 582 500
Federal Reserve and Federal Home Loan Bank Stock ...................... 1,391 1,299 1,256
-------- -------- --------
Total Interest Income ............................................ 219,473 230,733 208,606
-------- -------- --------
Interest Expense
Deposits .............................................................. 67,581 89,921 74,314
Federal Funds Purchased ............................................... 1,856 3,589 1,842
Securities Sold Under Repurchase Agreements ........................... 2,600 3,856 3,228
Federal Home Loan Bank Advances ....................................... 11,168 12,497 10,734
Subordinated Debentures, Revolving
Credit Lines and Term Loans ......................................... 6,884 7,750 8,124
Other Borrowings ...................................................... 269
-------- -------- --------
Total Interest Expense ........................................... 90,089 117,613 98,511
-------- -------- --------
Net Interest Income ...................................................... 129,384 113,120 110,095
Provision for Loan Losses ............................................. 28,238 8,507 6,258
-------- -------- --------
Net Interest Income After Provision for Loan Losses ...................... 101,146 104,613 103,837
-------- -------- --------
Other Income
Service Charges on Deposit Accounts ................................... 13,002 12,421 11,262
Fiduciary Activities ........................... ...................... 8,031 8,372 7,625
Other Customer Fees ................................................... 6,776 6,479 5,517
Commission Income ..................................................... 5,824 5,113 4,302
Earnings on Cash Surrender Value
of Life Insurance ................................................... (267) 3,651 2,286
Net Gains and Fees on Sales of Loans .................................. 2,490 2,438 2,171
Net Realized and Unrealized Gains (Losses) on
Available-for-sale Securities .............................. ........ (2,083) (4)
Other Income .......................................................... 2,594 2,077 1,454
-------- -------- --------
Total Other Income ............................................... 36,367 40,551 34,613
-------- -------- --------
Other Expenses
Salaries and Employee Benefits ........................................ 63,006 58,843 56,125
Net Occupancy Expenses ................................................ 7,711 6,647 5,886
Equipment Expenses .................................................... 6,659 6,769 7,947
Marketing Expenses..................................................... 2,311 2,205 1,932
Outside Data Processing Fees .......................................... 4,087 3,831 3,449
Printing and Office Supplies .......................................... 1,214 1,410 1,496
Core Deposit Amortization.............................................. 3,216 3,159 3,066
Write-off of Unamortized Underwriting Expenses ........................ 1,771
Other Expenses ........................................................ 20,588 17,547 16,156
-------- -------- --------
Total Other Expenses ............................................. 108,792 102,182 96,057
-------- -------- --------
Income Before Income Tax ................................................. 28,721 42,982 42,393
Income Tax Expense .................................................... 8,083 11,343 12,195
-------- -------- --------
Net Income ............................................................... $ 20,638 $ 31,639 $ 30,198
======== ======== ========
Net Income Per Share:
Basic ................................................................. $ 1.14 $ 1.73 $ 1.64
Diluted ............................................................... 1.14 1.73 1.64
See notes to consolidated financial statements.
47
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) 2008 2007 2006
===================================================================================================================================
Net Income ........................................................................... $ 20,638 $ 31,639 $ 30,198
-------- -------- --------
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 $1,356, $(1,437), and $(1,242)........ (2,518) 2,743 2,087
Reclassification Adjustment for (Gains) Losses Included in Net Income,
Net of Income Tax Expenses (Benefit) of $(833), $0, and $(1)................... 1,250 2
Unrealized Gains (Losses) on Cash Flow Hedge Assets:
Unrealized (Gains) Losses Arising During the Period,
Net of Income Tax Benefit of $(1), $(501), and $83............................. 2 1,057 (125)
Defined Benefit Pension Plans, Net of Income Tax Expense of $7,689, ($1,827) and $0
Net Gain Arising During Period................................................... (11,518) 2,725
Prior Service Cost Arising During Period ........................................ 30
Amortization of Prior Service Cost............................................... (15) (15)
(12,799) 6,540 1,964
-------- -------- ---------
COMPREHENSIVE INCOME $ 7,839 $ 38,179 $ 32,162
======== ======== =========
-------- -------- ---------
48
PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
PREFERRED COMMON STOCK ACCUMULATED OTHER
================ ======================= ADDITIONAL RETAINED COMPREHENSIVE
(in thousands, except share data) SHARES AMOUNT SHARES AMOUNT PAID-IN CAPITAL EARNINGS INCOME (LOSS) TOTAL
------- --------- ----------- -------- -------------- --------- ------------------ -------
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 SFAS
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
----------- -------- -------- --------- --------- ---------
Net Income for 2008...................... 20,638 20,638
Cash Dividends ($.92 per Share).......... (16,775) (16,775)
Effects of changing the pension plan
measurement date pursuant to FASB
No. 158
Service cost, interest cost and
expected rate of return on plan
assets for October 1 – December
31, 2009 net of tax............... (64) (64)
Amortization of prior service costs
for October 1 – December 31,
2007, net of tax.................. (53) (53)
Cumulative preferred stock
Issued................................. 125 $125 125
Other Comprehensive Income (Loss),
Net of Tax............................ (12,799) (12,799)
Tax Benefit from Stock Options Exercised 156 156
Share-based Compensation ................ 225 1 1,897 1,898
Stock Issued Under Employee Benefit Plans 50,119 6 767 773
Stock Issued Under Dividend Reinvestment
and Stock Purchase Plan .............. 44,554 6 1,015 1,021
Stock Options Exercised.................. 122,890 15 1,618 1,633
Stock Redeemed........................... (134,169) (17) (2,171) (2,188)
Issuance of Stock Related to Acquisitions 3,091,717 386 61,216 61,602
------- --------- ----------- -------- -------- --------- --------- ---------
Balances, December 31, 2008 125 $125 21,178,123 $ 2,647 $202,299 $ 206,496 $ (15,664) $ 395,903
======= ========= =========== ======== ======== ========= ========= =========
See notes to consolidated financial statements.
49
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) 2008 2007 2006
================================================================================================================================
Operating Activities:
Net Income ......................................................... $ 20,638 $ 31,639 $ 30,198
Adjustments to Reconcile Net Income to
Net Cash Provided by Operating Activities:
Provision for Loan Losses ........................................ 28,238 8,507 6,258
Depreciation and Amortization..................................... 4,613 4,331 5,382
Change in tax accruals............................................ (8,666) (2,162) (2,412)
Share-based Compensation.......................................... 1,898 1,468 833
Tax Benefits from Stock Options Exercised......................... (156) (116) (139)
Mortgage Loans Originated for Sale................................ (102,591) (123,051) (123,256)
Proceeds from Sales of Mortgage Loans ............................ 104,250 124,729 122,753
Net Change in:
Interest Receivable .......................................... 2,858 943 (4,655)
Interest Payable.............................................. (1,217) (1,001) 3,452
Gains on Sales of Securities Available for Sale 599 (4)
Recognized Loss on Other-than-Temporary Impairment (2,682)
Pension Adjustments for Measurement Date Change (117)
Other Adjustments................................................. (8,652) 4,731 (2,829)
--------- --------- ---------
Net Cash Provided by Operating Activities..................... 39,013 50,018 35,581
--------- --------- ---------
Investing Activities:
Net Change in Interest-bearing Deposits ............................ 10,716 (13,647) (2,536)
Purchases of
Securities Available for Sale..................................... (100,988) (69,536) (100,355)
Securities Held to Maturity....................................... (29,058) (8,466)
Proceeds from Maturities of
Securities Available for Sale .................................... 139,825 81,069 64,778
Securities Held to Maturity....................................... 17,042 7,418 6,526
Proceeds from Sales of
Securities Available for Sale .................................... 60,335 7,219 575
Proceeds from Sales of Mortgages....................................
Purchase of Federal Reserve and Federal Home Loan Bank Stock........ (261) (1,559) (491)
Purchase of Bank-owned Life Insurance............................... (706) (4,500) (18,000)
Net Change in Loans................................................. (250,621) (221,873) (245,685)
Net Cash Received (Paid) in Acquisition.............................. 6,934 (370) (59)
Other Adjustments................................................... (4,181) (4,143 (8,358)
--------- --------- ---------
Net Cash Used by Investing Activities......................... (150,963) (201,615) (303,605)
--------- --------- ---------
26,773
Cash Flows from Financing Activities:
Net Change in:
Demand and Savings Deposits....................................... 74,992 65,035 133,591
Certificates of Deposit and Other Time Deposits .................. 144,328 28,548 234,372
Proceeds from the Sale of Other Real Estate Owned 10,775 3,633 6,301
Receipt of Borrowings .............................................. 961,074 457,157 182,454
Repayment of Borrowings............................................. (1,048,161) (331,016) (249,927)
Cash Dividends...................................................... (16,775) (16,852) (16,951)
Stock Issued Under Employee Benefit Plans........................... 773 787 857
Stock Issued Under Dividend Reinvestment
and Stock Purchase Plan .......................................... 1,021 1,170 1,190
Stock Options Exercised............................................. 1,633 496 1,228
Cumulative Preferred Stock Issued................................... 125
Tax Benefits from Stock Options Exercised........................... 156 116 139
Stock Redeemed...................................................... (2,188) (12,751) (5,690)
--------- --------- ---------
Net Cash Provided by Financing Activities..................... 127,753 196,323 287,564
--------- --------- ---------
Net Change in Cash and Cash Equivalents ............................... 15,803 44,726 19,540
Cash and Cash Equivalents, Beginning of Year........................... 134,683 89,957 70,417
--------- --------- ---------
Cash and Cash Equivalents, End of Year................................. $ 150,486 $ 134,683 $ 89,957
========= ========= =========
Additional Cash Flows Information:
Interest Paid ....................................................... $ 89,570 $ 118,614 $ 95,059
Income Tax Paid...................................................... 18,393 12,206 14,385
Loans Transferred to Other Real Estate Owned............................
24,647 4,038 5,605
See notes to consolidated financial statements.
50
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”), Commerce National Bank
(“Commerce National”), and Lincoln Bank (“Lincoln”), (collectively the “Banks"), First Merchants Trust
Company, National Association (“FMTC”), First Merchants Insurance Services, Inc. ("FMIS"), and First
Merchants Reinsurance Company ("FMRC"), conform to accounting principles generally accepted in the United
States of America and reporting practices followed by the banking industry.
On December 31, 2008, the Corporation acquired Lincoln Bancorp, parent company of Lincoln Bank, through a
merger of Lincoln Bancorp into the Corporation. Lincoln Bank adds seventeen Indiana banking locations in
the Indianapolis area. The banking locations are in Avon, Bargersville, Brownsburg, Crawfordsville,
Frankfort, Franklin, Greenwood, Mooresville, Morgantown, Nashville, Plainfield and Trafalgar. Lincoln also
has two loan production offices located in Carmel and Greenwood, Indiana.
On December 31, 2008, the Corporation sold its interest in Indiana Title Insurance Company, LLC, a full
service title insurance agency.
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. Four of 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 Comptroller of the Currency (“OCC”) and the Federal Deposit Insurance Corporation
(“FDIC”). Lincoln is an Indiana commercial bank, subject to examination by the Indiana Department of
Financial Institutions (“IDFI”) and FDIC. The IDFI and the FDIC regulate or monitor virtually all areas of
the Bank’s operations. The banks must undergo regular on-site examinations by the FDIC and IDFI and must
submit periodic reports to the FDIC and the IDFI. The Corporation plans to merge Lincoln with Central
Indiana under the Central Indiana charter and has applied to the OCC for approval of the merger.
The Banks generate commercial, mortgage, and consumer loans and receive deposits from customers located
primarily in central, north-central and east-central Indiana and Butler, Franklin and Hamilton counties in
Ohio. The addition of Lincoln adds seventeen locations to central Indiana. 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.
FAIR VALUE MEASUREMENTS
The Corporation used fair value measurements to record fair value adjustments, to certain assets, and
liabilities and to determine fair value disclosures. Effective January 1, 2008, the Corporation adopted
SFAS No. 157 for all applicable financial and nonfinancial assets and liabilities. The accounting guidance
defines fair value, establishes a framework for measuring fair value and expands disclosures about fair
value measurements. SFAS No. 157 applies only when other guidance requires or permits assets or
liabilities to be measured at fair value; it does not expand the use of fair value in any new
circumstances.
As defined in SFAS No. 157, fair value is the price to sell an asset or transfer a liability in an orderly
transaction between market participants. It represents an exit price at the measurement date. Market
participants are buyers and sellers, who are independent, knowledgeable, and willing and able to transact
in the principal (or most advantageous) market for the asset or liability being measured. Current market
conditions, including imbalances between supply and demand, are considered in determining fair value. The
Corporation values its assets and liabilities in the principal market where it sells the particular asset
or transfers the liability with the greatest volume and level of activity. In the absence of a principal
market, the valuation is based on the most advantageous market for the asset or liability (i.e., the market
where the asset could be sold or the liability transferred at a price that maximized the amount to be
received for the asset for minimizes the amount to be paid to transfer the liability).
Valuation inputs refer to the assumptions market participants would use in pricing a given asset or
liability. Inputs can be observable or unobservable. Observable inputs are those assumptions which market
participants would use in pricing the particular asset or liability. These inputs are based on market data
51
PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 1
FAIR VALUE MEASUREMENTS continued
and are obtained from a source independent of the Corporation. Unobservable inputs are assumptions based
on the Corporation’s own information or estimate of assumptions used by market participants in pricing the
asset or liability. Unobservable inputs are based on the best and most current information available on
the measurement date. All inputs, whether observable or unobservable, are ranked in accordance with a
prescribed fair value hierarchy which gives the highest ranking to quoted prices (unadjusted) in active
markets for identical assets or liabilities (Level 1) and the lowest ranking to unobservable inputs (Level
3). Fair values for assets or liabilities classified as Level 2 are based on one or a combination of the
following factors: (i) quoted prices for similar assets; (ii) observable inputs for the asset or liability,
such as interest rates or yield curves; or (iii) inputs derived principally from or corroborated by
observable market data. The level in the fair value hierarchy within which the fair value measurement in
its entirety falls is determined based on the lowest level input that is significant to the fair value
measurement in its entirety. The Corporation considers an input to be significant if it drives 10 percent
or more of the total fair value of a particular asset or liability.
Assets and liabilities are considered to be fair valued on a recurring basis if fair value is measured
regularly (i.e., daily, weekly, monthly or quarterly). Recurring valuation occurs at a minimum on the
measurement date. Assets and liabilities are considered to be fair valued on a nonrecurring basis if the
fair value measurement of the instrument does not necessarily result in a change in the amount recorded on
the balance sheet. Generally, nonrecurring valuation is the result of the application of other accounting
pronouncements which require assets or liabilities to be assessed for impairment or recorded at the lower
of cost or fair value. The fair value of assets or liabilities transferred in or out of Level 3 is
measured on the transfer date, with any additional changes in fair value subsequent to the transfer
considered to be realized or unrealized gains or losses.
A brief description of current accounting practices and current valuation methodologies are presented
below.
HELD TO MATURITY 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.
AVAILABLE FOR SALE SECURITIES are recorded at fair value on a recurring basis. Fair value measurement is
based upon quoted prices when available. If quoted prices are not available, fair values are measured
using independent third-party pricing services.
Where quoted market prices are available in an active market, securities are classified within Level 1 of
the valuation hierarchy. There are no securities classified within Level 1 of the hierarchy. If quoted
market prices are not available, then fair values are estimated by using pricing models, quoted prices of
securities with similar characteristics or discounted cash flows. Level 2 securities include treasury
securities, agencies, mortgage backs, state and municipal, corporate obligations, and marketable equity
securities. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified
within Level 3 of the hierarchy and include corporate obligations and municipal securities.
The Corporation has certain securities that have had a drop in fair market value as a result of the
widening in market spreads that many sectors have experienced in recent months. Management has determined
that most of these securities are not deemed to be other-than-temporarily impaired as the drop in market
value is a result of illiquidity in the current market rather than poor performance. Additionally, based on
managements analysis, there has not been an adverse change in future cash flows of the securities.
Securities available-for-sale are carried at fair value with unrealized gains and losses reported
separately in accumulated other comprehensive income, net of tax. As discussed in Note 4 INVESTMENT
SECURITIES, two securities were deemed to be other than temporarily impaired in 2008.
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.
INTEREST RATE SWAP AGREEMENTS are estimated by a third-party using inputs that are primarily unobservable
and cannot be corroborated by observable market data and, therefore, are classified within Level 3 of the
valuation hierarchy.
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
52
PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 1
FAIR VALUE MEASUREMENTS continued
due (principal and interest) according to the contractual terms of the loan agreement. In applying the
provisions of 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 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.
Impaired loans are carried at the present value of estimated future cash flows using the loan's existing
rate, or the fair value of collateral if the loan is collateral dependent. A portion of the allowance for
loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid
balance. If these allocations cause the allowance for loan losses to increase, such increase is reported as
a component of the provision for loan losses. Loan losses are charged against the allowance when
management believes the uncollectability of the loan is confirmed. The valuation would be considered Level
3, consisting of appraisals of underlying collateral and discounted cash flow analysis.
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.
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 is 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 ranging
from three to forty years. 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.
53
PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 1
FAIR VALUE MEASUREMENTS continued
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.
The Corporation offers interest rate derivative products (e.g. interest rate swaps) to certain of its high-
quality commercial borrowers. This product allows customers to enter into an agreement with the
Corporation to swap their variable rate loan to a fixed rate. These derivative products are designed to
reduce, eliminate or modify the risk of changes in the borrower's interest rate or market price risk. The
extension of credit incurred through the execution of these derivative products is subject to the same
approvals and rigorous underwriting standards as the related traditional credit product. The Corporation
limits its risk exposure to these products by entering into a mirror-image, offsetting swap agreement with
a separate, well-capitalized and rated counterparty previously approved by the Credit and Asset Liability
Committee. By using these interest rate swap arrangements, the Corporation is also better insulated from
the interest rate risk associated with underwriting fixed-rate loans. These derivative contracts are not
designated against specific assets or liabilities under SFAS No. 133 and, therefore, do not qualify for
hedge accounting. The derivatives are recorded on the balance sheet at fair value and changes in fair
value of both the customer and the offsetting swaps agreements are recorded (and essentially offset) in
non-interest income. The fair value of the derivative instruments incorporates a consideration of credit
risk (in accordance with SFAS No. 157), resulting in some volatility in earnings each period.
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.
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 prior financial statements to conform to the current financial
statement presentation. These reclassifications had no effect on net income.
CURRENT ECONOMIC CONDITIONS present financial institutions with unprecedented circumstances and challenges
that in some cases have resulted in large declines in the fair values of investments and other assets,
constraints on liquidity and significant credit quality problems, including severe volatility in the
valuation of real estate and other collateral supporting loans. The financial statements have been prepared
using values and information currently available to the Corporation.
Given the volatility of current economic conditions, the values of assets and liabilities recorded in the
financial statements could change rapidly, resulting in material future adjustments in asset values, the
allowance for loan losses, capital that could negatively impact the Corporation’s ability to meet
regulatory capital requirements and maintain sufficient liquidity.
54
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
On December 31, 2008, the Corporation acquired 100 percent of the outstanding shares of Lincoln Bancorp,
the holding company of Lincoln Bank. Lincoln Bank is a state chartered bank headquartered in Plainfield,
Indiana. Lincoln Bancorp was merged into the Corporation and Lincoln Bank maintained its state charter as a
wholly owned subsidiary of the Corporation. Lincoln Bank has seventeen banking centers in Brown, Clinton,
Hamilton, Hendricks, Johnson, Montgomery and Morgan counties in Indiana. As a result of this acquisition,
the Corporation will have the opportunity to increase its customer base and continue to increase its market
share in the Indianapolis area.
The aggregate purchase price was $77.3 million comprised of $16.8 million in cash, $60.1 million in stock
issued and $.4 million in legal and audit fees related to the acquisition. The purchase price resulted in
approximately $19.8 million in goodwill and $12.5 million in core deposit intangible. The core deposit
intangible asset is being amortized over ten years, using an accelerated method. Goodwill will not be
amortized but will instead be evaluated at least annually for impairment.
The following table summarizes the estimated fair value of assets acquired and liabilities assumed at the
date of acquisition.
===============================================================
(Dollars in Thousands) December 31,
===============================================================
2008
----------
Cash............................................. $ 7,177
Interest bearing time deposits................... 24,608
Investment securities............................ 122,093
Mortgage loans held for sale..................... 2,219
Loans, net of allowance for loan losses of $8,679 626,058
Premises and equipment........................... 15,624
Federal Home Loan Bank stock..................... 8,808
Interest receivable.............................. 3,465
Core Deposit Intangible.......................... 12,461
Goodwill......................................... 19,813
Cash Surrender value of life insurance........... 21,903
Other real estate owned.......................... 3,017
Other assets..................................... 11,788
Total assets acquired.................. $ 879,034
----------
----------
Deposits......................................... $ 653,157
Securities sold under repurchase agreements...... 15,300
FHLB advances.................................... 121,367
Interest payable................................. 1,736
Other liabilities................................ 10,184
----------
Total liabilities...................... 801,744
----------
Net assets acquired.......... $ 77,290
==========
The following table presents pro forma information for the periods ended December 31, 2008, as if the
acquisitions had occurred at the beginning of 2008 and 2007. The pro forma financial information is not
indicative of the results of operations had the transaction been effected on the assumed dates and is not
intended to be a projection of future results.
===================================================================================
(Dollars in Thousands except per share data) December 31,
===================================================================================
2008
2007
---------- --------
Net Interest Income.............................. $ 106,495 $ 134,906
Net Income (loss)................................ $ (13,638) $ 33,387
Per share – combined:
Basic net income....................... $ (5.20) $ 2.08
Diluted net income..................... $ (5.20) $ 2.07
On April 1, 2008, the Corporation acquired Patishall Insurance Agency, Inc. (“Patishall”), which was merged
into First Merchants Insurance Services, Inc., a wholly owned subsidiary of the Corporation. The
Corporation issued approximately 51,302 shares of its common stock at a cost of $28.513 per share to
complete the transaction. This transaction was deemed to be an immaterial acquisition.
55
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
Purchased Loans subject to SOP 03-3
The American Institute of Public Accountants Statement of Position 03-3, “Accounting for Certain Loans or
Debt Securities Acquired in a Transfer” (“SOP 03-3”) addresses accounting for differences between
contractual cash flows of certain loans and debt securities and the cash flows expected to be collected
when loans or debt securities are acquired in a transfer and those cash flow differences are attributable,
at least in part, to credit quality. As such, SOP 03-3 applies to loans and debt securities acquired
individually, in pools, or as a part of a business combination. It is not applicable to loans originated by
the lender. The application of SOP 03-3 limits interest income, including accretion of purchase price
discounts that may be recognized for certain loans and debt securities. Additionally, SOP-3 does not allow
the excess of contractual cash flows over cash flows expected to be collected to be recognized as an
adjustment of yield, loss accrual or valuation allowance, such as the allowance for possible loan losses.
SOP 03-3 requires that increases in expected cash flows subsequent to the initial investment be recognized
prospectively through adjustment of the yield on the loan or debt security over it’s remaining life.
Decreases in expected cash flows should be recognized as impairment.
The Corporation has purchased loans on December 31, 2008, for which there was, at acquisition, evidence of
deterioration of credit quality since origination and it was probable, at acquisition, that all
contractually required payments would not be collected. The carrying amount of these loans was reduced by
$2,003,000. The carrying amount of these loans is as follows as of December 31, 2008:
===============================================================
(Dollars in Thousands except per share data) December 31,
===============================================================
2008
---------
Outstanding Balance
Commercial real estate
$ 10,320
---------
10,320
---------
Carrying amount, net of allowance $ 8,317
=========
These loans were considered impaired at December 31, 2008 and no accretable yield was assigned at the date
of 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, 2008, was $17,275,000.
NOTE 4
INVESTMENT SECURITIES
The Corporation’s management has evaluated all securities with unrealized losses for other than temporary
impairment as of December 31, 2008. The evaluations are based on the nature of the securities, the extent
and duration of the loss and the intent and ability of the Corporation to hold these securities either to
maturity or through the expected recovery period.
The current unrealized losses are primarily concentrated within trust preferred securities held by the
Corporation. The Corporation holds ten trust preferred pool securities and four single issuer securities.
Such investments have a book value of $18.8 million and a fair value of $9.8, which is only 2 percent of
the Corporation’s entire investment portfolio. On all but one small pool investment, the Corporation
utilizes broker quotes to determine their fair value.
The Corporation utilizes a third party for portfolio accounting services, including market value input.
The Corporation has obtained an understanding of what inputs are being used by the vendor in pricing our
portfolio and how the vendor was classifying these securities based upon these inputs. From these
discussions, the Corporation’s management is comfortable the classifications are proper. The Corporation
has gained trust in the data for two reasons: (a) independent spot testing of the data is conducted by the
Corporation through obtaining market quotes from various brokers on a periodic basis and (b) actual gains
or loss resulting from the sale of certain securities has proven the data to be accurate over time.
56
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 fair values of the investments have been impacted by the recent market conditions which have caused
risk and liquidity premiums to increase resulting in a significant decline in the fair value of the
Corporation’s trust preferred securities, or the value the Corporation could realize if it were forced to
immediately sell the securities into the secondary market. Management has determined that (a) the drop in
market value is a result of illiquidity in the current market rather than poor performance, and (b) there
has not been an adverse change in future cash flows of the securities.
The Corporation has the intent and ability to hold these, and all other, investment securities until the
fair value is recovered, which may be maturity, and therefore, does not consider them, with one exception,
to be other-than-temporarily impaired at December 31, 2008. The one exception is a smaller trust preferred
pool that has been deemed other than temporarily impaired, due to a higher rate of defaults and deferrals
from the underlying banks in the pool. A $1.2 million loss was included in the earnings for 2008
establishing a new cost basis of $770,000.
During 2008, the Corporation owned shares of a series of preferred stock issued by the Federal Home Loan
Mortgage Corporation (“FHLMC”). On September 7, 2008, the Federal Housing Finance Agency (“FHFA”) was
appointed as conservator of FHLMC, and the U.S. Treasury Department disclosed that it had entered into a
Senior Preferred Stock Purchase Agreement with FHLMC, contemplating an investment of up to $100 billion.
The senior preferred stock has a liquidation preference senior to all FHLMC stock, including the series of
preferred stock held by the Corporation. In addition, the terms of the senior preferred stock prohibit
FHLMC from declaring or paying any dividend or making any other distribution with respect to any stock
other than the senior preferred stock without the consent of the U.S. Treasury Department. In connection
with the appointment of the FHFA as conservator, the FHFA announced that it was eliminating the payment of
all future dividends on all FHLMC stock, including dividends on the series of preferred stock that the
Corporation owns. After assessing these events, during the third quarter of 2008, the Corporation recorded
an other-than-temporary impairment write-down of $1,458,000 related to its investments in the preferred
securities issued by FHLMC. The investment was sold during the fourth quarter of 2008 triggering an
additional $47,000 loss.
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, 2008
U.S. Government-sponsored Agency Securities.. $ 15,451 $ 218 $ 15,669
State and Municipal ......................... 156,426
3,220 $ 107 159,539
Mortgage-backed Securities .................. 265,820 4,472 215 270,077
Corporate Obligations........ ............... 19,822 8,978 10,844
Marketable Equity Securities ................ 3,507
3,507
-------- -------- -------- --------
Total Available for Sale ................. 461,026 7,910 9,300 459,636
-------- -------- -------- --------
Held to Maturity at December 31, 2008
U.S. Treasury ............................... 11,675
1 11,674
State and Municipal ......................... 10,666 93 264 10,495
Mortgage-backed Securities .................. 7
7
-------- -------- -------- --------
Total Held to Maturity ................... 22,348 93 265 22,176
-------- -------- -------- --------
Total Investment Securities .............. $483,374 $ 8,003 $ 9,565 $481,812
======== ======== ======== ========
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
======== ======== ======== ========
57
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
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 $69,909,000 and $214,293,000 at
December 31, 2008 and 2007, respectively. Total fair value of these investments was $60,343,000 and
$210,391,000, which is approximately 12.5 and 46.6 percent of the Corporation's available-for-sale and
held-to-maturity investment portfolio at December 31, 2008 and 2007, respectively.
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.
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, 2008 and 2007:
====================================================================================================================================
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, 2008:
U.S. Treasury........................ ..................... $ 11,374 $ (1) $ 11,374 $ (1)
U.S. Government-sponsored Agency Securities ...............
State and Municipal ....................................... 10,274 (124) $ 3,582 $ (247) 13,856 (371)
Mortgage-backed Securities ................................ 13,315 (47) 11,755 (168) 25,070 (215)
Corporate Obligations ..................................... 7,302 (69) 2,741 (8,909) 10,043 (8,978)
Marketable Equity Securities ..............................
-------- ------- -------- ------- -------- --------
Total Temporarily Impaired Investment Securities ....... $ 42,265 $ (241) $ 18,078 $(9,324) $ 60,343 $ (9,565)
======== ======= ======== ======= ======== ========
---------
---------------------------------------------------------------------
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, 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)
======== ======= ======== ======= ======== ========
The amortized cost and fair value of securities available for sale and held to maturity at December 31,
2008 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 Distribution at December 31, 2008:
Due in One Year or Less.......................................... $ 30,737 $ 30,946 $ 13,131 $ 13,130
Due After One Through Five Years................................. 75,159 76,377 435 441
Due After Five Through Ten Years................................. 34,700 35,318 3,990 3,767
Due After Ten Years ............................................. 51,103 43,411 4,785 4,831
-------- -------- -------- --------
$191,699 $186,052 $ 22,341 $ 22,169
Mortgage-backed Securities....................................... 265,820 270,077 7 7
Marketable Equity Securities .................................... 3,507 3,507
-------- -------- -------- --------
Totals......................................................... $461,026 $459,636 $ 22,348 $ 22,176
======== ======== ======== ========
58
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
Securities with a carrying value of approximately $281,925,000, $191,470,000 and 143,652,000 were pledged
at December 31, 2008, 2007 and 2006, 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 2008, 2007 and 2006 were $60,335,000,
$7,219,000 and $575,000, respectively. Gross gains of $653,000, $0 and $0 in 2008, 2007 and 2006, and
gross losses of $54,000, $0 and $4,000 in 2008, 2007 and 2006, were realized on those sales.
NOTE 5
LOANS AND ALLOWANCE
2008 2007
=============================
Loans at December 31:
Commercial and Industrial Loans.............. $ 904,646 $ 662,701
Agricultural Production
Financing and Other Loans to Farmers....... 135,099 114,324
Real Estate Loans:
Construction............................... 252,487 165,425
Commercial and Farmland.................... 1,202,372 947,234
Residential................................ 956,245 744,627
Individuals' Loans for
Household and Other Personal Expenditures.. 201,632 187,880
Tax-exempt Loans............................. 28,070 16,423
Lease Financing Receivables,
Net of Unearned Income .................... 8,996 8,351
Other Loans.................................. 32,405 29,878
---------- ----------
3,721,952 2,876,843
Allowance for Loan Losses................... (49,543) (28,228)
---------- ----------
Total Loans........................ $3,672,409 $2,848,615
========== ==========
Residential Real Estate Loans Held for Sale at December 31, 2008 and 2007 were $4,295,000 and $3,735,000,
respectively.
2008 2007 2006
==============================================
Allowance for Loan Losses
Balance, January 1 ......................... $ 28,228 $ 26,540 $ 25,188
Provision for Losses ....................... 28,238 8,507 6,258
Recoveries on Loans ........................
Loans Charged Off .......................... (22,626) (8,557) (6,510)
Allowance Acquired in Acquisition........... 8,679
---------- ---------- -----------
Balance, December 31 ....................... $ 49,543 $ 28,228 $ 26,540
======== ========= ========
7,024 1,738 1,604
Information on nonaccruing, contractually past due 90 days or more other than nonaccruing and restructured
loans is summarized below:
2008 2007
============================
Non-accrual Loans......................... $ 87,546 $ 29,031
Loans Contractually Past Due 90
Days or More Other Than Nonaccruing..... 5,982 3,578
Restructured Loans........................ 130 145
-------- --------
Total Non-performing Loans........... $ 93,658 $ 32,754
======== =========
59
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
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 classified loans, including
substandard, doubtful and loss credits, are included in the impaired loan total. The fair value for
impaired loans is measured based on the value of the collateral securing those loans and is determined
using several methods. The fair value of real estate is generally determined based on appraisals by
qualified licensed appraisers. The appraisers typically determine the value of the real estate by
utilizing an income or market valuation approach. If an appraisal is not available, the fair value may be
determined by using a cash flow analysis. Fair value on other collateral such as business assets is
typically valued by using the financial information such as financial statements and aging reports provided
by the borrower and is discounted as considered appropriate. Information on impaired loans is summarized
below:
Information on impaired loans is summarized below:
2008 2007 2006
=====================================================================================================================
As of, and for the Year Ending December 31:
Impaired Loans with an Allowance .......................... $ 25,397 $ 21,304 $ 17,291
Impaired Loans for which the Discounted
Cash Flows or Collateral Value Exceeds the
Carrying Value of the Loan ............................ 180,729 65,645 43,029
------- ------- -------
Total Impaired Loans ............................... $206,126 $86,949 $ 60,320
======== ======= ========
Total Impaired Loans as a Percent
of Total Loans ........................................ 5.53% 3.02% 2.24%
Allowance for Impaired Loans (Included in the
Corporation's Allowance for Loan Losses) .............. $ 9,790 $ 6,034 $ 4,130
Average Balance of Impaired Loans ......................... 229,608 103,272 66,139
Interest Income Recognized on Impaired Loans .............. 8,078 6,675 5,143
Cash Basis Interest Included Above ........................ 997 1,143 1,364
NOTE 6
PREMISES AND EQUIPMENT
2008 2007
================================================================================
Cost at December 31:
Land .......................................... $ 14,839 $ 7,993
Buildings and Leasehold Improvements .......... 61,295 47,853
Equipment ..................................... 49,817 40,455
-------- --------
Total Cost ................................ 125,951 96,301
Accumulated Depreciation and Amortization ..... (66,310) (51,856)
-------- --------
Net ....................................... $ 59,641 $ 44,445
======== ========
The Corporation is committed under various noncancelable lease contracts for certain subsidiary office
facilities and equipment. Total lease expense for 2008, 2007 and 2006 was $2,213,000, $2,477,000 and
$2,651,000, respectively. The future minimum rental commitments required under the operating leases in
effect at December 31, 2008, expiring at various dates through the year 2016 are as follows for the years
ending December 31:
====================================================
2009 ................................ $ 2,010
2010 ................................ 1,844
2011 ................................ 1,647
2012 ................................ 1,104
2013 ................................ 461
After 2013 ........................... 677
-------
Total Future Minimum Obligations $ 7,743
=======
60
PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 7
GOODWILL
The changes in the carrying amount of goodwill at December 31 are noted below. During 2008, the
Corporation purchased Lincoln Bancorp and Patishall, as discussed in Note 2, Business Combinations. These
purchases resulted in acquired Goodwill of approximately $19,813,000 for Lincoln and $1,415,000 for
Patishall. Also, on December 31, 2008, the Corporation sold its interest in the assets of Indiana Title
Insurance Company, LLC (ITIC). This sale resulted in a write-off of Goodwill of approximately $1,190,000.
No impairment loss was recorded in 2008 and 2007.
2008 2007
=============================================================================
Balance, January 1 .............................. $ 123,444 $ 123,168
Goodwill acquired ............................... 21,228 276
Write-off from sale of subsidiary assets (1,190)
--------- ---------
Balance, December 31 ............................ $ 143,482 $ 123,444
========= =========
NOTE 8
CORE DEPOSIT AND OTHER INTANGIBLES
The carrying basis and accumulated amortization of recognized core deposit and other intangibles are noted
below. On December 31, 2008, the Corporation purchased Lincoln Bancorp and Patishall, as discussed in Note
2, Business Combinations. This purchase resulted in acquired core deposit intangibles of $12,461,000 for
Lincoln and other intangibles for Patishall of $$835,000.
2008 2007
=============================================================================
Gross Carrying Amount ........................... $ 45,422 $ 32,126
Accumulated Amortization ........................ (22,930) (19,714)
--------- ---------
Core Deposit and Other Intangibles ........... $ 22,492 $ 12,412
========= =========
Amortization expense for the years ended December 31, 2008, 2007 and 2006, was $3,216,000, $3,159,000 and
$3,066,000, respectively. Estimated amortization expense for each of the following five years is:
====================================================
2009 ................................ $ 5,109
2010 ................................ 4,721
2011 ................................ 3,548
2012 ................................ 1,858
2013 ................................ 1,441
After 2013 .......................... 5,815
------
$22,492
=======
NOTE 9
DEPOSITS
2008 2007
============================================================================
Deposits at December 31:
Demand Deposits ............................. $1,136,267 $ 903,380
Savings Deposits ............................ 721,387 552,380
Certificates and Other Time Deposits
of $100,000 or more ....................... 546,081 495,630
Other Certificates and Time Deposits ........ 1,315,076 892,731
---------- ----------
Total Deposits .......................... $3,718,811 $2,844,121
========== ==========
=====================================================
Certificates and Other Time Deposits Maturing
in Years Ending December 31:
2009 ....................... $1,187,569
2010 ....................... 373,533
2011 ....................... 200,841
2012 ....................... 55,779
2013 ....................... 28,943
After 2013 ................. 14,492
----------
$1,861,157
==========
61
PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 9
DEPOSITS continued
Time deposits obtained through brokers were $477,283,000 and $239,019,000 at December 31, 2008 and 2007,
respectively.
NOTE 10
BORROWINGS
2008 2007
===================================================================================
Borrowings at December 31:
Federal Funds Purchased ........................... $ 52,350
Securities Sold Under Repurchase Agreements ....... $122,311 106,497
Federal Home Loan Bank Advances ................... 360,217 294,101
Subordinated Debentures, Revolving Credit
Lines and Term Loans ............................ 135,826 115,826
-------- --------
Total Borrowings .............................. $618,354 $568,774
======== ========
Securities sold under repurchase agreements consist of obligations of the Banks to other parties. The
obligations are secured by U.S. Treasury and U.S. Government Sponsored Enterprise obligations. The maximum
amount of outstanding agreements at any month-end during 2008 and 2007 totaled $122,311,000 and
$128,023,000, respectively, and the average of such agreements totaled $99,840,000 and $85,853,000 during
2008 and 2007, 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, 2008, are as follows:
REPURCHASE AGREEMENTS BANK ADVANCES AND TERM LOANS
===========================================================================================================================
SECURITIES SOLD UNDER FEDERAL HOME LOAN REVOLVING CREDIT LINES
SUBORDINATED DEBENTURES
AMOUNT AMOUNT AMOUNT
===========================================================================================================================
Maturities in Years Ending December 31:
2009 .............. $ 88,061 $137,015 $ 20,000
2010 .............. 10,000 86,183
2011 .............. 32,163
2012 .............. 14,250 72,097
2013 .............. 7,756
After 2013 ........ 10,000 25,003 115,826
-------- -------- --------
Total ...... $122,311 $360,217 $135,826
======== ======== ========
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 0.39 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, 2008, was $95,214,000.
Subordinated Debentures, Revolving Credit Lines and Term Loans. Three borrowings were outstanding on
December 31, 2008, for $135,826,000.
•
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 Board of Governors of the Federal
Reserve System, 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.
62
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
•
•
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.
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 February 15, 2008.
The LaSalle Agreement includes three credit facilities:
o
o
The Term Loan of $5,000,000 matures on February 15, 2015. 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 and Lafayette. 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 $20,000,000 at December 31, 2008. 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 February 15, 2009. 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 and Lafayette. 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. At December 31, 2008, the Corporation was in violation of
capital and earnings covenants with LaSalle on this Revolving Loan. The covenant requires
the Corporation to exceed a minimum return on average assets of 75 basis points over the
most recent four quarter period. The Corporation was not provided a loan covenant waiver as
LaSalle is currently in the process of renewing the Revolving Loan Agreement. LaSalle
required the Corporation to pay down the outstanding balance by $10 million in order to
renew the agreement. Accordingly, on February 20, 2009, the Corporation reduced the
outstanding balance to $10 million and has the ability to further reduce the outstanding
balance to zero. When renewed, the Corporation will have a reduced borrowing capacity on
this Revolving Loan of $10 million.
o
The Subordinated Debenture of $50,000,000 matures on February 15, 2015. 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.
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 Board of Governors of the Federal
Reserve System, 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.
63
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
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.
o
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.
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 $231,548,000 $115,618,000 and $98,538,000 at December 31, 2008, 2007 and 2006, respectively, the
amount of capitalized servicing assets is considered immaterial.
NOTE 12
INCOME TAX
2008 2007 2006
=================================================================================================================================
Income Tax Expense for the Year Ended December 31:
Currently Payable:
Federal ................................................................ $ 16,533 $ 13,343 $ 13,192
State .................................................................. 216 162 1,415
Deferred:
Federal ................................................................ (8,450) (1,664) (1,785)
State .................................................................. (216) (498) (627)
-------- -------- --------
Total Income Tax Expense ............................................ $ 8,083 $ 11,343 $ 12,195
======== ======== ========
Reconciliation of Federal Statutory to Actual Tax Expense:
Federal Statutory Income Tax at 35% .................................... $ 10,052 $ 15,043 $ 14,837
Tax-exempt Interest .................................................... (2,226) (2,259) (2,215)
Effect of State Income Taxes ........................................... (220) 475
Earnings on Life Insurance ............................................. 300 (1,064) (594)
Tax Credits ............................................................ (177) (348) (391)
Other .................................................................. 134 191 83
-------- -------- --------
Actual Tax Expense ................................................. $ 8,083 $ 11,343 $ 12,195
======== ======== ========
Tax expense (benefit) applicable to security gains and losses, including unrealized losses relating to
other than temporary impairment charges, for the years ended December 31, 2008, 2007 and 2006, was
$(833,000), $0 and $(2,000), respectively.
64
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:
2008 2007
======================================================================================================================
Deferred Tax Asset at December 31:
Assets:
Differences in Accounting for Loan Losses ............................. $20,946 $11,086
Differences in Accounting for Loan Fees ............................... 386
Deferred Compensation ................................................. 6,564 3,841
Difference in Accounting for Pensions
and Other Employee Benefits ......................................... 4,207 3,071
Federal Income Tax Loss Carryforward and Credits ......................
State Income Tax ...................................................... 156
Net Unrealized Loss on Securities Available for Sale................... 2,688
Other ................................................................. 814 322
------ ------
Total Assets ...................................................... 39,311 18,476
------ ------
Liabilities:
Differences in Depreciation Methods ................................... 4,053 3,508
Differences in Accounting for Loans and Securities .................... 2,822 3,889
Differences in Accounting for Loan Fees ............................... 399
State Income Tax ......................................................
Net Unrealized Gain on Securities Available for Sale................... 220
Other ................................................................. 3,711 2,344
------ ------
Total Liabilities ................................................. 10,918 10,360
------ ------
Net Deferred Tax Asset ............................................ $28,393 $ 8,116
======= =======
3,706
332
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:
2008 2007
======== ========
Commitments
to Extend Credit $794,240 $747,070
Standby Letters
of Credit 31,194 25,431
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.
65
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, 2008, available for 2009 dividends from First
Merchants, Central Indiana, Lafayette, Commerce National, Lincoln, FMTC and FMIS to the Corporation totaled
$20,235,000, $1,115,000, $0, $10,678,000, $0, $294,000 and $10,534,000, respectively.
Total stockholders' equity for all subsidiaries at December 31, 2008, was $527,166,000 of which
$484,698,000 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, 2008, 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
four of the Corporation’s 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.
As of December 31, 2008, four of the five bank subsidiaries of the Corporation were "well capitalized"
based on the "prompt corrective action" ratios and deadlines described above. Lincoln was not considered
well capitalized at December 31, 2008. However, on February 20, 2009, the Corporation added $30 million in
capital to Lincoln, which returned them to well capitalized status. It should be noted 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.
66
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.
=================================================================================================================================
2008 2007
REQUIRED FOR REQUIRED FOR
ACTUAL ADEQUATE CAPITAL1 ACTUAL ADEQUATE CAPITAL1
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
=================================================================================================================================
December 31
Total Capital1 (to Risk-weighted Assets)
Consolidated ...................... $385,452 10.24% $313,423 8.00% $312,080 10.55% $236,636 8.00%
First Merchants ................... 181,281 10.52 137,842 8.00 169,678 11.07 122,567 8.00
Central Indiana.................... 28,830 11.42 20,205 8.00 29,268 11.72 19,984 8.00
Lincoln............................ 56,010 7.86 57,012 8.00
Lafayette ......................... 84,568 12.94 55,306 8.00 79,692 11.46 55,646 8.00
Commerce National.................. 57,367 10.58 43,385 8.00 52,353 10.76 38,922 8.00
Tier I Capital1 (to Risk-weighted Assets)
Consolidated ...................... $286,473 7.71% $156,711 4.00% $258,918 8.75% $118,318 4.00%
First Merchants ................... 159,767 9.27 68,921 4.00 154,624 10.09 61,284 4.00
Central Indiana.................... 26,089 10.33 10,102 4.00 26,669 10.68 9,992 4.00
Lincoln............................ 47,975 6.64 28,506 4.00
Lafayette ......................... 75,920 11.69 27,653 4.00 73,437 10.56 27,823 4.00
Commerce National.................. 51,884 9.57 21,692 4.00 48,099 9.89 19,461 4.00
Tier I Capital1 (to Average Assets)
Consolidated ...................... $286,473 8.16% $148,164 4.00% $258,918 7.19% $144,000 4.00%
First Merchants ................... 159,767 8.05 79,366 4.00 154,624 8.10 76,293 4.00
Central Indiana.................... 26,089 8.41 12,401 4.00 26,669 8.91 11,966 4.00
Lincoln............................ 47,975 5.90 32,071 4.00
Lafayette ......................... 75,920 9.28 34,834 4.00 73,437 8.01 36,669 4.00
Commerce National.................. 51,884 8.51 24,379 4.00 48,099 9.11 21,119 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 and, therefore, any unvested shares are forfeited. Deferred stock units (“DSUs”) have been credited to
non-employee directors who have elected to defer payment of compensation under the Corporation’s 2008
Equity Compensation plan for Non-employee Directors. DSUs credited are equal to the restricted shares that
the non-employee directors would have received under the plan. As of December 31, 2008, there were 1,620
DSUs credited to the non-employee directors.
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 No. 123(R) requires the Corporation to record compensation expense related to unvested share-based
awards by recognizing the unamortized 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 are valued
at fair value in accordance with provisions of SFAS No. 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 compensation for the years ended December 31, 2008, 2007 and 2006 totaled $1,898,000, $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.
1 As defined by regulatory agencies
67
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 estimated fair value of the stock options granted during 2008, 2007, and 2006 was calculated using a
Black Scholes options pricing model. The following summarizes the assumptions used in the Black Scholes
model:
2008 2007 2006
---- ---- ----
Risk-free Interest Rate ................................. 2.69% 4.67% 4.59%
Expected Price Volatility ............................... 32.13% 29.76% 29.84%
Dividend Yield .......................................... 3.68% 3.64% 3.54%
Forfeiture Rate.......................................... 5.00% 5.00% 4.00%
Weighted-average Expected Life, Until Exercise .......... 6.53 years 5.99 years 5.75 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 No. 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, 2008, based on historical experience.
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 Year Ended
December 31, 2008 December 31, 2007 December 31, 2006
----------------- ----------------- -----------------
Stock and ESPP Options:
Pre-tax Compensation Expense ...................... $ 650 $ 602 $ 449
Income Tax Benefit................................. (49) (41) (42)
---------------- ---------------- ----------------
Stock and ESPP Options Expense, Net of Income........ $ 601 $ 561 $ 407
================ ================ ================
Year Ended
Restricted Stock Awards:
Pre-tax Compensation Expense ...................... $ 1,248 $ 866 $ 384
Income Tax Benefit................................. (437) (303) (135)
---------------- ---------------- ----------------
Restricted Stock Awards Expense, Net of Tax ......... $ 811 $ 563 $ 249
================ ================ ================
Total Share-based Compensation:
Pre-tax Compensation Expense ...................... $ 1,898 $ 1,468 $ 833
Income Tax Benefit................................. (486) (344) (177)
---------------- ---------------- ----------------
Total Share-based Compensation Expense, Net of Tax... $ 1,412 $ 1,124 $ 656
================ ================ ================
As of December 31, 2008, unrecognized compensation expense related to stock options, RSAs and ESPP options
totaling $259,000, $1,681,000 and $119,000, respectively, is expected to be recognized over weighted-
average periods of .67, 1.31 and .5 years, respectively.
68
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
Stock option activity under the Corporation's stock option plans as of December 31, 2008 and changes during
the year ended December 31, 2008 were as follows:
Weighted-
Average
Weighted- Remaining
Number Average Contractual Aggregate
of Exercise Term Intrinsic
Shares Price (in Years) Value
---------- ------------ ----------- ----------
Outstanding at January 1, 2008 .................. 1,054,430 $ 24.30
Granted.......................................... 82,713 26.76
Exercised........................................ (124,896) 22.70
Cancelled........................................ (60,925) 24.77
----------
Outstanding at December 31, 2008 ................ 951,322 $ 24.70 5.30 $533,634
==========
Vested and Expected to Vest at December 31, 2008. 951,322 $ 24.70 5.30 $533,634
Exercisable at December 31, 2008 ................ 809,159 $ 24.36 4.70 $496,772
The weighted-average grant date fair value was $6.08, $5.85 and $6.22 for stock options granted during the
year ended December 31, 2008, 2007 and 2006, 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 2008 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 2008. 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, 2008, 2007 and
2006 were $615,000, $250,185 and $665,000, respectively. Exercise of options during these same periods
resulted in cash receipts of $1,633,000, $496,000 and $1,228,000, respectively. The Corporation recognized
a tax benefit of approximately $156,000 for the year ended December 31, 2008, related to the exercise of
employee stock options and has been recorded as an increase to additional paid-in capital.
The following table summarizes information on unvested restricted stock awards outstanding as of December
31, 2008:
Number of Grant-Date
Shares Fair Value
---------- ----------
Unvested RSAs at January 1, 2008............ 98,027 $ 27.12
Granted .................................... 69,899 26.94
Forfeited................................... (2,719) 24.54
Vested...................................... (2,713) 24.82
-------- --------
Unvested RSAs at December 31, 2008 ......... 162,494 $ 26.20
======== ========
The grant date fair value of ESPP options was estimated at the beginning of the July 1, 2008 offering
period and approximates $240,000. The ESPP options vest during the twelve-month period ending June 30,
2009. At December 31, 2008, total unrecognized compensation expense related to unvested ESPP options was
$120,000, which is expected to be recognized over a six-month period ending June 30, 2009.
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 Corporation also
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.
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
69
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
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,
"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 table below sets forth the plans' funded status and amounts recognized in the consolidated balance
sheet at December 31, using measurement dates of December 31, 2008 and September 30, 2007.
December 31
2008 2007
===================================================================================
Change in benefit obligation
Benefit obligation at beginning of year ............ $ 57,500 $ 58,078
Service cost ....................................... 1,852 671
Interest cost....................................... 2,032 3,146
Actuarial (gain)/loss .............................. 493 (1,640)
Adjustment due to measurement date change .......... 546
Benefits paid....................................... (3,548) (2,755)
-------- --------
Benefit obligation at end of year .................. 58,875 57,500
-------- --------
Change in plan assets
Fair value of plan assets at beginning of year...... 46,252 41,591
Actual return on plan assets........................ (13,768) 6,563
Expected return on plan assets ..................... 2,134
Employer Contributions.............................. 15,911 853
Adjustment due to measurement date change .......... 533
Benefits Paid....................................... (3,548) (2,755)
-------- --------
End of Year ........................................ 47,514 46,252
-------- --------
Unfunded Status at End of Year........................... $ 11,361 $ 11,248
======== ========
Assets and Liabilities Recognized in the Balance Sheets:
Deferred Tax Assets................................. $ 9,107 $ 2,804
Liabilities ........................................ $ 11,361 $ 11,248
Amounts Recognized in Accumulated Other Comprehensive Income Not Yet
Recognized as Components of Net Periodic Benefit Cost Consist of:
Accumulated loss.................................... $ 13,559 $ 4,089
Prior Service Credit................................ 101 118
-------- --------
$ 13,660 $ 4,207
======== ========
The accumulated benefit obligation for all defined benefit plans was $58,437,000 and $56,739,000 at
December 31, 2008 and 2007, respectively.
Information for pension plans with an accumulated benefit obligation in excess of plan assets:
December 31
2008 2007
===================================================================================
Projected Benefit Obligation........................ $ 58,875 $ 57,500
======== ========
Accumulated Benefit Obligation ..................... $ 58,437 $ 51,770
======== ========
Fair Value of Plan Assets........................... $ 47,514 $ 46,252
======== ========
The following table shows the components of net periodic pension costs. The 2008 column includes gross for
the 15-month period due to the measurement date change:
December 31
2008 2007
===================================================================================
Service Cost ....................................... $ 537 $ 671
Interest Cost....................................... 3,084 3,146
Expected Return on Plan Assets...................... (3,506) (3,164)
Amortization of Prior Service Costs ................ 25 25
Amortization of Net Loss ........................... 167 527
-------- --------
Net Periodic Pension Cost........................... $ 307 $ 1,205
======== ========
70
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
Other changes in plan assets and benefit obligations recognized in other comprehensive income:
December 31
2008 2007
==============================================================================================
Net Periodic Pension Cost .............................................. $ 307 $ 1,205
Net gain (loss)...................................................... (10,056) 2,725
Prior service cost arising during period............................. 30
Amortization of prior service (cost) credit.......................... (15) (15)
-------- -------
Total Recognized in Other Comprehensive Income....................... (10,071) 2,740
-------- -------
Total Recognized in NPPC and OCI........................................$ (9,764) $ 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:
December 31
2008 2007
==============================================================================================
Amortization of Net Loss................................. $ 1,203 $ 152
Amortization of Prior Service Cost ......................
25 16
--------- ---------
Total................................................ $ 1,228 $ 168
========= =========
Significant assumptions include:
December 31
2008 2007
==================================================================================
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% 7.75%
Rate of Compensation Increase ...................... 3.50% 3.52%
At December 31, 2008 and September 30, 2007, 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 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, 2008, the maturities of the plans' debt securities ranged from 96 days to 9.7 years, with a
weighted average maturity of 3.4 years. 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.
The following benefit payments, which reflect expected future service, as appropriate, are expected to be
paid as of December 31, 2008. The minimum contribution required in 2009 will likely be zero but the
Corporation may decide to make a discretionary contribution during the year.
===================================================
2009................................ $ 3,078
2010................................ 3,231
2011................................ 3,463
2012................................ 3,663
2013................................ 3,798
2014 and After...................... 19,898
71
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
Plan assets are re-balanced quarterly. At December 31, 2008 and 2007, plan assets by category are as
follows:
December 31
2008 2007
===========================================================================
Equity Securities................................. 30% 65%
Debt Securities .................................. 31% 32%
Other............................................. 39% 3%
-------- --------
100% 100%
======== ========
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 $2,615,000 for 2008, $2,454,000 for 2007 and $2,026,000 for
2006.
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 $4,792,000 and $1,317,000 at December 31, 2008 and 2007, respectively. Post-retirement plan expense
totaled $225,000, $171,000 and $127,000 for the years ending December 31, 2008, 2007 and 2006,
respectively.
NOTE 18
NET INCOME PER SHARE
=========================================================================================================================================
Year Ended December 31, 2008 2007 2006
----------------------------------------------------------------------------------------------------------------------------------
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 .......... $20,638 18,066,404 $1.14 $31,639 18,249,919 $1.73 $30,198 18,383,074 $1.64
===== ===== =====
Effect of Dilutive Stock Options.. 95,477 64,045 83,679
------- ---------- ------- ---------- ------- ----------
Diluted Net Income Per Share:
Net Income Available to
Common Stockholders
and Assumed Conversions ...... $20,638 18,161,881 $1.14 $31,639 18,313,964 $1.73 $30,198 18,466,753 $1.64
======= ========== ===== ======= ========== ===== ======= ========== =====
Options to purchase 797,595, 831,795 and 590,736 shares of common stock with weighted average exercise
prices of $24.70, $25.67 and $26.21 at December 31, 2008, 2007 and 2006, 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
Effective January 1, 2008, the Corporation adopted Statement of Financial Accounting Standards No. 157,
Fair Value Measurements (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair
value and expands disclosures about fair value measurements. FAS 157 has been applied prospectively as of
the beginning of the year.
FAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date. FAS 157 also
establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and
72
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
minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of
inputs that may be used to measure fair value:
Level 1 Quoted prices in active markets for identical assets or liabilities
Level 2 Observable inputs other than Level 1 prices, such as quoted prices for
similar assets or liabilities; quoted prices in active markets that are
not active; or other inputs that are observable or can be corroborated
by observable market data for substantially the full term of the assets
or liabilities
Level 3 Unobservable inputs that are supported by little or no market activity
and that are significant to the fair value of the assets or liabilities
Following is a description of the valuation methodologies used for instruments measured at fair value on a
recurring basis and recognized in the accompanying balance sheet, as well as the general classification of
such instruments pursuant to the valuation hierarchy.
Available-For-Sale Securities: Where quoted market prices are available in an active market, securities
are classified within Level 1 of the valuation hierarchy. There are no securities classified within Level
1 of the hierarchy. If quoted market prices are not available, then fair values are estimated by using
pricing models, quoted prices of securities with similar characteristics or discounted cash flows. Level 2
securities include treasury securities, agencies, mortgage backs, state and municipal, corporate
obligations, and marketable equity securities. In certain cases where Level 1 or Level 2 inputs are
not available, securities are classified within Level 3 of the hierarchy and include mortgage-
backed securities and corporate obligations.
Interest Rate Swap Agreements: The fair value is estimated by a third party using inputs that are
primarily unobservable and cannot be corroborated by observable market data and, therefore, are classified
within Level 3 of the valuation hierarchy.
The following table presents the fair value measurements of assets and liabilities recognized in
the accompanying balance sheet measured at fair value on a recurring basis and the level within the FAS
157 fair value hierarchy in which the fair value measurements fall at December 31, 2008.
Fair Value Measurements Using
-----------------------------------------------------------------
Quoted Prices in Significant
Active Markets Other Significant
for Identical Observable Unobservable
Assets Inputs Inputs
Fair Value (Level 1) (Level 2) (Level 3)
--------------------------------------------------------------------------------
Available for sale securities........ $ 459,636 $ 451,707 $ 7,929
Hedged loans......................... 57,970 57,970
Interest rate swap agreements........ (4,224) (4,224)
The following is a reconciliation of the beginning and ending balances of recurring fair value measurements
recognized in the accompanying balance sheet using significant unobservable Level 3 inputs for year ended
December 31, 2008.
Year Ended
December 31, 2008
---------------------------------------------------------
Available for Sale Hedged Interest
Securities Loans Rate Swaps
---------------------------------------------------------
Beginning balance......................... $ 12,023
Total realized and unrealized gains and losses
Included in net income.................. (2,682) $ 4,094 $ (4,224)
Included in other comprehensive income.. (7,002)
Purchases, issuances, and settlements..... 54,657
Transfers in/(out) of Level 3............. 5,710
Principal payments........................ (120) (781)
---------------------------------------------------------
Ending balance $ 7,929 $ 57,970 $ (4,224)
=========================================================
73
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
At January 1, 2008, Level 2 securities include pooled trust preferred securities. The fair value of these
securities was priced using third-party servicer quotations. At December 31, 2008, trading of these types
of securities was only conducted on a distress sale or forced liquidation basis. Given that a quoted market
price was not readily available, the fair value on the trust preferred securities is now calculated using
discounted cash flow projections. The Corporation has included the pooled trust preferred securities in
Level 3 at December 31, 2008.
Following is a description of valuation methodologies used for instruments measured at fair value on a non-
recurring basis and recognized in the accompanying balance sheet, as well as the general classification of
such instruments pursuant to the valuation hierarchy.
Fair Value Measurements Using
-----------------------------------------------------------------
Quoted Prices in Significant
Active Markets Other Significant
for Identical Observable Unobservable
Assets Inputs Inputs
Fair Value (Level 1) (Level 2) (Level 3)
--------------------------------------------------------------------------------
Impaired Loans................................. $ 21,847 $21,847
Assets acquired on December 31, 2008:
Loans...................................... 626,058 626,058
Deposits................................... 655,370 655,370
Securities sold under repurchase agreements 15,300 15,300
FHLB Advances.............................. 121,367 121,367
IMPAIRED LOANS are reported when scheduled payments under contractual terms are deemed uncollectible.
Impaired loans are carried at the present value of estimated future cash flows using the loan's existing
rate, or the fair value of collateral if the loan is collateral dependent. A portion of the allowance for
loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid
balance. If these allocations cause the allowance for loan losses to increase, such increase is reported as
a component of the provision for loan losses. Loan losses are charged against the allowance when
management believes the uncollectability of the loan is confirmed. The valuation of impaired loans would
be considered Level 3, consisting of appraisals of underlying collateral and discounted cash flow analysis.
LOANS acquired at December 31, 2008, with the Lincoln acquisition are estimated using discounted cash flows
at the current rates at which similar loans would be made to borrowers with similar credit ratings and for
the same remaining maturities. Loans with similar characteristics were aggregated for purposes of the
calculations. The carrying amount of accrued interest approximates fair value.
CORE DEPOSIT INTANGIBLES are estimated using a third party valuation.
DEPOSITS include demand deposits, NOW accounts, savings accounts and certain money market accounts. The
carrying amount approximates fair value. The fair value of fixed-maturity time deposits is estimated using
a discounted cash flow calculation that applied the rates currently offered for deposits of similar
remaining maturities.
SECURITIES SOLD UNDER REPURCHASE AGREEMENTS AND FHLB ADVANCES are reported using quoted market prices or a
discounted cash flow method to estimate the fair value of these instruments. Discounting was based on the
contractual cash flows and the current rate at which debt with similar terms could be issued.
74
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
The estimated fair values of the Corporation’s financial instruments are as follows:
2008 2007
=======================================================================================================================================
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
=======================================================================================================================================
Assets at December 31:
Cash and Due from Banks .................................... $ 150,486 $ 150,486 $ 134,683 $ 134,683
Interest-bearing Time Deposits ............................. 38,823 38,823 24,931 24,931
Investment Securities Available for Sale ................... 459,636 459,636 440,836 440,836
Investment Securities Held to Maturity ..................... 22,348 22,176 10,331 10,270
Mortgage Loans Held for Sale ............................... 4,295 4,295 3,735 3,735
Loans ...................................................... 3,672,409 3,660,499 2,848,615 2,846,625
FRB and FHLB Stock ......................................... 34,319 34,319 25,250 25,250
Interest Receivable ........................................ 23,976 23,976 23,402 23,402
Interest Rate Floors ....................................... 2,001 2,001
Liabilities at December 31:
Deposits ................................................... $3,718,811 $3,617,980 $2,844,121 $2,731,895
Borrowings:
Federal Funds Purchased ................................ 52,350 52,350
Securities Sold Under Repurchase Agreements ............ 122,311 122,311 106,497 106,497
FHLB Advances .......................................... 360,217 370,418 294,101 298,574
Subordinated Debentures, Revolving Credit
Lines and Term Loans ................................. 135,826 144,891 115,826 121,177
Interest Payable ........................................... 8,844 8,844 8,325 8,325
Cash and Due from Banks: 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: See Fair Value of Financial Instruments above.
Mortgage Loans Held for Sale: The fair value of mortgage loans held for sale approximates carrying value.
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 analysis, using interest rates currently being offered for loans with
similar terms to borrowers of similar credit quality. See Impaired Loans above.
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.
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 and Interest Payable: The fair values of interest receivable/payable 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 floors are based on an expectation of future
interest rates derived from observed market interest rate curves and volatilities.
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.
75
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)
Presented below is condensed financial information as to financial position, results of operations, and
cash flows of the Corporation:
CONDENSED BALANCE SHEETS
December 31,
2008 2007
================================================================================
Assets
Cash .............................................. $ 19,365 $ 8,192
Investment in Subsidiaries ........................ 527,166 445,104
Goodwill .......................................... 448 448
Other Assets ...................................... 14,992 12,282
-------- --------
Total Assets ................................... $561,971 $466,026
======== ========
Liabilities
Borrowings ........................................ $135,826 $115,826
Other Liabilities ................................. 30,242 10,264
-------- --------
Total Liabilities .............................. 166,068 126,090
Stockholders' Equity ................................. 395,903 339,936
-------- --------
Total Liabilities and Stockholders' Equity ..... $561,971 $466,026
======== ========
CONDENSED STATEMENTS OF INCOME
December 31,
2008 2007 2006
=================================================================================================================================
Income
Dividends from Subsidiaries ................................................ $ 24,528 $ 20,979 $ 33,919
Administrative Services Fees from Subsidiaries.............................. 18,252 17,670 15,104
Other Income ............................................................... 3,316 102 240
-------- -------- --------
Total Income ............................................................ 46,096 38,750 49,263
-------- -------- --------
Expenses
Amortization of Fair Value Adjustments...................................... 11 11
Interest Expense............................................................ 6,870 7,750 8,124
Salaries and Employee Benefits.............................................. 18,325 16,111 13,934
Net Occupancy Expenses...................................................... 1,286 1,198 1,232
Equipment Expenses.......................................................... 3,895 3,772 4,210
Telephone Expenses.......................................................... 910 915 1,108
Postage and Courier Expenses................................................ 1,807 1,797 1,658
Other Expenses.............................................................. 3,656 5,898 2,548
-------- -------- --------
Total Expenses .......................................................... 36,749 37,452 32,825
-------- -------- --------
Income Before Income Tax Benefit and Equity in
Undistributed Income of Subsidiaries ....................................... 9,347 1,298 16,438
Income Tax Benefit ...................................................... 5,436 7,355 6,771
-------- -------- --------
Income Before Equity in Undistributed Income of Subsidiaries ................. 14,783 8,653 23,209
Equity in Undistributed (Distributions in Excess of)
Income of Subsidiaries ................................................... 5,855 22,986 6,989
-------- -------- --------
Net Income ................................................................... $ 20,638 $ 31,639 $ 30,198
======== ======== ========
76
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 CASH FLOWS
Year Ended December 31,
=====================================================================================================================
2008 2007 2006
=====================================================================================================================
Operating Activities:
Net Income ........................................................ $ 20,638 $ 31,639 $ 30,198
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
Amortization .................................................... 11 11
Share-based Compensation ........................................ 848 723 41
Distributions in Excess of (Equity in Undistributed)
Income of Subsidiaries ............... ........................ (5,855) (22,986) (6,989)
Net Change in:
Other Assets ................................................. (2,307) 3,143 (3,166)
Other Liabilities ............................................ (539) (2,237) 5,923
Investment in Subsidiaries – Operating Activities..... ....... .. (6,460)
-------- -------- --------
Net Cash Provided by Operating Activities ................. 6,325 10,293 26,018
-------- -------- --------
Investing Activities – Investment in Subsidiaries 388
-------- -------- --------
Net Cash Provided (Used) by Investing Activities .......... 388 2,559
-------- -------- --------
Financing Activities:
Cash Dividends .................................................... (16,775) (16,854) (16,951)
Borrowings......................................................... 45,000 73,202 3,750
Repayment of Borrowings ........................................... (25,000) (56,832) (8,250)
Stock Issued Under Employee Benefit Plans ......................... 773 787 857
Stock Issued Under Dividend Reinvestment
and Stock Purchase Plan ......................................... 1,021 1,170 1,190
Stock Options Exercised ........................................... 1,633 496 1,228
Stock Redeemed .................................................... (2,188) (12,751) (5,690)
Other ............................................................. (4) 381
-------- -------- --------
Net Cash Used by Financing Activities ..................... 4,460 (10,782) (23,485)
-------- -------- --------
Net Change in Cash ................................................... 11,173 2,070 3,373
Cash, Beginning of Year .............................................. 8,192 6,122 2,749
-------- -------- --------
Cash, End of Year .................................................... $ 19,365 $ 8,192 $ 6,122
======== ======== ========
2,559
840
840
NOTE 21
QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The following table sets forth certain quarterly results for the years ended December 31, 2008 and 2007:
NET REALIZED
AND UNREALIZED
GAINS/(LOSSES)
PROVISION AVAILABLE AVERAGE SHARES OUTSTANDING NET INCOME PER SHARE
QUARTER INTEREST INTEREST NET INTEREST FOR LOAN FOR SALE NET -------------------------- --------------------
ENDED INCOME EXPENSE INCOME LOSSES SECURITIES INCOME BASIC DILUTED BASIC DILUTED
2008:
March ............ $ 56,653 $ 25,844 $ 30,809 $ 3,823 $ 73 $ 8,126 17,938,442 18,054,967 $ .45 $ .45
June ............. 54,106 21,933 32,173 7,070 13 16,542 18,050,956 18,159,207 .36 .36
September......... 54,978 21,724 33,254 7,094 (1,255) 5,749 18,114,916 18,196,453 .32 .32
December.......... 53,736 20,588 33,148 10,251 (914) 221 18,159,745 18,256,843 .01 .01
---------- ---------- ----------- -------- ------- -------- ----- -----
$ 219,473 $ 90,089 $ 129,384 $ 28,238 $(2,083) $ 20,638 18,066,404 18,161,881 $1.14 $1.14
========== ========== =========== ======== ======= ======== ===== =====
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 $ 0 $ 31,639 18,249,919 18,313,964 $1.73 $1.73
========== ========== =========== ======== ======= ======== ===== =====
77
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
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, SFAS No. 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 No. 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.
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.
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 has used interest
rate floors to protect against movements in interest rates below the floors’ strike rates over the life of
the agreements. On August 1, 2006, the Corporation purchased three prime-based interest rate floor
agreements with an aggregate notional amount of $250 million and strike rates ranging from 6 to 7 percent.
The combined purchase price of approximately $550,000 was to be amortized on an allocated fair value basis
over the three-year term of the agreements. On March 19, 2008, the Corporation received $5,216,000 in
connection with the termination of the three interest rate floor agreements. The contractual maturity of
the floors was August 1, 2009. During the life of the floors, pre-tax gains of approximately $4,662,500
were deferred in accumulated other comprehensive income (AOCI) in accordance with cash flow hedge
accounting rules established by SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities
(as amended). The amounts deferred in AOCI will be reclassified out of equity into earnings over the
remaining contractual term of the original contract. SFAS No. 133 requires that amounts deferred in AOCI
be reclassified into earnings in the same periods during which the originally hedged cash flows (prime-
based interest payments on loan assets) affects earnings, as long as the originally hedged cash
flows remain probable of occurring (i.e. the principal amount of designated prime-based loans match
or exceed the notional amount of the terminated floor through August 1, 2009). If the principal amount of
the originally hedged loans falls below the notional amount of the terminate floors, then amounts in AOCI
could be accelerated. The Corporation decided to terminate the interest rate floor agreements only after
considering the impact of the transaction on its risk management objectives and after alternative
strategies were in place to mitigate the adverse impact of falling interest rates on its net interest
margin. At December 31, 2008, the remaining pre-tax gains are approximately $1.4 million.
The Corporation offers interest rate derivative products (e.g. interest rate swaps) to certain of its high-
quality commercial borrowers. This product allows customers to enter into an agreement with the
Corporation to swap their variable rate loan to a fixed rate. These derivative products are designed to
reduce, eliminate or modify the risk of changes in the borrower's interest rate or market price risk. The
extension of credit incurred through the execution of these derivative products is subject to the same
approvals and rigorous underwriting standards as the related traditional credit product. The Corporation
limits its risk exposure to these products by entering into a mirror-image, offsetting swap agreement with
a separate, well-capitalized and rated counterparty previously approved by the Credit and Asset Liability
78
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
Committee. By using these interest rate swap arrangements, the Corporation is also better insulated from
the interest rate risk associated with underwriting fixed-rate loans. These derivative contracts are not
designated against specific assets or liabilities under SFAS No. 133 and, therefore, do not qualify for
hedge accounting. The derivatives are recorded on the balance sheet at fair value and changes in fair
value of both the customer and the offsetting swaps agreements are recorded (and essentially offset) in
non-interest income. The fair value of the derivative instruments incorporates a consideration of credit
risk (in accordance with SFAS No. 157), resulting in some volatility in earnings each period. As of
December 31, 2008, the notional amount of customer-facing swaps is approximately $53,876,000. This amount
is offset with third-party counterparties, as described above, in the same amount. As of December 31, the
fair value of derivative assets in this program is approximately $4,094,000; the fair value of derivative
liabilities is approximately $4,224,000.
NOTE 23
SUBSEQUENT EVENTS
On February 20, 2009, the Corporation completed the sale to the U.S. Treasury of $116.0 million of newly
issued First Merchants non-voting preferred shares with a liquidation value of $1,000 as part of the
Capital Purchase Program. All of the proceeds from this sale of the Series A Preferred Shares and the
Warrant by the Corporation to the Treasury will qualify as Tier 1 capital for regulatory purposes. In
addition to the preferred shares, the Treasury received a warrant to purchase up to 991,453 shares of the
Corporation at an initial exercise price of $17.55 per share. The warrant provides for the adjustment of
the exercise price and has a term of 10 years. The additional capital would have increased Tier 1 capital
ratio to 10.9 percent at December 31, 2008, and increased its total capital ratio to 12.8 percent at
December 31, 2008. The Corporation continues to evaluate the manner in which it intends to deploy the
proceeds of this sale of the Series A Preferred Shares and Warrant.
On February 27, 2009, the FDIC announced the adoption of an interim rule to impose a 20 basis point
emergency special assessment under 12 U.S.C. 1817(b)(5) on June 30, 2009. The interim rule also provides
that, after June 30, 2009, if the reserve ratio of the Deposit Insurance Fund is estimated to fall to a
level that the Board believes would adversely affect public confidence or to a level which shall be close
to zero or negative at the end of a calendar quarter, an emergency special assessment of up to 10 basis
points may be imposed by a vote of the Board on all insured depository institutions based on each
institution’s assessment base calculated pursuant to 12 CFR section 327.5 for the corresponding assessment
period. There has been further discussion on the possibility of the special assessment being reduced to 10
basis points but the final decision has not yet been made.
NOTE 24
ACCOUNTING MATTERS
Statement of Financial Accounting Standards No. 157, Fair Value measurements (“SFAS 157”). Effective
January 1, 2008, the Corporation adopted SFAS 157 for existing fair value measurement requirements related
to financial and nonfinancial assets and liabilities. SFAS 157 establishes a hierarchy to be used in
performing measurements of fair value. Additionally, SFAS 157 emphasizes that fair value should be
determined from the perspective of a market participant while also indicating that valuation methodologies
should first reference available market data before using internally developed assumptions. SFAS 157 also
provides expanded disclosure requirements regarding the effects of fair value measurements on the financial
statements. The adoption of SFAS 157 did not have a material impact on the consolidated financial
condition or results of operations, or liquidity.
On October 10, 2008 the Financial Accounting Standards Board (“FASB”) issues FSP FAS 157-3, “Determining
the Fair Value of a Financial Asset When the Market For That Asset Is Not Active” (“FSP FAS 157-3”). FSP
FAS 157-3 clarifies the application of SFAS 157 in a market that is not active and provides an example to
illustrate key consideration in determining the fair value of a financial asset when the market for that
financial asset is not active. FSP FAS 157-3 is effective upon issuance, including prior periods for which
financial statements have not been issued. The Corporation adopted FSP FAS 157-3 for the period ended
September 30, 2008 and the adoption did not have any significant impact on consolidated statements of
financial position, consolidated statement of operations, or disclosures.
Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and
Financial Liabilities (“SFAS 159”). In February 2007, the FASB issued SFAS 159 which permits companies to
elect to measure certain eligible items at fair value. Subsequent unrealized gains and losses on those
items will be reported in earnings. Upfront costs and fees related to those items will be reported in
earnings as incurred and not deferred. SFAS 159 is effective for fiscal years beginning after November 15,
79
PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 24
ACCOUNTING MATTERS continued
2007. The Corporation does not expect the adoption of SFAS 159 to have a material impact on the operations
of the Corporation.
Statement of Financial Accounting Standards No. 141 (Revised 2007), Business Combinations (“SFAS 141(R)”.
During December 2007, the FASB issues SFAS 141(R). This Statement replaces SFAS 141 “Business
Combinations” (“Statement 141”). SFAS 141(R) retains the fundamental requirements in Statement 141 that
the acquisition method of accounting (called the ‘purchase method’) be used for all business combinations
and for an acquirer to be identified for each business combination. This Statement defines the acquirer as
the entity that obtains control of one or more businesses, including those sometimes referred to as “true
mergers” or “mergers of equals” and combinations achieved without the transfer of consideration, for
example, by contract alone or through the lapse of minority veto rights. This is broader than in Statement
141 which applied only to business combinations in which control was obtained by transferring
consideration. This Statement requires an acquirer to recognize the assets acquired, liabilities assumed
and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as
of that date. SFAS 141(R) recognized and measures the goodwill acquired in the business combination and
defines a bargain purchase as a business combination in which the total acquisition-date fair value of the
identifiable net assets acquired exceeds the fair value of the consideration transferred plus any
noncontrolling interest in the acquiree, and it requires the acquirer to recognize that excess as a gain
attributable to the acquirer. In contrast, Statement 141 required the “negative goodwill” amount to be
allocated as a pro rata reduction of the amounts assigned to assets acquired. SFAS 141(R) applies
prospectively to business combinations for which the acquisition date is on or after December 15, 2008. An
entity may not apply it before that date.
Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and
Other Postretirement Plans (“SFAS 158”). In September 2006, the FASB issued SFAS 158. Except for the
measurement requirement, the Corporation adopted this accounting guidance as of December 31, 2006.
Additional information regarding the adoption of SFAS 158 is included in Note 17 (“Pension and Other Post
Retirement Benefit Plans”). The requirement to measure plan assets and benefit obligations as of the end
of an employer’s fiscal year is effective for years ending December 15, 2008 (December 31, 2008 for the
Corporation). Adoption of this guidance did not have a material effect on the Corporation’s financial
condition or results of operations.
Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial
Statements – an amendment of ARB No. 51 (“SFAS 160”). During December 2007, the FASB issued SFAS 160 to
establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the
deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an
ownership interest in the consolidated entity that should be reported as equity in the consolidated
financial statement, but separate from the parent’s equity. Before the Statement was issued these so-
called minority interests were reported in the consolidated statement of financial position as liabilities
or in the mezzanine section between liabilities and equity. The amount of consolidated net income
attributable to the parent and to the noncontrolling interest must be clearly identified and presented in
the consolidated statement of income. This Statement requires that a parent recognize a gain or loss
within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited.
Management does not anticipate that this Statement will have a material impact on the Corporation’s
consolidated financial condition or results of operations.
Statement of Financial Accounting Standards No. 161, Disclosures about Derivative Instruments and Hedging
Activities – an amendment of FASB Statement No. 133 (“SFAS 161”). During March 2008, the FASB issued SFAS
161, SFAS 161 amends and expands the disclosure requirement of SFAS 133 “Accounting for Derivative
Instruments and Hedging Activities” (“SFAS 133”) with the intent to provide users of financial statements
with an enhanced understanding of: (1) how and why an entity uses derivative instruments; (b) how
derivative instruments and related hedged items are accounted for under SFAS 133 and its related
interpretations; and (c) how derivative instruments and related hedged items affect an entity’s financial
position, financial performance, and cash flows. To meet those objectives, SFAS 161 requires qualitative
disclosures about objectives and strategies for using derivative, quantitative disclosures about fair value
amounts of and gains and losses on derivative instruments, and disclosures about credit-risk related
contingent features in derivative agreements. SFAS 161 is effective for financial statements issued for
fiscal years and interim periods beginning after November 15, 2008. Early application is encouraged.
Statement of Financial Accounting Standards, The Hierarchy of Generally Accepted Accounting Principles
(“SFAS 162”). During May 2008, the FASB issued SFAS 162. This Statement identifies the sources of account
principles and the framework for selecting the principles to be used in the preparation of financial
statements of nongovernmental entities that are presented in conformity with generally accepted accounting
principles (GAAP) in the United States. This Statement is effective 60 days following SEC approval of the
Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in
Conformity With Generally Accepted Accounting Principles.” Adoption of SFAS 162 will not be a change in
80
PART II: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 24
ACCOUNTING MATTERS continued
the Corporation’s current accounting practices; therefore, it will not have a material impact on the
Corporation’s consolidated financial condition or results of operations.
FASB Staff Position EITF 03-6-1, Determining Whether Instruments Granted in Share Based Payment
Transactions are Participating Securities (“FSP EITF 03-6-1”). During June 2008, the FASB issued FSP EITF
03-6-1. FSP EITF 03-6-1 clarifies whether instruments, such as restricted stock, granted in share-based
payments are participating securities prior to vesting. Such participating securities must be included in
the computation of earnings per share under the two-class method as described in SFAS No. 128, “Earnings
per Share.” FSP EITF 03-6-1 requires companies to treat unvested share based payment awards that have non-
forfeitable rights to dividend or dividend equivalents as a separate class of securities in calculation
earnings per share. FSP EITF 03-6-1 is effective for financial statements issued for fiscal years and
interim periods beginning after December 15, 2008, and requires a company to retrospectively adjust its
earnings per share data. Early adoption is not permitted. It is not expected that the adoption of FSP
EITF 03-6-1 will have a material effect on consolidated results of operations or earnings per share.
81
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, 2008, 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, 2008. 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. This assessment excluded internal control over financial reporting for Lincoln Bancorp, as
allowed by the SEC for current year acquisitions. Lincoln Bancorp was acquired on December 31, 2008, and
represented 18% of assets at December 31, 2008. Based on this assessment, management has determined that
the Corporation's internal control over financial reporting as of December 31, 2008 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.
82
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,
2008, 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.
As permitted, the Corporation excluded the operations of Lincoln Bancorp, a financial institution acquired
on December 31, 2008, from the scope of management’s report on internal control over financial reporting.
As such, this entity has also been excluded from the scope of our audit of internal control over financial
reporting.
In our opinion, First Merchants Corporation maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2008, based on criteria established in Internal Control
- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO).
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
March 16, 2009, expressed an unqualified opinion thereon.
Indianapolis, Indiana
March 16, 2009
ITEM 9B. OTHER INFORMATION
None
83
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 27, 2009 furnished to its stockholders in
connection with an annual meeting to be held May 6, 2009 (the "2009 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, the Chief Banking Officer, the Chief Accounting Officer, the Corporate
Controller and the Corporate 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 2009 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 2009 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 2009 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 2009 Proxy Statement, under the caption "INDEPENDENT AUDITOR", is
expressly incorporated herein by reference.
84
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 2008 Annual
Report on Form 10-K, (ii) the signatures required on the Corporation’s 2008 Annual Report on Form 10-K and
(iii) the exhibits required to be filed as part of the Corporation’s 2008 Annual Report on Form 10-K. A
complete copy of the Corporation’s 2008 Annual Report on Form 10-K may be obtained as provided on page 6
hereof.
85
c o m m i t m e n t t o t h e c o m m u n i t y
a n n u a l r e p o r t 2 0 0 8
Since 1893, First Merchants has provided the best of what banking
can offer – customer-valued products and services delivered locally
by bankers who are known and trusted in their communities.
• Local leadership and relationship professionals
• Community involvement with talent, time and treasury
• Local decision making
• Local boards of directors who are committed and engaged
to ensure that the voice of the customer is heard
culture stateMent
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.
core values
• ciient 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,
communities and stakeholders.
• quality:
Provide predictable superior execution.
• people:
Respect and value people as our competitive advantage.
• financial performance:
Operate profitable lines of business to benefit our stakeholders.
The greater part of progress is the desire to progress.
our Mission
To deliver superior, personalized financial
solutions to consumer and closely held
commercial clients, in diverse community
markets, by providing sound advice and
products that exceed expectations.
our vision
A financial 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.
• corporate heaDquarters
First Merchants Corporation
200 East Jackson Street
Muncie, Indiana 47305
765.747.1500
8
— seneca
www.firstmerchants.com
a n n u a l r e p o r t 2 0 0 8
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 .
www.firstmerchants.com