10-Q



FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
___________________

[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2016
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from _______ to _______

Commission File Number 0-17071

FIRST MERCHANTS CORPORATION
(Exact name of registrant as specified in its charter)

Indiana                                                                            35-1544218
(State or other jurisdiction of                                   (I.R.S. Employer
incorporation or organization)                               Identification No.)

200 East Jackson Street, Muncie, IN                  47305-2814
(Address of principal executive offices)                   (Zip code)

(Registrant’s telephone number, including area code): (765) 747-1500

Not Applicable
(Former name, former address and former fiscal year,
if changed since last report)

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 whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes [X]   No [  ]

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 definitions of “large accelerated filer,”  “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer [X]   Accelerated filer [ ]   Non-accelerated filer [ ] (Do not check if smaller reporting company)  Smaller reporting company [ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ]   No [X]

As of April 29, 2016, there were 40,749,494 outstanding common shares of the registrant.

1

Table of Contents
TABLE OF CONTENTS


FIRST MERCHANTS CORPORATION



Page No.
Item 1.
 
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
 
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
 

2

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)



CONSOLIDATED CONDENSED BALANCE SHEETS

March 31,
2016

December 31,
2015

(Unaudited)

ASSETS
 

 
Cash and cash equivalents
$
85,738


$
102,170

Interest-bearing time deposits
77,453


32,315

Investment securities available for sale
636,785


658,400

Investment securities held to maturity (fair value of $655,445 and $632,380)
633,992


618,599

Loans held for sale
3,628


9,894

Loans, net of allowance for loan losses of $62,086 and $62,453
4,647,821


4,631,369

Premises and equipment
96,494


97,648

Federal Reserve and Federal Home Loan Bank stock
37,553


37,633

Interest receivable
22,836


24,415

Core deposit intangibles
17,799


16,635

Goodwill
244,000


243,129

Cash surrender value of life insurance
200,549


200,539

Other real estate owned
15,626


17,257

Tax asset, deferred and receivable
47,982


46,977

Other assets
30,283


24,023

TOTAL ASSETS
$
6,798,539


$
6,761,003

LIABILITIES
 

 
Deposits:
 

 
Noninterest-bearing
$
1,282,462


$
1,266,027

Interest-bearing
4,028,608


4,023,620

Total Deposits
5,311,070


5,289,647

Borrowings:
 

 
Federal funds purchased
602


49,721

Securities sold under repurchase agreements
150,134


155,325

Federal Home Loan Bank advances
263,588


235,652

Subordinated debentures and term loans
127,523


127,846

Total Borrowings
541,847


568,544

Interest payable
3,910


3,092

Other liabilities
74,449


49,211

Total Liabilities
5,931,276


5,910,494

COMMITMENTS AND CONTINGENT LIABILITIES





STOCKHOLDERS' EQUITY



Cumulative Preferred Stock, $1,000 par value, $1,000 liquidation value:
 

 
Authorized - 600 shares
 

 
Issued and outstanding - 125 shares
125


125

Common Stock, $.125 stated value:
 

 
Authorized - 50,000,000 shares
 

 
Issued and outstanding - 40,749,340 and 40,664,259 shares
5,094


5,083

Additional paid-in capital
504,661


504,530

Retained earnings
355,317


342,133

Accumulated other comprehensive income (loss)
2,066


(1,362
)
Total Stockholders' Equity
867,263


850,509

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
$
6,798,539


$
6,761,003

 

See NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS.

3

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)



CONSOLIDATED CONDENSED STATEMENTS OF INCOME
(Unaudited)

 
Three Months Ended
March 31,
 
2016
 
2015
INTEREST INCOME
 
 
 
Loans receivable:
 
 
 
Taxable
$
50,489

 
$
43,551

Tax exempt
1,315

 
248

Investment securities:
 
 
 
Taxable
4,328

 
4,723

Tax exempt
4,509

 
3,835

Deposits with financial institutions
106

 
37

Federal Reserve and Federal Home Loan Bank stock
480

 
550

Total Interest Income
61,227

 
52,944

INTEREST EXPENSE
 
 
 
Deposits
4,063

 
3,516

Federal funds purchased
28

 
23

Securities sold under repurchase agreements
100

 
78

Federal Home Loan Bank advances
796

 
691

Subordinated debentures and term loans
1,785

 
1,660

Total Interest Expense
6,772

 
5,968

NET INTEREST INCOME
54,455

 
46,976

Provision for loan losses
550

 


NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
53,905

 
46,976

OTHER INCOME
 
 
 
Service charges on deposit accounts
4,145

 
3,548

Fiduciary activities
2,494

 
2,507

Other customer fees
5,059

 
3,667

Commission income


 
2,328

Earnings on cash surrender value of life insurance
1,476

 
747

Net gains and fees on sales of loans
1,460

 
1,489

Net realized gains on sales of available for sale securities
997

 
1,025

Other income
690

 
921

Total Other Income
16,321

 
16,232

OTHER EXPENSES
 
 
 
Salaries and employee benefits
27,337

 
24,541

Net occupancy
4,022

 
3,790

Equipment
3,238

 
2,566

Marketing
737

 
780

Outside data processing fees
2,069

 
1,717

Printing and office supplies
364

 
364

Core deposit amortization
978

 
721

FDIC assessments
950

 
863

Other real estate owned and foreclosure expenses
1,235

 
1,229

Professional and other outside services
2,162

 
1,491

Other expenses
3,867

 
3,140

Total Other Expenses
46,959

 
41,202

INCOME BEFORE INCOME TAX
23,267

 
22,006

Income tax expense
5,574

 
5,834

NET INCOME AVAILABLE TO COMMON STOCKHOLDERS
$
17,693

 
$
16,172

Per Share Data:
 
 
 
Basic Net Income Available to Common Stockholders
$
0.43

 
$
0.43

Diluted Net Income Available to Common Stockholders
$
0.43

 
$
0.43

Cash Dividends Paid
$
0.11

 
$
0.08

Average Diluted Shares Outstanding (in thousands)
40,917

 
38,000



See NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS.


4

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)



CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)


Three Months Ended
March 31,
 
2016
 
2015
Net income
$
17,693


$
16,172

Other comprehensive income net of tax:
 

 
Unrealized holding gain on securities available for sale arising during the period, net of tax of $2,765 and $528
5,135


980

Unrealized loss on cash flow hedges arising during the period, net of tax of $684 and $447
(1,270
)

(829
)
Reclassification adjustment for gains included in net income, net of tax of $236 and $235
(437
)

(436
)
 
3,428


(285
)
Comprehensive income
$
21,121


$
15,887

 

See NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS.


5

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)



CONSOLIDATED CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY
(Unaudited)
 

Preferred

Common Stock

Additional



Accumulated
Other



Shares

Amount

Shares

Amount

Paid in
Capital

Retained
Earnings

Comprehensive
Income (Loss)

Total
Balances, December 31, 2015
125


$
125


40,664,259


$
5,083


$
504,530


$
342,133


$
(1,362
)

$
850,509

Comprehensive income
 

 

 

 

 

 

 


Net income
 









17,693




17,693

Other comprehensive income, net of tax
 











3,428


3,428

Cash dividends on common stock ($.11 per share)
 



 

 

 

(4,509
)

 

(4,509
)
Share-based compensation
 



101,984


13


580


 

 

593

Stock issued under employee benefit plans
 



5,932


1


118


 

 

119

Stock issued under dividend reinvestment and
stock purchase plan
 



7,030


1


164


 

 

165

Stock options exercised
 



6,700


1


75


 

 

76

Stock redeemed
 



(36,565
)

(5
)

(806
)

 

 

(811
)
Balances, March 31, 2016
125


$
125


40,749,340


$
5,094


$
504,661


$
355,317


$
2,066


$
867,263



See NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS.


6

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)



CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(Unaudited)
 
Three Months Ended
 
March 31, 2016
 
March 31, 2015
Cash Flow From Operating Activities:
 

 
Net income
$
17,693


$
16,172

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
Provision for loan losses
550




Depreciation and amortization
1,835


1,534

Change in deferred taxes
3,324


3,643

Share-based compensation
593


517

Tax benefit from stock options exercised
(3
)

(14
)
Loans originated for sale
(87,689
)

(69,384
)
Proceeds from sales of loans
93,955


70,227

Gains on sales of securities available for sale
(997
)

(1,025
)
Change in interest receivable
1,579


427

Change in interest payable
818


484

Other adjustments
(6,862
)

(4,883
)
Net cash provided by operating activities
$
24,796


$
17,698

Cash Flows from Investing Activities:
 

 
Net change in interest-bearing deposits
$
(45,138
)

$
(35,708
)
Purchases of:


 
Securities available for sale
(32,632
)

(20,193
)
Securities held to maturity
(35,086
)

(39,542
)
Proceeds from sales of securities available for sale
69,623


38,198

Proceeds from maturities of:


 
Securities available for sale
13,137


14,887

Securities held to maturity
19,134


18,685

Change in Federal Reserve and Federal Home Loan Bank stock
80


80

Net change in loans
(20,235
)

(43,939
)
Proceeds from the sale of other real estate owned
2,084


2,799

Other adjustments
(1,226
)

(1,311
)
Net cash used in investing activities
$
(30,259
)

$
(66,044
)
Cash Flows from Financing Activities:
 

 
Net change in :
 

 
Demand and savings deposits
$
44,902


$
(4,643
)
Certificates of deposit and other time deposits
(24,650
)

12,024

Borrowings
110,060


59,484

Repayment of borrowings
(136,321
)

(44,319
)
Cash dividends on common stock
(4,509
)

(3,049
)
Stock issued under employee benefit plans
119


129

Stock issued under dividend reinvestment and stock purchase plans
165


135

Stock options exercised
73


355

Tax benefit from stock options exercised
3


14

Stock redeemed
(811
)

(1,157
)
Net cash provided by (used in) financing activities
$
(10,969
)

$
18,973

Net Change in Cash and Cash Equivalents
(16,432
)

(29,373
)
Cash and Cash Equivalents, January 1
102,170


118,616

Cash and Cash Equivalents, March 31
$
85,738


$
89,243

Additional cash flow information:
 

 
Interest paid
$
5,954


$
5,484

Income tax paid
$
3,500


$
500

Loans transferred to other real estate owned
$
32


$
2,109

Fixed assets transferred to other real estate owned
$
360

 


Non-cash investing activities using trade date accounting
$
19,935


$
20,424



See NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS.


7

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




NOTE 1 
 
GENERAL
 
Financial Statement Preparation

The significant accounting policies followed by First Merchants Corporation (the “Corporation”) and its wholly owned subsidiaries for interim financial reporting are consistent with the accounting policies followed for annual financial reporting. All adjustments, which are of a normal recurring nature and are in the opinion of management necessary for a fair statement of the results for the periods reported, have been included in the accompanying consolidated condensed financial statements.

The Consolidated Condensed Balance Sheet of the Corporation as of December 31, 2015, has been derived from the audited consolidated balance sheet of the Corporation as of that date. Certain information and note disclosures normally included in the Corporation’s annual financial statements, prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted. These consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2015 filed with the Securities and Exchange Commission. The results of operations for the three months ended March 31, 2016, are not necessarily indicative of the results to be expected for the year. Reclassifications have been made to prior financial statements to conform to the current financial statement presentation. These reclassifications had no effect on net income.


NOTE 2

ACQUISITIONS AND DIVESTITURES

Acquisition - Ameriana Bancorp, Inc.

On December 31, 2015, the Corporation acquired 100 percent of Ameriana Bancorp, Inc. ("Ameriana"). Ameriana merged with and into the Corporation (the "Ameriana Merger") whereupon the separate corporate existence of Ameriana ceased and the Corporation survived. Immediately following the Ameriana Merger, Ameriana Bank, an Indiana bank and wholly-owned subsidiary of Ameriana, merged with and into First Merchants Bank, National Association, a national bank and wholly-owned subsidiary of the Corporation (the "Bank"), with the Bank continuing as the surviving bank. Ameriana was headquartered in New Castle, Indiana and had 13 banking centers serving central and east central Indiana. Pursuant to the merger agreement, each Ameriana shareholder received 0.9037 shares of the Corporation's common stock for each outstanding share of Ameriana common stock held. The Corporation issued approximately 2.8 million shares of common stock, which was valued at approximately $70.4 million. The Corporation engaged in this transaction with the expectation that it would be accretive and expand the existing footprint in central and east central Indiana. Goodwill resulted from this transaction due to the expected synergies and economies of scale that are expected.

Under the acquisition method of accounting, the total purchase price is allocated to net tangible and intangible assets based on their current estimated fair values on the date of the acquisition. Based on preliminary valuations of the fair value of tangible and intangible assets acquired and liabilities assumed, which are based on assumptions that are subject to change, the purchase price for the Ameriana acquisition is detailed in the following table. If prior to the end of the one year measurement period for finalizing the purchase price allocation, information becomes available which would indicate adjustments are required to the purchase price allocation, such adjustments will be included in the purchase price allocation retrospectively.
 
 
Fair Value
Cash and cash equivalents
 
$
4,068

Interest-bearing time deposits
 
8,790

Investment securities
 
61,754

Loans
 
316,929

Premises and equipment
 
13,946

Federal Home Loan Bank stock
 
2,693

Other real estate owned
 
5,613

Interest receivable
 
1,306

Cash surrender value of life insurance
 
28,188

Other assets
 
6,713

Deposits
 
(383,718
)
Interest payable
 
(24
)
Federal Home Loan Bank Advances
 
(24,884
)
Subordinated debentures
 
(5,487
)
Other liabilities
 
(9,451
)
Net tangible assets acquired
 
26,436

Core deposit intangible
 
5,342

Goodwill
 
38,624

Purchase price
 
$
70,402



8

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




Of the total purchase price, $5,342,000 has been allocated to a core deposit intangible that will be amortized over its estimated life of 10 years. The remaining purchase price has been allocated to goodwill, which is not deductible for tax purposes.

Acquisition - C Financial Corporation

On April 17, 2015, the Corporation acquired 100 percent of C Financial Corporation, ("C Financial"). C Financial merged with and into the Corporation (the “C Financial Merger”) whereupon the separate corporate existence of C Financial ceased and the Corporation survived.  Immediately following the C Financial Merger, Cooper State Bank, an Ohio state bank and wholly-owned subsidiary of C Financial, merged with and into the Bank, with the Bank continuing as the surviving bank.  C Financial was headquartered in Columbus, Ohio and had 6 full service banking centers serving the Columbus, Ohio market. As part of the $14.5 million C Financial Merger, shareholders of C Financial received $6.738 in cash for each share of C Financial common stock held.

The Corporation expects the transaction to be accretive to income and expand the existing footprint in Columbus, Ohio. Goodwill resulted from this transaction due to the synergies and economies of scale that were expected. The purchase price of the C Financial acquisition was allocated as follows:
 
 
Fair Value
Cash and cash equivalents
 
$
2,496

Federal Funds sold
 
7,018

Interest-bearing time deposits
 
922

Loans
 
110,625

Premises and equipment
 
7,290

Federal Home Loan Bank stock
 
855

Interest receivable
 
292

Other assets
 
119

Deposits
 
(105,326
)
Interest payable
 
(29
)
Federal Home Loan Bank Advances

(18,958
)
Other liabilities
 
(2,911
)
Net tangible assets acquired
 
2,393

Core deposit intangible
 
981

Goodwill
 
11,126

Purchase price
 
$
14,500



Of the total purchase price, $981,000 has been allocated to a core deposit intangible that will be amortized over its estimated life of 10 years. The remaining purchase price has been allocated to goodwill, which is deductible for tax purposes because the transaction was considered a taxable exchange.

Subsidiary Divestiture - First Merchants Insurance Services, Inc.

On June 12, 2015, the Corporation sold all of its stock in First Merchants Insurance Services, Inc., an Indiana corporation ("FMIG"), to USI Insurance Services LLC, a Delaware limited liability company. The sale price was $18 million, of which $16 million was paid at closing with the remaining $2 million paid through a two-year promissory note. The sale of FMIG generated a gain on sale of $8.3 million.



9

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




NOTE 3 
 
INVESTMENT SECURITIES
 
The amortized cost, gross unrealized gains and losses and approximate fair value of the investment securities portfolio at the dates indicated were:
 
Amortized
Cost

Gross
Unrealized
Gains

Gross
Unrealized
Losses

Fair
Value
Available for sale at March 31, 2016
 

 

 

 
U.S. Government-sponsored agency securities
$
100


$
3




$
103

State and municipal
312,516


17,711


$
107


330,120

U.S. Government-sponsored mortgage-backed securities
295,443


7,183


40


302,586

Corporate obligations
31







31

Equity securities
3,882


63




3,945

Total available for sale
611,972


24,960


147


636,785

Held to maturity at March 31, 2016
 

 

 

 
Federal agencies
13,978

 
22

 


 
14,000

State and municipal
218,374


9,244


49


227,569

U.S. Government-sponsored mortgage-backed securities
401,640


12,261


25


413,876

Total held to maturity
633,992


21,527


74


655,445

Total Investment Securities
$
1,245,964


$
46,487


$
221


$
1,292,230


 
 
Amortized
Cost

Gross
Unrealized
Gains

Gross
Unrealized
Losses

Fair
Value
Available for sale at December 31, 2015
 

 

 

 
U.S. Government-sponsored agency securities
$
100


$
4




$
104

State and municipal
291,730


14,241


$
60


305,911

U.S. Government-sponsored mortgage-backed securities
342,550


4,234


518


346,266

Corporate obligations
31







31

Equity securities
3,912






3,912

Certificates of deposit
2,176

 


 


 
2,176

Total available for sale
640,499


18,479


578


658,400

Held to maturity at December 31, 2015
 

 

 

 
State and municipal
219,767


6,982


15


226,734

U.S. Government-sponsored mortgage-backed securities
398,832


7,601


787


405,646

Total held to maturity
618,599


14,583


802


632,380

Total Investment Securities
$
1,259,098


$
33,062


$
1,380


$
1,290,780



The amortized cost and fair value of available for sale and held to maturity securities at March 31, 2016, 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 March 31, 2016:
 

 

 

 
Due in one year or less
$
3,963


$
3,990


$
2,533


$
2,541

Due after one through five years
17,175


18,087


32,527


34,282

Due after five through ten years
54,387


57,310


90,434


92,992

Due after ten years
237,122


250,867


106,858


111,754

 
$
312,647


$
330,254


$
232,352


$
241,569

U.S. Government-sponsored mortgage-backed securities
295,443


302,586


401,640


413,876

Equity securities
3,882


3,945





Total Investment Securities
$
611,972


$
636,785


$
633,992


$
655,445








10

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




 
Available for Sale
 
Held to Maturity
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
Fair Value
Maturity Distribution at December 31, 2015
 
 
 
 
 
 
 
Due in one year or less
$
4,658

 
$
4,704

 
$
4,144

 
$
4,148

Due after one through five years
13,725

 
14,295

 
28,054

 
29,175

Due after five through ten years
52,878

 
55,375

 
81,483

 
83,646

Due after ten years
220,600

 
231,672

 
106,086

 
109,765

 
$
291,861

 
$
306,046

 
$
219,767

 
$
226,734

U.S. Government-sponsored mortgage-backed securities
342,550

 
346,266

 
398,832

 
405,646

Equity securities
3,912

 
3,912

 

 

Certificates of deposit
2,176

 
2,176

 

 

Total Investment Securities
$
640,499

 
$
658,400

 
$
618,599

 
$
632,380



The carrying value of securities pledged as collateral, to secure borrowings and for other purposes, was $625,319,000 at March 31, 2016, and $637,358,000 at December 31, 2015.

The book value of securities sold under agreements to repurchase amounted to $145,639,000 at March 31, 2016, and $153,789,000 at December 31, 2015.

Gross gains on the sales and redemptions of available for sale securities for the three months ended March 31, 2016 and 2015 are shown below.

Three Months Ended
March 31,

2016

2015
Sales and Redemptions of Available for Sale Securities:
 

 
Gross gains
$
997


$
1,025

Gross losses



Other-than-temporary impairment losses




 
The following table shows investment securities with unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2016, and December 31, 2015:
 
Less than
12 Months

12 Months
or Longer

Total
 
Fair
Value

Gross
Unrealized
Losses

Fair
Value

Gross
Unrealized
Losses

Fair
Value

Gross
Unrealized
Losses
Temporarily Impaired Available for Sale Securities at March 31, 2016
 

 

 

 

 

 
State and municipal
$
8,375


$
98


$
1,197


$
9


$
9,572


$
107

U.S. Government-sponsored mortgage-backed securities
1,131


5


$
3,845


$
35


4,976


40

Total Temporarily Impaired Available for Sale Securities
9,506


103


5,042


44


14,548


147

Temporarily Impaired Held to Maturity Securities at March 31, 2016
 

 

 

 

 

 
State and municipal
3,179


48


673


1


3,852


49

U.S. Government-sponsored mortgage-backed securities






4,784


25


4,784


25

Total Temporarily Impaired Held to Maturity Securities
3,179


48


5,457


26


8,636


74

Total Temporarily Impaired Investment Securities
$
12,685


$
151


$
10,499


$
70


$
23,184


$
221


 
 
Less than
12 Months

12 Months
or Longer

Total
 
Fair
Value

Gross
Unrealized
Losses

Fair
Value

Gross
Unrealized
Losses

Fair
Value

Gross
Unrealized
Losses
Temporarily Impaired Available for Sale Securities at December 31, 2015
 

 

 

 

 

 
State and municipal
$
7,558


$
60






$
7,558


$
60

U.S. Government-sponsored mortgage-backed securities
83,396


445


2,101


73


85,497


518

Total Temporarily Impaired Available for Sale Securities
90,954


505


2,101


73


93,055


578

Temporarily Impaired Held to Maturity Securities at December 31, 2015
 

 

 

 

 

 
State and municipal






1,982


15


1,982


15

U.S. Government-sponsored mortgage-backed securities
69,641


519


12,906


268


82,547


787

Total Temporarily Impaired Held to Maturity Securities
69,641


519


14,888


283


84,529


802

Total Temporarily Impaired Investment Securities
$
160,595


$
1,024


$
16,989


$
356


$
177,584


$
1,380




11

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




Certain investments in debt and equity securities are reported in the financial statements at an amount less than their historical cost as indicated in the table below.

March 31, 2016

December 31, 2015
Investments reported at less than historical cost:
 

 
Historical cost
$
23,406


$
178,964

Fair value
$
23,184


$
177,584

Percent of the Corporation's available for sale and held to maturity portfolio
1.8
%

13.9
%


Management believes the decline in fair value for these securities was 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 during the period the other-than-temporary impairment is identified.

The Corporation’s management has evaluated all securities with unrealized losses for other-than temporary impairment as of March 31, 2016. 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.

In determining the fair value of the investment securities portfolio, the Corporation utilizes a third party for portfolio accounting services, including market value input, for those securities classified as Level 1 and Level 2 in the fair value hierarchy. The Corporation has obtained an understanding of what inputs are being used by the vendor in pricing the portfolio and how the vendor was classifying these securities based upon these inputs.  From these discussions, the Corporation’s management is comfortable that 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 losses resulting from the sale of certain securities has proven the data to be accurate over time.  The fair value of securities classified as Level 3 in the valuation hierarchy was determined using a discounted cash flow model that incorporated market estimates of interest rates and volatility in markets that have not been active.

State and Municipal and U.S. Government-Sponsored Mortgage-Backed Securities

The unrealized losses on the Corporation’s investments in securities of state and political subdivisions and U.S. Government-sponsored mortgage-backed securities were caused by changes in interest rates and not credit quality. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. The Corporation does not intend to sell the investments and more likely than not the Corporation won't be required to sell the investments before recovery of its lower amortized cost basis, which may be maturity. The Corporation does not consider the investment securities to be other-than-temporarily impaired at March 31, 2016.

Credit Losses Recognized on Investments

Certain corporate obligations experienced fair value deterioration due to credit losses and other market factors. The following table provides information about those securities for which only a credit loss was recognized in income and other losses were recorded in other comprehensive income.
 
Accumulated
Credit Losses in
2016

Accumulated
Credit Losses in
2015
Credit losses on debt securities held:
 

 
Balance, January 1




$
500

Reductions for previous other-than-temporary losses realized on securities sold during the year


(500
)
Balance, March 31
$


$



In the first quarter of 2015, the Corporation sold its remaining trust preferred security which had no remaining book value as a result of other than temporary impairment of approximately $500,000 taken in 2009. The sale of this security resulted in a gain of $45,000, which is included in the Consolidated Condensed Statement of Income for the three months ended March 31, 2015.



12

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




NOTE 4  
 
LOANS AND ALLOWANCE
 
The Corporation’s primary lending focus is small business and middle market commercial, commercial real estate, residential real estate and consumer, which results in portfolio diversification.  The following tables show the composition of the loan portfolio, the allowance for loan losses and certain credit quality aspects, all excluding loans held for sale.  Loans held for sale as of March 31, 2016, and December 31, 2015, were $3,628,000 and $9,894,000, respectively.

The following table shows the composition of the Corporation’s loan portfolio by loan class for the periods indicated:

March 31, 2016

December 31, 2015
Commercial and industrial loans
$
1,060,559


$
1,057,075

Agricultural production financing and other loans to farmers
92,137


97,711

Real estate loans:
 

 
Construction
391,621


366,704

Commercial and farmland
1,806,395


1,802,921

Residential
769,592


786,105

Home Equity
353,946


348,613

Individuals' loans for household and other personal expenditures
73,622


74,717

Lease financing receivables, net of unearned income
461


588

Other commercial loans
161,574


159,388

  Loans
$
4,709,907


$
4,693,822

Allowance for loan losses
(62,086
)

(62,453
)
             Net Loans
$
4,647,821


$
4,631,369


 
Allowance, Credit Quality and Loan Portfolio

The Corporation maintains an allowance for loan losses to cover probable credit losses identified during its loan review process. Management believes the allowance for loan losses is adequate to cover probable losses inherent in the loan portfolio at March 31, 2016.  The process for determining the adequacy of the allowance for loan losses is critical to the Corporation’s financial results.  It requires management to make difficult, subjective and complex judgments, to estimate the effect of uncertain matters.  The allowance for loan losses considers current factors, including economic conditions and ongoing internal and external examinations, and will increase or decrease as deemed necessary to ensure it 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, portfolio mix and collateral values.

The allowance for loan losses is maintained through the provision for loan losses, which is a charge against earnings. The allowance is increased by provision expense and decreased by charge offs less recoveries. All charge offs are approved by the Bank’s senior loan officers or loan committees, depending on the amount of the charge off. The Bank charges off a loan when a determination is made that all or a portion of the loan is uncollectible. The amount provided for loan losses in a given period may be greater than or less than net loan losses experienced during the period, and is based on management’s judgment as to the appropriate level of the allowance for loan losses. The determination of the provision amount is based on management’s ongoing review and evaluation of the loan portfolio, including an internally administered loan "watch" list and independent loan reviews.  The evaluation takes into consideration identified credit problems, the possibility of losses inherent in the loan portfolio that are not specifically identified and management’s judgment as to the impact of the current environment and economic conditions on the portfolio.

The allowance consists of specific impairment reserves as required by ASC 310-10-35, a component for historical losses in accordance with ASC 450 and the consideration of current environmental factors in accordance with ASC 450. 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.

The historical loss allocation for loans not deemed impaired according to ASC 310 is the product of the volume of loans within the non-impaired criticized and non-criticized risk grade classifications, each segmented by call code, and the historical loss factor for each respective classification and call code segment. The historical loss factors are based upon actual loss experience within each risk and call code classification. The historical look back period for non-criticized loans looks to the most recent rolling-four-quarter average and aligns with the look back period for non-impaired criticized loans. Each of the rolling four quarter periods used to obtain the average, include all charge offs for the previous twelve-month period, therefore the historical look back period includes seven quarters. The resulting allocation is reflective of current conditions. Criticized loans are grouped based on the risk grade assigned to the loan. Loans with a special mention grade are assigned a loss factor, and loans with a classified grade but not impaired are assigned a separate loss factor. The loss factor computation for this allocation includes a segmented historical loss migration analysis of risk grades to charge off.


13

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




In addition to the specific reserves and historical loss components of the allowance, consideration is given to various environmental factors to ensure that losses inherent in the portfolio are reflected in the allowance for loan losses. The environmental component adjusts the historical loss allocations for non-impaired loans to reflect relevant current conditions that, in management's opinion, have an impact on loss recognition. Environmental factors that management reviews in the analysis include: national and local economic trends and conditions; trends in growth in the loan portfolio and growth in higher risk areas; levels of, and trends in, delinquencies and non-accruals; experience and depth of lending management and staff; adequacy of, and adherence to, lending policies and procedures including those for underwriting; industry concentrations of credit; and adequacy of risk identification systems and controls through the internal loan review and internal audit processes.

In conformance with ASC 805 and ASC 820, loans purchased after December 31, 2008 are recorded at the acquisition date fair value. Such loans are included in the allowance to the extent a specific impairment is identified that exceeds the fair value adjustment on an impaired loan or the historical loss and environmental factor analysis indicates losses inherent in a purchased portfolio exceeds the fair value adjustment on the portion of the purchased portfolio not deemed impaired.

The following tables summarize changes in the allowance for loan losses by loan segment for the three months ended March 31, 2016, and March 31, 2015:
 
Three Months Ended March 31, 2016
 
Commercial

Commercial
Real Estate

Consumer

Residential

Finance
Leases

Total
Allowance for loan losses:
 

 

 

 

 

 
Balances, January 1
$
26,478


$
22,145


$
2,689


$
11,139


$
2


$
62,453

Provision for losses
139


214


33


164




550

Recoveries on loans
292


952


78


312




1,634

Loans charged off
(645
)

(994
)

(153
)

(759
)



(2,551
)
Balances, March 31, 2016
$
26,264


$
22,317


$
2,647


$
10,856


$
2


$
62,086

 
 
 
 
 
 
 
 
 
 
 
 

Three Months Ended March 31, 2015
 
Commercial

Commercial
Real Estate

Consumer

Residential

Finance
Leases

Total
Allowance for loan losses:
 

 

 

 

 

 
Balances, January 1
$
28,824


$
19,327


$
2,658


$
13,152


$
3


$
63,964

Provision for losses
1,834


(2,896
)

527


534


1




Recoveries on loans
450


412


78


132





1,072

Loans charged off
(1,101
)

(460
)

(125
)

(549
)



(2,235
)
Balances, March 31, 2015
$
30,007


$
16,383


$
3,138


$
13,269


$
4


$
62,801

 
 
 
 
 
 
 
 
 
 
 
 

The following tables show the Corporation’s allowance for loan losses and loan portfolio by segment as of the periods indicated:
 
March 31, 2016
 
Commercial

Commercial
Real Estate

Consumer

Residential

Finance
Leases

Total
Allowance Balances:
 

 

 

 

 

 
Individually evaluated for impairment
$
967


$
192




$
59




$
1,218

Collectively evaluated for impairment
25,229


22,075


$
2,647


10,760


$
2


60,713

Loans Acquired with Deteriorated Credit Quality
68


50





37




155

Total Allowance for Loan Losses
$
26,264


$
22,317


$
2,647


$
10,856


$
2


$
62,086

Loan Balances:
 

 

 

 

 

 
Individually evaluated for impairment
$
7,899


$
22,411




$
4,136




$
34,446

Collectively evaluated for impairment
1,299,488


2,127,038


$
73,622


1,114,759


$
461


4,615,368

Loans Acquired with Deteriorated Credit Quality
6,883


48,567





4,643





60,093

Loans
$
1,314,270


$
2,198,016


$
73,622


$
1,123,538


$
461


$
4,709,907













14

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




 
December 31, 2015
 
Commercial

Commercial
Real Estate

Consumer

Residential

Finance
Leases

Total
Allowance Balances:
 

 

 

 

 

 
Individually evaluated for impairment
$
1,277


$
243




$
169




$
1,689

Collectively evaluated for impairment
25,201


21,753


$
2,689


10,966


$
2


60,611

Loans Acquired with Deteriorated Credit Quality



149





$
4




153

Total Allowance for Loan Losses
$
26,478


$
22,145


$
2,689


$
11,139


$
2


$
62,453

Loan Balances:
 

 

 

 

 

 
Individually evaluated for impairment
$
7,877


$
16,670




$
4,020




$
28,567

Collectively evaluated for impairment
1,298,988


2,096,089


$
74,717


1,125,316


$
588


4,595,698

Loans Acquired with Deteriorated Credit Quality
7,309


56,866





5,382





69,557

Loans
$
1,314,174


$
2,169,625


$
74,717


$
1,134,718


$
588


$
4,693,822

 
 
The risk characteristics of the Corporation’s material portfolio segments are as follows:

Commercial

Commercial loans are primarily based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate

These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. Management monitors and evaluates commercial real estate loans based on collateral and risk grade criteria. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans.

Residential and Consumer

With respect to residential loans that are secured by 1-4 family residences and are typically owner occupied, the Corporation generally establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded. Home equity loans are typically secured by a subordinate interest in 1-4 family residences, and consumer loans are secured by consumer assets such as automobiles or recreational vehicles. Some consumer loans are unsecured such as small installment loans and certain lines of credit. Repayment of these loans is primarily dependent on the personal income and credit rating of the borrowers, which can be impacted by economic conditions in their market areas such as unemployment levels. Repayment can also be impacted by changes in property values on residential properties. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

Loans are reclassified to a non-accruing status when, in management’s judgment, the collateral value and financial condition of the borrower do not justify accruing interest. Uncollected interest previously recorded, but not deemed collectible, is reversed and charged against current income. Payments subsequently received on non-accrual loans are applied to principal. A loan is returned to accrual status when principal and interest are no longer past due and collectability is probable, typically after a minimum of six consecutive months of performance.  Payments received on impaired accruing or delinquent loans are applied to interest income as accrued.

The following table summarizes the Corporation’s non-accrual loans by loan class as of the periods indicated:

March 31, 2016

December 31, 2015
Commercial and industrial loans
$
3,694


$
4,634

Agriculture production financing and other loans to farmers
1,535


827

Real estate Loans:
 

 
Construction
731


736

Commercial and farmland
16,440


11,277

Residential
11,674


11,818

Home Equity
2,449


1,952

Individuals' loans for household and other personal expenditures
196


145

Total
$
36,719


$
31,389

 
 


15

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




Commercial impaired loans include non-accrual loans, loans accounted for under ASC 310-30, and loans risk graded as substandard, doubtful and loss that were still accruing but deemed impaired according to the guidance set forth in ASC 310. Also included in impaired loans are accruing loans that are contractually past due 90 days or more and troubled debt restructurings.

Allowable methods for determining the amount of impairment include estimating fair value using the fair value of the collateral for collateral dependent loans. If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized.  This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value. The fair value of real estate is generally 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 ascertained by assessing, either singularly or some combination of, asset appraisals, accounts receivable aging reports, inventory listings and or customer financial statements. Both appraised values and values based on borrower’s financial information are discounted as considered appropriate based on age and quality of the information and current market conditions.

The following tables show the composition of the Corporation’s commercial impaired loans by loan class as of the periods indicated:
 
March 31, 2016
 
Unpaid
Principal
Balance

Recorded
Investment

Related
Allowance
Impaired loans with no related allowance:
 

 


Commercial and industrial loans
$
21,751


$
11,559




Agriculture production financing and other loans to farmers
724


716




Real estate Loans:
 

 


Construction
8,482


4,300




Commercial and farmland
88,293


64,710




Residential
11,991


7,317




Home equity
296


225




Other commercial loans
18







Total
$
131,555


$
88,827




Impaired loans with related allowance:
 

 


Commercial and industrial loans
$
1,610


$
1,357


$
620

Agriculture production financing and other loans to farmers
1,150


1,150


415

Real estate Loans:
 

 

 
Commercial and farmland
1,907


1,738


242

Residential
946


877


96

Total
$
5,613


$
5,122


$
1,373

Total Impaired Loans
$
137,168


$
93,949


$
1,373









16

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)



 
December 31, 2015
 
Unpaid
Principal
Balance
 
Recorded
Investment
 
Related
Allowance
Impaired loans with no related allowance:
 
 
 
 
 
Commercial and industrial loans
$
22,151

 
$
11,669

 
 
Agriculture production financing and other loans to farmers
370

 
361

 
 
Real estate Loans:
 
 
 
 
 
Construction
4,551

 
2,336

 
 
Commercial and farmland
95,930

 
69,024

 
 
Residential
11,262

 
7,338

 
 
Home equity
297

 
247

 
 
Other commercial loans
20

 


 
 
Total
$
134,581

 
$
90,975

 
 
Impaired loans with related allowance:
 
 
 
 
 
Commercial and industrial loans
$
3,043

 
$
2,690

 
$
1,247

Agriculture production financing and other loans to farmers
466


466


30

Real estate Loans:
 
 
 
 
 
Commercial and farmland
2,144

 
1,933

 
392

Residential
2,300

 
1,463

 
173

Total
$
7,953

 
$
6,552

 
$
1,842

Total Impaired Loans
$
142,534

 
$
97,527

 
$
1,842


 
Three Months Ended March 31, 2016
 
Average
Recorded Investment

Interest
Income Recognized
Impaired loans with no related allowance:
 

 
Commercial and industrial loans
$
12,052


$
109

Agriculture production financing and other loans to farmers
716


1

Real estate Loans:
 

 
Construction
4,262


85

Commercial and farmland
65,461


871

Residential
7,746


58

Home equity
225




Total
$
90,462


$
1,124

Impaired loans with related allowance:
 

 
Commercial and industrial loans
$
1,363


$
9

Agriculture production financing and other loans to farmers
1,315



Real estate Loans:
 

 
Commercial and farmland
1,756



Residential
879



Total
$
5,313


$
9

Total Impaired Loans
$
95,775


$
1,133


 
Three Months Ended March 31, 2015
 
Average
Recorded Investment

Interest
Income Recognized
Impaired loans with no related allowance:
 

 
Commercial and industrial loans
$
16,150


$
139

Agriculture production financing and other loans to farmers
303



Real estate Loans:



Construction
8,542


104

Commercial and farmland
69,036


878

Residential
8,528


48

Home equity
533


3

Total
$
103,092


$
1,172

Impaired loans with related allowance:



Commercial and industrial loans
$
4,379


$
10

Agriculture production financing and other loans to farmers
3,991



Real estate Loans:



Commercial and farmland
3,113




Residential
1,761



Total
$
13,244


$
10

Total Impaired Loans
$
116,336


$
1,182


17

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




As part of the ongoing monitoring of the credit quality of the Corporation's loan portfolio, management tracks certain credit quality indicators including trends related to: (i) the level of criticized commercial loans, (ii) net charge offs, (iii) non-performing loans and (iv) the general national and local economic conditions.
 
The Corporation utilizes a risk grading of pass, special mention, substandard, doubtful and loss to assess the overall credit quality of large commercial loans. All large commercial credit grades are reviewed at a minimum of once a year for pass grade loans. Loans with grades below pass are reviewed more frequently depending on the grade. A description of the general characteristics of these grades is as follows:

Pass - Loans that are considered to be of acceptable credit quality.
Special Mention - Loans which possess some credit deficiency or potential weakness, which deserves close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Corporation's credit position at some future date. Special mention assets are not adversely classified and do not expose the Corporation to sufficient risk to warrant adverse classification. The key distinctions of this category's classification are that it is indicative of an unwarranted level of risk; and weaknesses are considered “potential”, not “defined”, impairments to the primary source of repayment. Examples include businesses that may be suffering from inadequate management, loss of key personnel or significant customer or litigation.
Substandard - A substandard loan is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified have a well-defined weakness that jeopardizes the liquidation of the debt. They are characterized by the distinct possibility that the Corporation will sustain some loss if the deficiencies are not corrected. Other characteristics may include:
 
o
the likelihood that a loan will be paid from the primary source of repayment is uncertain or financial deterioration is underway and very close attention is warranted to ensure that the loan is collected without loss,
 
o
the primary source of repayment is gone, and the Corporation is forced to rely on a secondary source of repayment, such as collateral liquidation or guarantees,
 
o
loans have a distinct possibility that the Corporation will sustain some loss if deficiencies are not corrected,
 
o
unusual courses of action are needed to maintain a high probability of repayment,
 
o
the borrower is not generating enough cash flow to repay loan principal; however, it continues to make interest payments,
 
o
the Corporation is forced into a subordinated or unsecured position due to flaws in documentation,
 
o
loans have been restructured so that payment schedules, terms and collateral represent concessions to the borrower when compared to the normal loan terms,
 
o
the Corporation is seriously contemplating foreclosure or legal action due to the apparent deterioration of the loan, and
 
o
there is significant deterioration in market conditions to which the borrower is highly vulnerable.

Doubtful - Loans that have all of the weaknesses of those classified as Substandard. However, based on currently existing facts, conditions and values, these weaknesses make full collection of principal highly questionable and improbable. Other credit characteristics may include the primary source of repayment is gone or there is considerable doubt as to the quality of the secondary sources of repayment. The possibility of loss is high, but because of certain important pending factors that may strengthen the loan, loss classification is deferred until the exact status of repayment is known.

Loss – Loans that are considered uncollectible and of such little value that continuing to carry them as an asset is not warranted. Loans will be classified as Loss when it is neither practical not desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future.



18

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




The following tables summarize the credit quality of the Corporation’s loan portfolio, by loan class for the periods indicated.  Consumer non-performing loans include accruing consumer loans 90 plus days delinquent and consumer non-accrual loans.  The entire balance of a loan is considered delinquent if the minimum payment contractually required to be made is not received by the specified date. Loans that evidenced deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected are included in the applicable categories below.
 
March 31, 2016
 
Commercial
Pass

Commercial
Special
Mention

Commercial Substandard

Commercial
Doubtful

Commercial Loss

Consumer Performing

Consumer
Non-Performing

Total
Commercial and industrial loans
$
984,052


$
46,952


$
29,555






 

 

$
1,060,559

Agriculture production financing and other loans to farmers
48,604


22,829


20,704


 



 

 

92,137

Real estate Loans:
 

 

 

 



 

 

 
Construction
365,808


4,021


3,441






$
18,272


$
79


391,621

Commercial and farmland
1,669,322


55,336


81,737






 




1,806,395

Residential
158,931


8,095


10,706






584,262


7,598


769,592

Home equity
7,164


72


568


 



343,812


2,330


353,946

Individuals' loans for household and other personal expenditures
 

 

 

 



73,322


300


73,622

Lease financing receivables, net of unearned income
371


 

90


 









461

Other commercial loans
161,564


10





 



 

 

161,574

Loans
$
3,395,816


$
137,315


$
146,801






$
1,019,668


$
10,307


$
4,709,907


 
 
December 31, 2015
 
Commercial
Pass

Commercial
Special
Mention

Commercial Substandard

Commercial
Doubtful

Commercial Loss

Consumer Performing

Consumer
Non-Performing

Total
Commercial and industrial loans
$
962,340


$
48,432


$
45,984


$
319




 

 

$
1,057,075

Agriculture production financing and other loans to farmers
77,884


6,665


13,162


 



 

 

97,711

Real estate Loans:


 



 



 

 

 
Construction
345,449


1,271


1,790


 



$
18,114


$
80


366,704

Commercial and farmland
1,679,141


46,442


77,338







 





1,802,921

Residential
171,576


3,107


10,428







593,533


7,461


786,105

Home equity
8,218


48


600


 



337,718


2,029


348,613

Individuals' loans for household and other personal expenditures
 

 

 

 



74,491


226


74,717

Lease financing receivables, net of unearned income
495


 

93


 








588

Other commercial loans
159,388








 




 

 

159,388

Loans
$
3,404,491


$
105,965


$
149,395


$
319




$
1,023,856


$
9,796


$
4,693,822



The tables below show a past due aging of the Corporation’s loan portfolio, by loan class, as of March 31, 2016, and December 31, 2015.
 
March 31, 2016
 
Current

30-59 Days
Past Due

60-89 Days
Past Due

Loans > 90 Days
And Accruing

Non-Accrual

Total Past Due
& Non-Accrual

Total
Commercial and industrial loans
$
1,054,549


$
2,017


$
239


$
60


$
3,694


$
6,010


$
1,060,559

Agriculture production financing and other loans to farmers
90,452


150








1,535


1,685


92,137

Real estate Loans:


 

 

 

 

 

 
Construction
385,222


5,668






731


6,399


391,621

Commercial and farmland
1,788,591


1,355


9





16,440


17,804


1,806,395

Residential
753,121


3,565


539


693


11,674


16,471


769,592

Home equity
349,986


1,298


107


106


2,449


3,960


353,946

Individuals' loans for household and other personal expenditures
73,053


168


101


104


196


569


73,622

Lease financing receivables, net of unearned income
461




 









461

Other commercial loans
161,574




 

 







161,574

Loans
$
4,657,009


$
14,221


$
995


$
963


$
36,719


$
52,898


$
4,709,907




19

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




 
December 31, 2015
 
Current

30-59 Days
Past Due

60-89 Days
Past Due

Loans > 90 Days
And Accruing

Non-Accrual

Total Past Due
& Non-Accrual

Total
Commercial and industrial loans
$
1,052,275


$
166








$
4,634


$
4,800


$
1,057,075

Agriculture production financing and other loans to farmers
96,884









827


827


97,711

Real estate Loans:
 

 

 

 

 



 
Construction
362,084


3,884





 


736


4,620


366,704

Commercial and farmland
1,786,092


5,552







11,277


16,829


1,802,921

Residential
765,634


6,090


$
2,061


$
502


11,818


20,471


786,105

Home equity
344,344


1,433


560


324


1,952


4,269


348,613

Individuals' loans for household and other personal expenditures
73,990


445


56


81


145


727


74,717

Lease financing receivables, net of unearned income
588


 

 

 





588

Other commercial loans
159,324


 

64


 




64


159,388

Loans
$
4,641,215


$
17,570


$
2,741


$
907


$
31,389


$
52,607


$
4,693,822

 
 
See the information regarding the analysis of loan loss experience in the "LOAN QUALITY/PROVISION FOR LOAN LOSSES" section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included as ITEM 2 of this Quarterly Report on Form 10-Q.

On occasion, borrowers experience declines in income and cash flow. As a result, these borrowers seek to reduce contractual cash outlays including debt payments. Concurrently, in an effort to preserve and protect its earning assets, specifically troubled loans, the Corporation works to maintain its relationship with certain customers who are experiencing financial difficulty by contractually modifying the borrower's debt agreement with the Corporation. In certain loan restructuring situations, the Corporation may grant a concession to a debtor experiencing financial difficulty, resulting in a trouble debt restructuring. A concession is deemed to be granted when, as a result of the restructuring, the Corporation does not expect to collect all original amounts due, including interest accrued at the original contract rate. If the payment of principal at original maturity is primarily dependent on the value of collateral, the current value of the collateral is considered in determining whether the principal will be paid.

The following tables summarize troubled debt restructurings in the Corporation's loan portfolio that occurred during the periods indicated:

Three Months Ended March 31, 2016

Pre-Modification
Recorded
Balance

Post-Modification
Recorded
Balance

Number
of
Loans
Commercial and industrial loans
$
260


$
260


3

Agriculture production financing and other loans to farmers
465

 
331

 
2

Real estate Loans:
 

 

 
Commercial and farmland
352


352


1

Residential
113


133


3

Individuals' loans for household and other personal expenditures
13


13


1

Total
$
1,203


$
1,089


10


 

Three Months Ended March 31, 2015

Pre-Modification
Recorded
Balance

Post-Modification
Recorded
Balance

Number
of
Loans
Commercial and industrial loans
$
2,362


$
1,361


4

Real estate Loans:


 

 
Construction
79


80


1

Commercial and farmland



1,743


1

Residential
24


24


1

Total
$
2,465


$
3,208


7




20

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




The following tables summarize the recorded investment of troubled debt restructurings, by modification type, that occurred during the periods indicated:

Three Months Ended March 31, 2016

Term
Modification

Rate
Modification

Combination

Total
Modification
Commercial and industrial loans




$
260


$
260

Agriculture production financing and other loans to farmers
 
 
$
331

 
 
 
331

Real estate Loans:
 

 

 


Commercial and farmland





351


351

Residential


123





123

Individuals' loans for household and other personal expenditures


13





13

Total


$
467


$
611


$
1,078

 
 
 
 
 
 
 
 

Three Months Ended March 31, 2015

Term
Modification

Rate
Modification

Combination

Total
Modification
Commercial and industrial loans
$
253




$
1,079


$
1,332

Real estate Loans:
 

 

 


Construction
2







2

Commercial and farmland
1,548








1,548

Residential



$
26





26

Total
$
1,803


$
26


$
1,079


$
2,908

 
 
 
 
 
 
 
 

Agriculture production financing and other loans to farmers made up 48 percent of the post-modification balance of troubled debt restructured loans made in the three months ended March 31, 2016.

The following tables summarize troubled debt restructures that occurred during the twelve months ended March 31, 2016 and March 31, 2015, that subsequently defaulted during the period indicated and remained in default at period end. For purposes of this discussion, a loan is considered in default if it is 30 or more days past due.

Three Months Ended March 31, 2016

Number of
Loans

Recorded
Balance
Commercial and industrial loans
3


$
260

Real estate Loans:
 

 
Commercial and farmland
1


717

Total
4


$
977




Three Months Ended March 31, 2015

Number of
Loans

Recorded
Balance
Home Equity
1


$
6

Total
1


$
6



For potential consumer loan restructures, impairment evaluation occurs prior to modification. Any subsequent impairment is typically addressed through the charge off process, or may be addressed through a specific reserve. Consumer troubled debt restructurings are generally included in the general historical allowance for loan loss at the post modification balance. Consumer non-accrual and delinquent troubled debt restructurings are also considered in the calculation of the non-accrual and delinquency trend environmental allowance allocation. Consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings are in process totaled $3,208,000 and $1,391,000 at March 31, 2016 and December 31, 2015, respectively.

Commercial troubled debt restructured loans risk graded special mention, substandard, doubtful and loss are individually evaluated for impairment under ASC 310. Any resulting specific reserves are included in the allowance for loan losses. Commercial 30 - 89 day delinquent troubled debt restructurings are included in the calculation of the delinquency trend environmental allowance allocation. All commercial non-impaired loans, including non-accrual and 90+ day delinquents, are included in the ASC 450 loss migration analysis.



21

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




NOTE 5

ACCOUNTING FOR CERTAIN LOANS ACQUIRED IN A PURCHASE

The acquired loans detailed in the tables below are included in NOTE 4. LOANS AND ALLOWANCE, in the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q. As described in NOTE 4, loans purchased after December 31, 2008 are recorded at the acquisition date fair value, which could result in a fair value discount or premium. Purchased loans with evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the acquirer will not collect all contractually required principal and interest payments are accounted for under ASC 310-30, Loans Acquired with Deteriorated Credit Quality. The difference between contractually required payments and the cash flows expected to be collected at acquisition is referred to as the nonaccretable portion of the fair value discount or premium. The accretable portion of the fair value discount or premium is the difference between the expected cash flows and the net present value of expected cash flows, with such difference accreted into earnings over the term of the loans. All other loans not accounted for under ASC 310-30 are accounted for under ASC 310-20.

The following table includes the outstanding balance and carrying amount of all acquired loans which were included in the Corporation's balance sheet at March 31, 2016, and December 31, 2015.

March 31, 2016

Ameriana
 
C Financial

Community

CFS

SCB

Total
Commercial and industrial loans
$
23,363

 
$
99


$
7,224


$
50,476


$
4,351


$
85,513

Agricultural production financing and other loans to farmers


 



2,472





1,263


3,735

Real estate loans:

 








 
Construction
30,414

 
6,928


9,681


862





47,885

Commercial and farmland
131,371

 
25,729


47,190


175,692


12,494


392,476

Residential
116,116

 
52,720


19,212


113,633


5,645


307,326

       Home Equity
13,390

 
8,824


7,445


30,705


13,000


73,364

Individuals' loans for household and other personal expenditures
1,433

 
8


306


348


43


2,138

Other commercial loans
1,840

 






70





1,910

Total
$
317,927

 
$
94,308


$
93,530


$
371,786


$
36,796


$
914,347



 









Carrying Amount
$
304,615

 
$
92,097


$
87,523


$
353,882


$
32,390


$
870,507

Allowance


 



105


50





155

Carrying Amount Net of Allowance
$
304,615

 
$
92,097


$
87,418


$
353,832


$
32,390


$
870,352




December 31, 2015

Ameriana
 
C Financial
 
Community

CFS

SCB

Total
Commercial and industrial loans
$
21,888

 
$
104

 
$
6,769


$
52,060


$
4,620


$
85,441

Agricultural production financing and other loans to farmers


 
 
 
1,761





1,288


3,049

Real estate loans:

 
 
 






 
Construction
23,365

 
6,214

 
10,436


976





40,991

Commercial and farmland
144,514

 
27,838

 
49,997


189,372


13,293


425,014

Residential
123,231

 
55,856

 
21,886


118,105


6,063


325,141

       Home Equity
14,261

 
9,144

 
8,231


31,986


13,431


77,053

Individuals' loans for household and other personal expenditures
1,731

 
10

 
461


443


48


2,693

Other commercial loans
1,928

 
 
 



72





2,000

Total
$
330,918

 
$
99,166

 
$
99,541


$
393,014


$
38,743


$
961,382



 
 
 







Carrying Amount
$
319,664

 
$
96,829

 
$
93,355


$
373,649


$
34,092


$
917,589

Allowance


 
 
 
4


149





153

Carrying Amount Net of Allowance
$
319,664

 
$
96,829

 
$
93,351


$
373,500


$
34,092


$
917,436



The outstanding balance and related carrying amount of loans acquired and accounted for under ASC 310-30 as of March 31, 2016 were $84.5 million and $60.1 million, respectively. Additionally, the outstanding balance and related carrying amount of those loans as of December 31, 2015 were $95.8 million and $69.6 million, respectively.


22

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




As customer cash flow expectations improve, nonaccretable yield can be reclassified to accretable yield. The accretable yield, or income expected to be collected, and reclassifications from nonaccretable yield, are identified in the table below.  The table reflects only purchased loans accounted for under ASC 310-30 and not the entire portfolio of purchased loans.

Three Months Ended March 31, 2016

Ameriana
 
C Financial

Community

CFS

SCB

Total
Beginning balance
$
2,160

 
$
114


$
1,508


$
1,188


$
642


$
5,612

Additions


 














Accretion
(40
)
 
(15
)

(63
)

(1,290
)

(88
)

(1,496
)
Reclassification from nonaccretable


 
1


11


1,135


36


1,183

Disposals


 














Ending balance
$
2,120

 
$
100


$
1,456


$
1,033


$
590


$
5,299

 
 
 
 
 
 
 
 
 
 

Three Months Ended March 31, 2015

Community
 
CFS

SCB

Total
Beginning balance
$
2,122

 
$
2,400


$
868


$
5,390

Additions

 





Accretion
(179
)
 
(1,341
)

(185
)

(1,705
)
Reclassification from nonaccretable
47

 
950


135


1,132

Disposals

 





Ending balance
$
1,990

 
$
2,009


$
818


$
4,817

 
 
 
 
 
 
 
 
 
 
NOTE 6

GOODWILL

2016

2015
Balance, January 1
$
243,129


$
202,724

Measurement period adjustment
871



Balance, March 31
$
244,000


$
202,724



Goodwill is recorded on the acquisition date of an entity. During the measurement period, the Corporation may record subsequent adjustments to goodwill for provisional amounts recorded at the acquisition date. There was a $871,000 measurement period adjustment recorded during the three months ended March 31, 2016 related to the Ameriana acquisition.


NOTE 7

CORE DEPOSIT AND OTHER INTANGIBLES

The carrying basis and accumulated amortization of recognized core deposit and other intangibles are noted below.

March 31, 2016

March 31, 2015
Gross carrying amount
$
16,635


$
16,031

Accumulated amortization
(978
)

(721
)
Measurement period adjustment
2,142



Core deposit and other intangibles
$
17,799


$
15,310



Core deposit and other intangibles are recorded on the acquisition date of an entity. During the measurement period, the Corporation may record subsequent adjustments to core deposit and other intangibles for provisional amounts recorded at the acquisition date. There was a $2,142,000 measurement period adjustment recorded during the three months ended March 31, 2016 related to the Ameriana acquisition.


23

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




Estimated future amortization expense is summarized as follows:
 
Amortization Expense
2016
$
2,933

2017
3,614

2018
2,299

2019
1,914

2020
1,733

After 2020
5,306

 
$
17,799



NOTE 8
 
DERIVATIVE FINANCIAL INSTRUMENTS
 
Risk Management Objective of Using Derivatives

The Corporation is exposed to certain risks arising from both its business operations and economic conditions.  The Corporation principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Corporation manages economic risks, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities and through the use of derivative financial instruments.  Specifically, the Corporation enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates.  The Corporation’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Corporation’s known or expected cash payments principally related to certain variable-rate liabilities.  The Corporation also has derivatives that are a result of a service the Corporation provides to certain qualifying customers, and, therefore, are not used to manage interest rate risk in the Corporation’s assets or liabilities. The Corporation manages a matched book with respect to its derivative instruments offered as a part of this service to its customers in order to minimize its net risk exposure resulting from such transactions.

Cash Flow Hedges of Interest Rate Risk

The Corporation’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish these objectives, the Corporation primarily uses interest rate swaps and interest rate caps as part of its interest rate risk management strategy.  Interest rate swaps designated as cash flow hedges involve the payment of fixed amounts to a counterparty in exchange for the Corporation receiving variable payments over the life of the agreements without exchange of the underlying notional amount.  Interest rate caps designated as cash flow hedges involve the receipt of variable amounts from a counterparty if interest rates rise above the strike rate on the contract in exchange for an up-front premium.  As of March 31, 2016 and 2015, the Corporation had five interest rate swaps with a notional amount of $56.0 million and one interest rate cap with a notional amount of $13.0 million that were designated as cash flow hedges.  

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into interest expense as interest payments are made on the Corporation’s variable-rate liabilities.  During the next twelve months, the Corporation expects to reclassify $1,228,000 from accumulated other comprehensive income to interest expense.

During 2016, $26.0 million of the interest rate swaps and the $13.0 million interest rate cap were used to hedge the LIBOR-based variable cash outflows associated with existing trust preferred securities when the outflows converted from a fixed rate to variable rate in September of 2012.  In addition, the remaining $30.0 million of interest rate swaps were used to hedge the LIBOR-based variable cash outflows associated with three Federal Home Loan Bank advances. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. During the three months ended March 31, 2016, and 2015, the Corporation did not recognize any ineffectiveness.

Non-designated Hedges

The Corporation does not use derivatives for trading or speculative purposes.  Derivatives not designated as hedges are not speculative and result from a service the Corporation provides to certain customers. The Corporation executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies.  Those interest rate swaps are simultaneously hedged by offsetting interest rate swaps that the Corporation executes with a third party, such that the Corporation minimizes its net risk exposure resulting from such transactions.  As the interest rate swaps associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings.  As of March 31, 2016, the notional amount of customer-facing swaps was approximately $204,667,000.  This amount is offset with third party counterparties, as described above.


24

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




Fair Values of Derivative Instruments on the Balance Sheet

The table below presents the fair value of the Corporation’s derivative financial instruments, as well as their classification on the Balance Sheet, as of March 31, 2016, and December 31, 2015.
 
Asset Derivatives

Liability Derivatives
 
March 31, 2016

December 31, 2015

March 31, 2016

December 31, 2015
 
Balance
Sheet
Location

Fair
Value

Balance
Sheet
Location

Fair
Value

Balance
Sheet
Location

Fair
Value

Balance
Sheet
Location

Fair
Value
Derivatives designated as hedging instruments:
 

 

 

 

 

 

 

 
Interest rate contracts
Other Assets

$
12


Other Assets

$
36


Other Liabilities

$
4,565


Other Liabilities

$
2,921

Derivatives not designated as hedging instruments:
 

 

 

 

 

 

 

 
Interest rate contracts
Other Assets

$
8,635


Other Assets

$
4,938


Other Liabilities

$
9,091


Other Liabilities

$
5,149



Effect of Derivative Instruments on the Income Statement

The tables below present the effect of the Corporation’s derivative financial instruments on the Income Statement for the three months ended March 31, 2016, and 2015.
Derivatives Not Designated as
Hedging Instruments under
FASB ASC 815-10
 
Location of Gain (Loss)
Recognized Income on
Derivative
 
Amount of Gain (Loss) Recognized in Income on Derivative
 
 
Three Months Ended
March 31, 2016
 
Three Months Ended
March 31, 2015
Interest rate contracts
 
Other income
 
$
(245
)
 
$
(100
)
 
 
 
 
 
 
 

The amount of gain (loss) recognized in other comprehensive income is included in the table below for the periods indicated.
Derivatives in Cash Flow Hedging Relationships
Amount of Gain (Loss) Recognized in Other Comprehensive Income on Derivative
(Effective Portion)
Three Months Ended
March 31, 2016
 
March 31, 2015
Interest Rate Products
$
(1,954
)
 
$
(1,276
)


The amount of gain (loss) reclassified from other comprehensive income into income is included in the table below for the periods indicated.
Location of Loss Reclassified from Accumulated Other Comprehensive Income (Effective Portion)
Amount of Gain (Loss) Reclassified from Other Comprehensive Income into Income
(Effective Portion)
Three Months Ended
March 31, 2016
 
March 31, 2015
Interest Expense
$
(324
)
 
$
(354
)


The Corporation’s exposure to credit risk occurs because of nonperformance by its counterparties.  The counterparties approved by the Corporation are usually financial institutions, which are well capitalized and have credit ratings through Moody’s and/or Standard & Poor’s, at or above investment grade.  The Corporation’s control of such risk is through quarterly financial reviews, comparing mark-to-mark values with policy limitations, credit ratings and collateral pledging.

Credit-risk-related Contingent Features

The Corporation has agreements with certain of its derivative counterparties that contain a provision where if the Corporation fails to maintain its status as a well or adequately capitalized institution, then the Corporation could be required to terminate or fully collateralize all outstanding derivative contracts.

The Corporation also has agreements with certain of its derivative counterparties that contain a provision where if the Corporation defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, the Corporation could also be declared in default on its derivative obligations. As of March 31, 2016, the termination value of derivatives in a net liability position related to these agreements was $13,966,000. As of March 31, 2016, the Corporation had minimum collateral posting thresholds with certain of its derivative counterparties and had posted collateral of $15,681,000. If the Corporation had breached any of these provisions at March 31, 2016, it could have been required to settle its obligations under the agreements at their termination value.



25

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




NOTE 9 

DISCLOSURES ABOUT FAIR VALUE OF ASSETS AND LIABILITIES

The Corporation used fair value measurements to record fair value adjustments, to certain assets, and liabilities and to determine fair value disclosures. The accounting guidance defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  ASC 820 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 ASC 820, 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 maximizes the amount to be received for the asset or 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 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 for which there is little or no market activity (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.

Recurring Measurements

Following is a description of the valuation methodologies and inputs used for instruments measured at fair value on a recurring basis and recognized in the accompanying Consolidated Condensed Balance Sheets, as well as the general classification of such instruments pursuant to the valuation hierarchy.  There have been no significant changes in the valuation techniques as of March 31, 2016.

Available for Sale Investment Securities

Where quoted, market prices are available in an active market and 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 a discounted cash flow model. Level 2 securities include agencies, mortgage- backed, state and municipal, and equity securities. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy. Level 3 fair value, including corporate obligations, state and municipal and equity securities, was determined using a discounted cash flow model that incorporated market estimates of interest rates and volatility in markets that have not been active.

Third party vendors compile prices from various sources and may apply such techniques as matrix pricing to determine the value of identical or similar investment securities classified within Level 2. Matrix pricing is a mathematical technique widely used in the banking industry to value investment securities without relying exclusively on quoted prices for specific investment securities but rather relying on the investment securities’ relationship to other benchmark quoted investment securities. Any investment security not valued based upon the methods above are considered Level 3.

Interest Rate Derivative Agreements

See information regarding the Corporation's interest rate derivative products in NOTE 8. DERIVATIVE FINANCIAL INSTRUMENTS, included within the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.












26

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




The following table presents the fair value measurements of assets and liabilities recognized in the Consolidated Condensed Balance Sheets measured at fair value on a recurring basis and the level within the fair value hierarchy in which the fair value measurements fall at March 31, 2016, and December 31, 2015.
 
 

Fair Value Measurements Using:
March 31, 2016
Fair Value

Quoted Prices in Active Markets for Identical Assets
(Level 1)

Significant Other
Observable Inputs
(Level 2)

Significant
Unobservable
Inputs
(Level 3)
Available for sale securities:
 
 
 
 
 
 
 
U.S. Government-sponsored agency securities
$
103

 
 
 
$
103

 
 
State and municipal
330,120

 
 
 
324,651

 
$
5,469

U.S. Government-sponsored mortgage-backed securities
302,586

 
 
 
302,586

 
 
Corporate obligations
31

 
 
 
 
 
31

Equity securities
3,945

 
 
 
3,941

 
4

Interest rate swap asset
8,635

 
 
 
8,635

 
 
Interest rate cap
12

 
 
 
12

 
 
Interest rate swap liability
13,656

 
 
 
13,656

 
 


 
 

Fair Value Measurements Using:
December 31, 2015
Fair Value

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

Significant Other Observable Inputs
(Level 2)

Significant
Unobservable
Inputs
(Level 3)
Available for sale securities:
 

 

 

 
U.S. Government-sponsored agency securities
$
104


 

$
104


 
State and municipal
305,911


 

300,014


$
5,897

U.S. Government-sponsored mortgage-backed securities
346,266


 

346,266


 
Certificates of deposit
2,176

 
 
 
2,176

 
 
Corporate obligations
31


 

 

31

Equity securities
3,912


 

3,908


4

Interest rate swap asset
4,938


 

4,938




Interest rate cap
36


 

36




Interest rate swap liability
8,070


 

8,070






Level 3 Reconciliation

The following is a reconciliation of the beginning and ending balances of recurring fair value measurements recognized in the Consolidated Condensed Balance Sheets using significant unobservable (Level 3) inputs for three months ended March 31, 2016 and 2015.
 
Available for Sale Securities
 
Three Months Ended
March 31, 2016

Three Months Ended
March 31, 2015
Balance at beginning of the period
$
5,932


$
6,646

Total realized and unrealized gains and losses:
 


Included in other comprehensive income
38


91

Principal payments
(466
)

(539
)
Ending balance
$
5,504


$
6,198



There were no gains or losses for the period included in earnings that were attributable to the changes in unrealized gains or losses related to assets or liabilities held at March 31, 2016 or December 31, 2015.



27

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




Transfers Between Levels

There were no transfers in or out of Level 3 for the three months ended March 31, 2016 and 2015.
 
 
 
 
 
 
 
 
Nonrecurring Measurements

The following table presents the fair value measurement of assets and liabilities measured at fair value on a nonrecurring basis and the level within the fair value hierarchy in which the fair value measurements fall at March 31, 2016, and December 31, 2015.
 

 

Fair Value Measurements Using
March 31, 2016

Fair Value

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

Significant Other
Observable
Inputs
(Level 2)

Significant Unobservable
Inputs
(Level 3)
Impaired loans (collateral dependent)

$
9,530


 

 

$
9,530

Other real estate owned

1,287


 

 

1,287

 
 
 

 

Fair Value Measurements Using
December 31, 2015

Fair Value

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

Significant Other
Observable
 Inputs
(Level 2)

Significant Unobservable
Inputs
(Level 3)
Impaired loans (collateral dependent)

$
7,066


 

 

$
7,066

Other real estate owned

5,529


 

 

5,529

 

Following is a description of valuation methodologies used for instruments measured at fair value on a nonrecurring basis and recognized in the Consolidated Condensed Balance Sheets, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Impaired Loans (collateral dependent)

Loans for which it is probable that the Corporation will not collect all principal and interest due according to contractual terms are measured for impairment. Allowable methods for determining the amount of impairment include estimating fair value of the collateral for collateral dependent loans. If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value. 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. During 2016, certain impaired loans were partially charged off or re-evaluated. Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method.

Other Real Estate Owned

The fair value for impaired loans and other real estate owned is measured based on the value of the collateral securing those loans or real estate 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 ascertained by assessing, either singularly or some combination of,  asset appraisals, accounts receivable aging reports, inventory listings and/or customer financial statements. Both appraised values and values based on borrower’s financial information are discounted as considered appropriate based on age and quality of the information and current market conditions.


28

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




Unobservable (Level 3) Inputs

The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements, other than goodwill, at March 31, 2016 and December 31, 2015.
March 31, 2016
Fair Value

Valuation Technique

Unobservable Inputs

Range (Weighted-Average)
State and municipal securities
$
5,469


Discounted cash flow

Maturity/Call date

1 month to 15 yrs
 
 

 

Blend of US Muni BQ curve

A- to BBB-
 
 

 

Discount rate

.69% - 5%
 
 
 
 
 
 
 
 
Corporate obligations and Equity securities
$
35


Discounted cash flow

Risk free rate

3 month LIBOR
 
 

 

plus premium for illiquidity

plus 200bps
 
 
 
 
 
 
 
 
Impaired loans (collateral dependent)
$
9,530


Collateral based measurements

Discount to reflect current market conditions and ultimate collectability

0% - 50% (1%)
 
 





 
Other real estate owned
$
1,287


Appraisals

Discount to reflect current market conditions

0% - 20% (2%)


December 31, 2015
Fair Value
 
Valuation Technique
 
Unobservable Inputs
 
Range (Weighted-Average)
State and municipal securities
$
5,897

 
Discounted cash flow
 
Maturity/Call date
 
1 month to 15 yrs
 
 
 
 
 
Blend of US Muni BQ curve
 
A- to BBB-
 
 
 
 
 
Discount rate
 
.80% - 5%
 
 
 
 
 
 
 
 
Corporate obligations and Equity securities
$
35

 
Discounted cash flow
 
Risk free rate
 
3 month LIBOR
 
 
 
 
 
plus premium for illiquidity
 
plus 200bps
 
 
 
 
 
 
 
 
Impaired loans (collateral dependent)
$
7,066

 
Collateral based measurements
 
Discount to reflect current market conditions and ultimate collectability
 
0% - 50% (2%)
 
 
 
 
 
 
 
 
Other real estate owned
$
5,529

 
Appraisals
 
Discount to reflect current market conditions
 
0% - 20% (2%)


Sensitivity of Significant Unobservable Inputs

The following is a discussion of the sensitivity of significant unobservable inputs, the interrelationships between those inputs and other unobservable inputs used in recurring fair value measurement and how those inputs might magnify or mitigate the effect of changes in the unobservable inputs on the fair value measurement.

State and Municipal Securities, Corporate Obligations and Equity Securities

The significant unobservable inputs used in the fair value measurement of the Corporation’s state and municipal securities, corporate obligations and equity securities are premiums for unrated securities and marketability discounts.  Significant increases or decreases in either of those inputs in isolation would result in a significantly lower or higher fair value measurement.  




29

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




Fair Value of Financial Instruments

The following table presents estimated fair values of the Corporation’s financial instruments and the level within the fair value hierarchy in which the fair value measurements fall at March 31, 2016, and December 31, 2015.



March 31, 2016


 
Carrying
Amount

Quoted Prices in Active Markets
for Identical
Assets

Significant
Other
Observable
Inputs

Significant Unobservable
Inputs
 
(Level 1)

(Level 2)

(Level 3)
Assets:
 

 

 

 
Cash and cash equivalents
$
85,738


$
85,738


 

 
Interest-bearing time deposits
77,453


77,453


 

 
Investment securities available for sale
636,785


 

$
631,281


$
5,504

Investment securities held to maturity
633,992


 

626,164


29,281

Loans held for sale
3,628


 

3,628


 
Loans
4,647,821


 

 

4,600,417

Federal Reserve Bank and Federal Home Loan Bank stock
37,553


 

37,553


 
Interest rate swap and cap asset
8,647


 

8,647


 
Interest receivable
22,836


 

22,836


 
Liabilities:
 

 

 

 
Deposits
$
5,311,070


$
4,139,907


$
1,158,592


 
Borrowings:




 

 
Federal funds purchased
602

 
 
 
602

 
 
Securities sold under repurchase agreements
150,134


 

150,118


 
Federal Home Loan Bank advances
263,588


 

265,170


 
Subordinated debentures and term loans
127,523


 

98,807


 
Interest rate swap liability
13,656


 

13,656


 
Interest payable
3,910


 

3,910


 





December 31, 2015


 
Carrying
Amount

Quoted Prices in Active Markets
for Identical
Assets

Significant
Other
Observable
Inputs

Significant Unobservable
Inputs
 
(Level 1)

(Level 2)

(Level 3)
Assets:
 

 

 

 
Cash and cash equivalents
$
102,170


$
102,170


 

 
Interest-bearing time deposits
32,315


32,315


 

 
Investment securities available for sale
658,400


 

$
652,468


$
5,932

Investment securities held to maturity
618,599


 

598,082


34,298

Loans held for sale
9,894


 

9,894


 
Loans
4,631,369


 

 

4,539,940

Federal Reserve Bank and Federal Home Loan Bank stock
37,633


 

37,633


 
Interest rate swap and cap asset
4,974


 

4,974




Interest receivable
24,415


 

24,415


 
Liabilities:
 

 

 

 
Deposits
$
5,289,647


$
4,095,004


$
1,177,142


 
Borrowings:
 

 

 

 
Federal funds purchased
49,721




49,721



Securities sold under repurchase agreements
155,325


 

155,325


 
Federal Home Loan Bank advances
235,652


 

236,375


 
Subordinated debentures and term loans
127,846


 

103,643


 

Interest rate swap liability
8,070


 

8,070



Interest payable
3,092


 

3,092


 


30

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




The following methods were used to estimate the fair value of all other financial instruments recognized in the Consolidated Condensed Balance Sheets at amounts other than fair value.

Cash and cash equivalents:  The fair value of cash and cash equivalents approximates carrying value.

Interest-bearing time deposits:  The fair value of interest-bearing time deposits approximates carrying value.

Investment securities:  Fair value is based on quoted market prices, if available.  If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. The fair value of certain Level III securities is estimated using discounted cash flow analysis, using interest rates currently being offered on investments with similar maturities and investment quality.

Loans Held For Sale:  The carrying amount approximates fair value due to the short duration between origination and date of sale.

Loans:  The fair value for 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.

Federal Reserve and Federal Home Loan Bank stock:  The fair value of Federal Reserve Bank and Federal Home Loan Bank stock is based on the price which it may be resold to the Federal Reserve and Federal Home Loan Bank.

Derivative instruments:  The fair value of the interest rate swaps reflects the estimated amounts that would have been received to terminate these contracts at the reporting date based upon pricing or valuation models applied to current market information.  Interest rate caps are valued using the market standard methodology of discounting the future expected cash receipts that would occur if variable interest rates rose above the strike rate of the caps.  The projected cash receipts on the caps are based on an expectation of future interest rates derived from observed market interest rate curves and volatilities.

Interest Receivable and Interest Payable:  The fair value of interest receivables/payable approximates the carrying amount.

Deposits:  The fair values of noninterest-bearing and 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 to a schedule of aggregated expected monthly maturities on such time deposits.

Federal funds purchased:  The fair value of Federal Funds purchased approximates the carrying amount.

Borrowings:  The fair value of borrowings is estimated using a discounted cash flow calculation, based on current rates for similar debt.


NOTE 10

TRANSFERS ACCOUNTED FOR AS SECURED BORROWINGS

The collateral pledged for all repurchase agreements that are accounted for as secured borrowings as of March 31, 2016 were:

Remaining Contractual Maturity of the Agreements

Overnight and Continuous

Up to 30 Days

30-90 Days

Greater Than 90 Days

Total
U.S. Government-sponsored mortgage-backed securities
$
127,329


$
7,559


$
15,246





$
150,134



















 

31

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




NOTE 11 
 
ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
 
The following table summarizes the changes in the balances of each component of accumulated other comprehensive income (loss), net of tax, as of March 31, 2016 and 2015:
 
Accumulated Other Comprehensive Income (Loss)
 
Unrealized Gains (Losses) on Securities Available for Sale
 
Unrealized Gains (Losses) on Cash Flow Hedges
 
Unrealized Gains (Losses) on Defined Benefit Plans
 
Total
Balance at December 31, 2015
$
12,325

 
$
(2,347
)
 
$
(11,340
)
 
$
(1,362
)
Other comprehensive income before reclassifications
5,135

 
(1,270
)
 


 
3,865

Amounts reclassified from accumulated other comprehensive income
(648
)
 
211

 


 
(437
)
Period change
4,487

 
(1,059
)
 

 
3,428

Balance at March 31, 2016
$
16,812

 
$
(3,406
)
 
$
(11,340
)
 
$
2,066

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2014
$
14,098

 
$
(2,182
)
 
$
(13,546
)
 
$
(1,630
)
Other comprehensive income before reclassifications
980

 
(829
)
 


 
151

Amounts reclassified from accumulated other comprehensive income
(666
)
 
230

 


 
(436
)
Period change
314

 
(599
)
 

 
(285
)
Balance at March 31, 2015
$
14,412

 
$
(2,781
)
 
$
(13,546
)
 
$
(1,915
)


The following table presents the reclassification adjustments out of accumulated other comprehensive income (loss) that were included in net income in the Consolidated Condensed Statements of Income for the three months ended March 31, 2016 and 2015:
 
 
Amount Reclassified from Accumulated Other Comprehensive Income (Loss) For the Three Months Ended March 31,
 
 
Details about Accumulated Other Comprehensive Income (Loss)Components
 
2016
 
2015
 
Affected Line Item in the Statements of Income
Unrealized gains (losses) on available for sale securities (1)
 
 
 
 
 
 
Realized securities gains (losses) reclassified into income
 
$
997

 
$
1,025

 
Other income - net realized gains on sales of available for sale securities
Related income tax expense
 
(349
)
 
(359
)
 
Income tax expense
 
 
$
648

 
$
666

 
 
 
 
 
 
 
 
 
Unrealized gains (losses) on cash flow hedges (2)
 
 
 
 
 
 
Interest rate contracts
 
$
(324
)
 
$
(354
)
 
Interest expense - subordinated debentures and term loans
Related income tax benefit
 
113

 
124

 
Income tax expense
 
 
$
(211
)
 
$
(230
)
 
 
 
 
 
 
 
 
 
Total reclassifications for the period, net of tax
 
$
437

 
$
436

 
 
 
 
 
 
 
 
 

(1) For additional detail related to unrealized gains (losses) on available for sale securities and related amounts reclassified from accumulated other comprehensive income see NOTE 3. INVESTMENT SECURITIES.

(2) For additional detail related to unrealized gains (losses) on cash flow hedges and related amounts reclassified from accumulated other comprehensive income see NOTE 8. DERIVATIVE FINANCIAL INSTRUMENTS.










32

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




NOTE 12 

SHARE-BASED COMPENSATION

Stock options and restricted stock awards ("RSAs") have been issued to directors, officers and other management employees under the Corporation's 1999 Long-term Equity Incentive Plan and the 2009 Long-term Equity Incentive Plan.  The stock options, which have a ten year life, become 100 percent vested ranging from six 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 issued to employees and non-employee directors 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 vest only if the employee is actively employed by the Corporation on the vesting date and, therefore, any unvested shares are forfeited.  For non-employee directors, the RSAs vest only if the non-employee director remains as an active board member on the vesting date and, therefore, any unvested shares are forfeited. RSAs for employees and non-employee directors retired from the Corporation are either immediately vested at retirement or continue to vest after retirement, depending on the plan under which the shares were granted. Deferred stock units ("DSUs") can be 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 director would have received under the plan.  As of March 31, 2016, there were no outstanding DSUs.

The Corporation’s 2009 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 quarterly offerings financed by payroll deductions. The price of the stock to be paid by the employees shall be equal to 85 percent of the average of the closing price of the Corporation’s common stock on each trading day during the offering period. However, in no event shall such purchase price be less than the lesser of an amount equal to 85 percent of the market price of the Corporation’s stock on the offering date or an amount equal to 85 percent of the market value on the date of purchase. Common stock purchases are made quarterly and are paid through advance payroll deductions up to a calendar year maximum of $25,000.

Compensation expense related to unvested share-based awards is recorded 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 share-based compensation guidance 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 three months ended March 31, 2016 was $593,000 compared to $517,000 for the three months ended March 31, 2015. Share-based compensation has been recognized as a component of salaries and benefits expense in the accompanying Consolidated Condensed Statements of Income.

The estimated fair value of the stock options granted during 2014 and in prior years was calculated using a Black Scholes option pricing model.  There have been no stock options granted since 2014.
 
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 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. Share-based compensation guidance 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 3.8 percent for the three months ended March 31, 2016, based on historical experience.

The following table summarizes the components of the Corporation's share-based compensation awards recorded as expense:
 
Three Months Ended
March 31,
 
 
2016
 
2015
 
Stock and ESPP Options
 
 
 
 
Pre-tax compensation expense
$
15

 
$
27

 
Income tax expense (benefit)


 
(1
)
 
Stock and ESPP option expense, net of income taxes
$
15

 
$
26

 
Restricted Stock Awards
 
 
 
 
Pre-tax compensation expense
$
578

 
$
490

 
Income tax benefit
(202
)
 
(168
)
 
Restricted stock awards expense, net of income taxes
$
376

 
$
322

 
Total Share-Based Compensation
 
 
 
 
Pre-tax compensation expense
$
593

 
$
517

 
Income tax benefit
(202
)
 
(169
)
 
Total share-based compensation expense, net of income taxes
$
391

 
$
348

 



33

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PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




As of March 31, 2016, unrecognized compensation expense related to RSAs was $5,277,000 and is expected to be recognized over a weighted-average period of 1.93 years. The Corporation did not have any unrecognized compensation expense related to stock options as of March 31, 2016.

Stock option activity under the Corporation's stock option plans as of March 31, 2016 and changes during the three months ended March 31, 2016, were as follows:
 
Number of
Shares

Weighted-Average Exercise Price

Weighted Average Remaining
Contractual Term
(in Years)

Aggregate
Intrinsic
Value
Outstanding at January 1, 2016
442,012


$
19.99


 

 
Granted





 

 
Exercised
(6,700
)

$
10.80


 

 
Canceled
(49,500
)

$
25.14


 

 
Outstanding March 31, 2016
385,812


$
19.49


3.23

1,992,120

Vested and Expected to Vest at March 31, 2016
385,812


$
19.49


3.23

1,992,120

Exercisable at March 31, 2016
385,812


$
19.49


3.23

1,992,120



There were no options granted during the three months ended March 31, 2016 and March 31, 2015.

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 the first three months of 2016 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 March 31, 2016.  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 three months ended March 31, 2016 and 2015 was $77,000 and $188,000, respectively. Cash receipts of stock options exercised during this same period were $73,000 and $355,000, respectively.

The following table summarizes information on unvested RSAs outstanding as of March 31, 2016:
 
Number of Shares

Weighted-Average
Grant Date Fair Value
Unvested RSAs at January 1, 2016
354,504


$
19.65

Granted
110,623


$
23.41

Vested
(101,984
)

$
15.32

Forfeited
(419
)

$
21.60

Unvested RSAs at March 31, 2016
362,724


$
22.31



The grant date fair value of ESPP options was estimated at the beginning of the January 1, 2016 quarterly offering period of approximately $15,000. The ESPP options vested during the three months ending March 31, 2016, leaving no unrecognized compensation expense related to unvested ESPP options at March 31, 2016.


NOTE 13

INCOME TAX

The following table summarizes the major components creating differences between income taxes at the federal statutory and the effective tax rate recorded in the consolidated statements of income for the three months ended March 31, 2016 and 2015:

Three Months Ended
March 31,
 
2016

2015
Reconciliation of Federal Statutory to Actual Tax Expense:
 

 
Federal statutory income tax at 35%
$
8,143


$
7,702

Tax-exempt interest income
(2,026
)

(1,429
)
Stock compensation
5


8

Earnings on life insurance
(517
)

(262
)
Tax credits
(129
)

(144
)
Other
98


(41
)
Actual Tax Expense
$
5,574


$
5,834







Effective Tax Rate
24.0
%

26.5
%

34

Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




NOTE 14
 
NET INCOME PER SHARE
 
Basic net income per share is computed by dividing net income by the weighted-average shares outstanding during the reporting period. Diluted net income per share is computed by dividing net income by the combination of all dilutive common share equivalents, comprised of shares issuable under the Corporation’s share-based compensation plans, and the weighted-average shares outstanding during the reporting period.

Dilutive common share equivalents include the dilutive effect of in-the-money share-based awards, which are calculated based on the average share price for each period using the treasury stock method. Under the treasury stock method, the exercise price of share-based awards, the amount of compensation expense, if any, for future service that the Corporation has not yet recognized, and the amount of estimated tax benefits that would be recorded in additional paid-in capital when share-based awards are exercised, are assumed to be used to repurchase common stock in the current period.
 
The following table reconciles basic and diluted net income per share for the three months ended March 31, 2016 and 2015.
 
Three Months Ended March 31,
 
2016
 
2015
 
Net Income
 
Weighted-Average Shares
 
Per Share
Amount
 
Net Income
 
Weighted-Average Shares
 
Per Share
Amount
Net income available to common stockholders
17,693

 
40,690,573

 
$
0.43

 
16,172

 
37,709,883

 
$
0.43

Effect of dilutive stock options and warrants
 
 
226,399

 
 
 
 
 
290,191

 
 
Diluted net income per share
$
17,693

 
40,916,972

 
$
0.43

 
$
16,172

 
38,000,074

 
$
0.43


 
 
 
 
 
 
 
 
 
 
 
 
Stock options to purchase 153,721 and 367,576 shares for the three months ended March 31, 2016 and 2015, respectively, were not included in the earnings per share calculation because the exercise price exceeded the average market price.


NOTE 15
 
IMPACT OF ACCOUNTING CHANGES

FASB Accounting Standards Update No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting
Summary - The amendments in ASU 2016-09 simplify several aspects of accounting for employee share-based payments including income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. Some areas of the simplification apply only to nonpublic entities. The new guidance will require all income tax effects of awards to be recognized as income tax expense or benefit in the income statement when the awards vest or are settled and additional paid in capital pools will be eliminated. The guidance requires companies to present excess tax benefits as an operating activity on the statement of cash flows rather than as a financing activity. Companies will be required to account for forfeitures of share-based payments by recognizing forfeitures of awards as they occur or estimating the number of awards expected to be forfeited and adjusting the estimate when it is likely to change, as currently required, through an accounting policy election. The guidance will increase the amount an employer can withhold to cover income taxes on awards and still qualify for the exception to liability classification for shares used to satisfy the employer's income tax withholding obligation. The guidance requires an employer to classify the cash paid to a tax authority when shares are withheld to satisfy its statutory income tax withholding obligation as a financing activity on the statement of cash flows. For public business entities, the amendments in this update are effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. Early adoption will be permitted in any interim or annual period for which financial statements have not yet been issued or have not been made available for issuance, however all of the guidance must be adopted in the same period. If early adoption is elected in an interim period, any adjustments should be reflected as of the beginning of the annual period that includes that interim period. Adoption of this ASU is not expected to have a significant effect on the Corporation’s consolidated financial statements.



35

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PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




FASB Accounting Standards Update No. 2016-07, Investments -Equity Method and Joint Ventures (Topic 323)
Summary - The FASB has issued Accounting Standards Update (ASU) No. 2016-07, Investments - Equity Method and Joint Ventures (Topic 323): Simplifying the Transition to the Equity Method of Accounting. The amendments affect all entities that have an investment that becomes qualified for the equity method of accounting as a result of an increase in the level of ownership interest or degree of influence.

The amendments eliminate the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held. The amendments require that the equity method investor add the cost of acquiring the additional interest in the investee to the current basis of the investor’s previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for equity method accounting. Therefore, upon qualifying for the equity method of accounting, no retroactive adjustment of the investment is required.

The amendments require that an entity that has an available-for-sale equity security that becomes qualified for the equity method of accounting recognize through earnings the unrealized holding gain or loss in accumulated other comprehensive income at the date the investment becomes qualified for use of the equity method.

The amendments are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. The amendments should be applied prospectively upon their effective date to increases in the level of ownership interest or degree of influence that result in the adoption of the equity method. Earlier application is permitted. Adoption of this ASU is not expected to have a significant effect on the Corporation’s consolidated financial statements.

FASB Accounting Standards Update No. 2016-06, Derivatives and Hedging (Topic 815): Contingent Put and Call Options in Debt Instruments
Summary - The FASB has issued Accounting Standards Update No. 2016-06, Derivatives and Hedging (Topic 815): Contingent Put and Call Options in Debt Instruments. The amendments apply to all entities that are issuers of or investors in debt instruments (or hybrid financial instruments that are determined to have a debt host) with embedded call (put) options.

Topic 815, Derivatives and Hedging, requires that embedded derivatives be separated from the host contract and accounted for separately as derivatives if certain criteria are met. One of those criteria is that the economic characteristics and risks of the embedded derivatives are not clearly and closely related to the economic characteristics and risks of the host contract (the “clearly and closely related” criterion).

U.S. GAAP provides specific guidance for assessing whether call (put) options that can accelerate the repayment of principal on a debt instrument meet the clearly and closely related criterion. The guidance states that for contingent call (put) options to be considered clearly and closely related, they can be indexed only to interest rates or credit risk.

The amendments clarify what steps are required when assessing whether the economic characteristics and risks of call (put) options are clearly and closely related to the economic characteristics and risks of their debt hosts, which is one of the criteria for bifurcating an embedded derivative. Consequently, when a call (put) option is contingently exercisable, an entity does not have to assess whether the event that triggers the ability to exercise a call (put) option is related to interest rates or credit risks.

Public business entities must apply the new requirements for fiscal years beginning after December 15, 2016 and interim periods within those fiscal years. If an entity early adopts the new requirements in an interim period, it must reflect any adjustments as of the beginning of the fiscal year that includes that interim period. Adoption of this ASU is not expected to have a significant effect on the Corporation’s consolidated financial statements.

FASB Accounting Standards Update No. 2016-05, Derivatives and Hedging (Topic 815): Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships
Summary - The FASB has issued Accounting Standards Update (ASU) No. 2016-05, Derivatives and Hedging (Topic 815): Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships. The amendments apply to all reporting entities for which there is a change in the counterparty to a derivative instrument that has been designated as a hedging instrument.

The term novation, as it relates to derivative instruments, refers to replacing one of the parties to a derivative instrument with a new party. In practice, derivative instrument novations may occur for a variety of reasons, including financial institution mergers, intercompany transactions, an entity exiting a particular derivatives business or relationship, an entity managing against internal credit limits, or in response to laws or regulatory requirements. The derivative instrument that is the subject of a novation may be the hedging instrument in a hedging relationship that has been designated under Topic 815, Derivatives and Hedging.


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Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




The issue is whether a change in the counterparty to a derivative instrument that has been designated as a hedging instrument, in and of itself, results in a requirement to dedesignate that hedging relationship and therefore discontinue the application of hedge accounting. The guidance in Topic 815 is not explicitly clear about the effect on an existing hedging
relationship, if any, of a change in the counterparty to a derivative instrument that has been designated as a hedging instrument. Furthermore, the existing guidance, which is limited, is interpreted and applied inconsistently in practice.

The amendments clarify that a change in the counterparty to a derivative instrument that has been designated as the hedging instrument does not, in and of itself, require dedesignation of that hedging relationship provided that all other hedge accounting criteria.

The amendments are effective for public business entities for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The amendments may be applied on either a prospective basis or a modified retrospective basis. Adoption of this ASU is not expected to have a significant effect on the Corporation’s consolidated financial statements.

FASB Accounting Standards Update No. 2016-02 - Leases (Topic 842)
Summary - The FASB has issued its new lease accounting guidance in Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date:

A lease liability, which is a lessee‘s obligation to make lease payments arising from a lease, measured on a discounted basis; and
A right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term.

Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers.

The new lease guidance simplified the accounting for sale and leaseback transactions primarily because lessees must recognize lease assets and lease liabilities. Lessees will no longer be provided with a source of off-balance sheet financing.

Public business entities should apply the amendments in ASU 2016-02 for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (i.e., January 1, 2019, for a calendar year entity). Early application is permitted for all public business entities and all nonpublic business entities upon issuance.

Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The Corporation is evaluating the effect of this ASU on its consolidated financial statements.

FASB Accounting Standards Update No. 2014-09 - Revenue from Contracts with Customers
Summary - The FASB issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, which implements a common revenue standard that clarifies the principles for recognizing revenue. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply the following steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract and (v) recognize revenue when (or as) the entity satisfies a performance obligation. ASU 2014-09 is effective on January 1, 2018 and is not expected to have a significant impact on the Corporation's financial statements.


NOTE 16
 
GENERAL LITIGATION AND REGULATORY EXAMINATIONS

The Corporation is subject to claims and lawsuits that arise primarily in the ordinary course of business. Additionally, the Corporation is subject to periodic examinations by various regulatory agencies. It is the opinion of management that the disposition or ultimate resolution of such claims, lawsuits, and examinations will not have a material adverse effect on the consolidated financial position, results of operations and cash flow of the Corporation.



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Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
(Unaudited)




NOTE 17
 
SUBSEQUENT EVENTS

On April 1, 2016, the Board of Directors of First Merchants Bank, National Association (the “Bank”), a wholly-owned subsidiary of First Merchants Corporation, adopted final resolutions approving the conversion of the Bank’s banking charter from a national association to an Indiana state-chartered bank. The initial application to convert was filed with the Indiana Department of Financial Institutions (the “Indiana DFI”) on February 9, 2016. Between the date of initial application and adoption of the final resolutions by the Bank’s Board, the Indiana DFI and the Federal Deposit Insurance Corporation (the “FDIC”) conducted a joint exam of the Bank and its banking activities. Final regulatory approval of the application was obtained at the meeting of the Members of the Indiana DFI on April 14, 2016. The Bank filed official conversion documents effective April 15, 2016. As a result of the conversion, the Indiana DFI became the Bank’s primary regulator and the FDIC became the Bank’s primary federal regulator. Upon conversion, the Bank’s official name changed from “First Merchants Bank, National Association” to “First Merchants Bank.” The Bank intends to continue operating under the following trade names in certain geographic markets: Lafayette Bank and Trust and First Merchants Private Wealth Advisors (each as a division of First Merchants Bank). The conversion is not expected to affect the Bank’s operations or customers in any way, and Bank customers will continue to receive identical protection on deposits through the FDIC’s deposit insurance program.


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Table of Contents
PART I: FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

From time to time, we include forward-looking statements in our oral and written communication. We may include forward-looking statements in filings with the Securities and Exchange Commission, such as this Quarterly Report on Form 10-Q, in other written materials and in oral statements made by senior management to analysts, investors, representatives of the media and others. We intend 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 we are 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 our goals, intentions and expectations;
statements regarding our business plan and growth strategies;
statements regarding the asset quality of our loan and investment portfolios; and
estimates of our risks and future costs and benefits.

These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, the following important factors which could affect the actual outcome of future events:

fluctuations in market rates of interest and loan and deposit pricing, which could negatively affect our net interest margin, asset valuations and expense expectations;
adverse changes in the economy, which might affect our business prospects and could cause credit-related losses and expenses;
adverse developments in our loan and investment portfolios;
competitive factors in the banking industry, such as the trend towards consolidation in our market;
changes in the banking legislation or the regulatory requirements of federal and state agencies applicable to bank holding companies and banks like our affiliate bank;
acquisitions of other businesses by us and integration of such acquired businesses;
changes in market, economic, operational, liquidity, credit and interest rate risks associated with our business; and
the continued availability of earnings and excess capital sufficient for the lawful and prudent declaration and payment of cash dividends.

Because of these and other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements. In addition, our past results of operations do not necessarily indicate our anticipated future results.

CRITICAL ACCOUNTING POLICIES
 
Generally accepted accounting principles are complex and require us to apply significant judgments to various accounting, reporting and disclosure matters. We must use assumptions and estimates to apply those principles where actual measurement is not possible or practical. For a complete discussion of our significant accounting policies, see “Notes to the Consolidated Financial Statements” in our Annual Report on Form 10-K for the year ended December 31, 2015. Certain policies are considered 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 financial statements. We have reviewed the application of these policies with the Audit Committee of our Board of Directors.

We believe there have been no significant changes during the three months ended March 31, 2016, to the items that we disclosed as our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2015.


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PART I: FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


BUSINESS SUMMARY

First Merchants Corporation (the “Corporation”) is a financial holding company headquartered in Muncie, Indiana and was organized in September 1982. The Corporation’s Common Stock is traded on NASDAQ’s Global Select Market System under the symbol FRME. The Corporation has one full-service bank charter, First Merchants Bank (the “Bank”), which opened for business in Muncie, Indiana, in March 1893. The Bank also operates Lafayette Bank and Trust and First Merchants Private Wealth Advisors as divisions of First Merchants Bank.  The Bank includes 109 banking locations in twenty-eight Indiana, two Illinois and two Ohio counties. In addition to its branch network, the Corporation’s delivery channels include ATMs, check cards, remote deposit capture, interactive voice response systems and internet technology. The Corporation’s business activities are currently limited to one significant business segment, which is community banking.

Through the Bank, the Corporation offers a broad range of financial services, including accepting time deposits, 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 private wealth management; and providing other corporate services, letters of credit and repurchase agreements.

The Corporation also operated First Merchants Insurance Services, Inc., operating as First Merchants Insurance Group ("FMIG"), a full-service property, casualty, personal lines, and employee benefit insurance agency headquartered in Muncie, Indiana. On June 12, 2015, the Corporation sold all of its stock in FMIG to USI Insurance Services LLC for $18,000,000. Additional details of the transaction are included in NOTE 2. ACQUISITIONS AND DIVESTITURES, included within the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.

On April 1, 2016, the Board of Directors of the Bank adopted final resolutions approving the conversion of the Bank’s banking charter from a national association to an Indiana state-chartered bank. The initial application to convert was filed with the Indiana Department of Financial Institutions (the “Indiana DFI”) on February 9, 2016. Between the date of initial application and adoption of the final resolutions by the Bank’s Board, the Indiana DFI and the Federal Deposit Insurance Corporation (the “FDIC”) conducted a joint exam of the Bank and its banking activities. Final regulatory approval of the application was obtained at the meeting of the Members of the Indiana DFI on April 14, 2016. The Bank filed official conversion documents effective April 15, 2016.

Along with economic benefits, the Board and management of the Bank feel the state charter is more consistent with the community banking philosophy embraced by the Bank. As a result of the conversion, the Indiana DFI became the Bank’s primary regulator and the FDIC became the Bank’s primary federal regulator. Upon conversion, the Bank’s official name changed from “First Merchants Bank, National Association” to “First Merchants Bank.” The Bank intends to continue operating under the following trade names in certain geographic markets: Lafayette Bank and Trust and First Merchants Private Wealth Advisors (each as a division of First Merchants Bank). The conversion is not expected to affect the Bank’s operations or customers in any way, and Bank customers will continue to receive identical protection on deposits through the FDIC’s deposit insurance program.

RESULTS OF OPERATIONS

Executive Summary

First Merchants Corporation reported net income available to common stockholders of $17.7 million for the three months ended March 31, 2016, an increase of $1.5 million, or 9.4 percent, compared to net income available to common stockholders of $16.2 million for the three months ended March 31, 2015. Diluted earnings per share for the three months ended March 31, 2016 and 2015 totaled $0.43 per share.

On April 17, 2015, the Corporation acquired C Financial and on December 31, 2015, the Corporation acquired Ameriana. Additionally, on June 12, 2015, the Corporation sold all of its stock in FMIG, resulting in a gain of $8.3 million. Details of these transactions are included in NOTE 2. ACQUISITIONS AND DIVESTITURES, included within the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.

As of March 31, 2016, total assets equaled $6.8 billion, an increase of $37.5 million, or 0.6 percent, from December 31, 2015.  The Corporation's loan portfolio increased $16.1 million, with the largest increase in real estate construction. Additional details of the changes in the Corporation's loans and other earning assets are discussed within NOTE 4. LOANS AND ALLOWANCE, included within the Notes to Consolidated Condensed Financial Statements, and the "EARNING ASSETS" section of Management's Discussion and Analysis of Financial Condition and Results of Operations of this Quarterly Report on Form 10-Q.

The Corporation’s allowance for loan losses totaled $62.1 million as of March 31, 2016.  The allowance provided 169 percent coverage of all non-accrual loans and 1.32 percent of total loans.  The Corporation's provision expense totaled $550,000 during the first quarter 2016, as net charge-offs totaled $917,000. During the same period of 2015, the Corporation had no provision expense and net charge offs during the period of $1.2 million.   Additional details are discussed within the “LOAN QUALITY/PROVISION FOR LOAN LOSSES” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Quarterly Report on Form 10-Q.

As of March 31, 2016, total deposits equaled $5.3 billion, an increase of $21.4 million from December 31, 2015. The largest increases were in savings deposits and brokered deposits, which accounted for $30.6 million and $16.0 million of the overall increase, respectively. This increase was offset by decreases in other certificates and time deposits and certificates and other time deposits of $100,000 or more of $20.4 million and $19.1 million, respectively, compared to December 31, 2015.


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PART I: FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


Total borrowings decreased $26.7 million as of March 31, 2016 compared to December 31, 2015 as Federal Funds purchased decreased $49.1 million, which was offset by an increase in Federal Home Loan Bank Advances of $27.9 million.

The Corporation was able to maintain all regulatory capital ratios in excess of the regulatory definition of “well-capitalized” as discussed in the “CAPITAL” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Quarterly Report on Form 10-Q.

NET INTEREST INCOME

Net interest income is the primary source of the Corporation’s earnings.  Net interest margin is a function of net interest income and the level of average earning assets.  Net interest income and net interest margin are presented in the following table on a fully taxable equivalent basis (“FTE”), which adjusts tax-exempt or nontaxable interest income to an amount that would be comparable to interest subject to income taxes using the federal statutory tax rate of 35 percent in effect for all periods.  

For the periods presented, the increases in net interest income and average earning assets were primarily driven by the acquisitions of C Financial in April 2015 and Ameriana in December 2015. As a result of the acquisitions, the Corporation recognized fair value accretion, which is included in interest income, of $2,509,000 and $2,169,000, respectively, for the three months ended March 31, 2016 and 2015. Net interest margin for the first quarter of 2016 increased to 3.83 percent compared to the first quarter of 2015 at 3.78 percent, and average earning assets increased by $815,336,000. Asset yields increased 4 basis points FTE and interest costs decreased 1 basis point, resulting in a 5 basis points FTE increase in net interest margin as compared to the same period in 2015.

Additional details of the Corporation's acquisitions, remaining loan fair value discount, accretable and nonaccretable yield can be found in NOTE 2. ACQUISITIONS AND DIVESTITURES and NOTE 5. ACCOUNTING FOR CERTAIN LOANS ACQUIRED IN A PURCHASE, included within the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.


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Table of Contents
PART I: FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


The following table presents the Corporation’s average balance sheet, interest income/interest expense, and the average rate as a percent of average earning assets for the three months ended March 31, 2016, and 2015.
(Dollars in Thousands)
Three Months Ended
 
March 31, 2016
 
March 31, 2015
 
Average Balance
 
Interest
 Income /
Expense
 
Average
Rate
 
Average Balance
 
Interest
 Income /
Expense
 
Average
Rate
Assets:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing time deposits
$
75,709

 
$
106

 
0.56
%
 
$
56,907

 
$
36

 
0.25
%
Federal Reserve and Federal Home Loan Bank stock
37,632

 
480

 
5.10

 
41,351

 
550

 
5.32

Investment Securities: (1)
 
 
 
 
 
 
 
 
 
 
 
Taxable
716,486

 
4,328

 
2.42

 
736,378

 
4,723

 
2.57

Tax-Exempt (2)
520,922

 
6,937

 
5.33

 
433,531

 
5,899

 
5.44

Total Investment Securities
1,237,408

 
11,265

 
3.64

 
1,169,909

 
10,622

 
3.63

Loans held for sale
6,247

 
122

 
7.81

 
4,927

 
110

 
8.93

Loans: (3)
 
 
 
 
 
 
 
 
 
 
 
Commercial
3,449,451

 
38,864

 
4.51

 
3,041,242

 
34,169

 
4.49

Real Estate Mortgage
575,266

 
6,394

 
4.45

 
459,794

 
4,849

 
4.22

Installment
456,654

 
5,109

 
4.48

 
394,063

 
4,424

 
4.49

Tax-Exempt (2)
181,950

 
2,023

 
4.45

 
36,788

 
382

 
4.15

Total Loans
4,669,568

 
52,512

 
4.50

 
3,936,814

 
43,934

 
4.46

Total Earning Assets
6,020,317

 
64,363

 
4.28

 
5,204,981

 
55,142

 
4.24

Net unrealized gain on securities available for sale
10,005

 
 
 
 
 
14,480

 
 
 
 
Allowance for loan losses
(63,213
)
 
 
 
 
 
(63,429
)
 
 
 
 
Cash and cash equivalents
101,913

 
 
 
 
 
98,791

 
 
 
 
Premises and equipment
96,698

 
 
 
 
 
77,707

 
 
 
 
Other assets
577,595

 
 
 
 
 
488,544

 
 
 
 
Total Assets
$
6,743,315

 
 
 
 
 
$
5,821,074

 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing deposits:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing NOW deposits
$
1,300,266

 
$
544

 
0.17
%
 
$
1,030,433

 
$
252

 
0.10
%
Money market deposits
865,932

 
491

 
0.23

 
823,761

 
412

 
0.20

Savings  deposits
689,305

 
135

 
0.08

 
571,751

 
159

 
0.11

Certificates and other time deposits
1,186,458

 
2,893

 
0.98

 
1,126,098

 
2,693

 
0.96

Total Interest-bearing Deposits
4,041,961

 
4,063

 
0.40

 
3,552,043

 
3,516

 
0.40

Borrowings
520,087

 
2,709

 
2.08

 
437,864

 
2,452

 
2.24

Total Interest-bearing Liabilities
4,562,048

 
6,772

 
0.59

 
3,989,907

 
5,968

 
0.60

Noninterest-bearing deposits
1,255,328

 
 
 
 
 
1,053,095

 
 
 
 
Other liabilities
64,287

 
 
 
 
 
43,561

 
 
 
 
Total Liabilities
5,881,663

 
 
 
 
 
5,086,563

 
 
 
 
Stockholders' Equity
861,652

 
 
 
 
 
734,511

 
 
 
 
Total Liabilities and Stockholders' Equity
$
6,743,315

 
6,772

 
0.45

 
$
5,821,074

 
5,968

 
0.46

Net Interest Income
 
 
$
57,591

 
 
 
 
 
$
49,174

 
 
Net Interest Margin
 
 
 
 
3.83
%
 
 
 
 
 
3.78
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1) Average balance of securities is computed based on the average of the historical amortized cost balances without the effects of the fair value adjustments. Annualized amounts are computed utilizing a 30/360 day basis.
(2)  Tax-exempt securities and loans are presented on a fully taxable equivalent basis, using a marginal tax rate of 35 percent for 2016 and 2015. These totals equal $3,136 and $2,198 for the three months ended March 31, 2016 and 2015, respectively.
(3) Non accruing loans have been included in the average balances.
 
 
 
 
 
 
 
 
 
 
 


 
 
 
 
 
 
 
 
 
 
 
 


42

Table of Contents
PART I: FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


NON-INTEREST INCOME

Non-interest income increased $89,000, or .5 percent, in the first quarter of 2016, compared to the first quarter of 2015.  In June 2015, the Corporation sold all of its stock in FMIG, resulting in no insurance commission income in the first quarter of 2016. This transaction accounted for a $2.3 million decline in commission income compared to the first quarter of 2015. In April 2015, the Corporation acquired C Financial and in December 2015, the Corporation acquired Ameriana. Each of the acquisitions contributed to a larger customer base, which resulted in an increase in other customer fees and service charge income of $1.4 million and $597,000, respectively, for the three months ended March 31, 2016 when compared to the same period in 2015. Additional details of the divestiture and acquisitions can be found in NOTE 2. ACQUISITIONS AND DIVESTITURES, included within the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.

Additionally, first quarter 2016 earnings on cash surrender value of life insurance increased by $729,000 from the same quarter of 2015. The increase was primarily due to a death benefit from Bank Owned Life Insurance of $471,000. Additionally, the Ameriana acquisition resulted in a $28.2 million Bank Owned Life Insurance portfolio that contributed to the increase in earnings.

NON-INTEREST EXPENSE

Non-interest expense increased $5.8 million, or 14.0 percent, in the first quarter of 2016, compared to the first quarter of 2015.  The sale of FMIG resulted in $1.5 million less in expense in the first quarter of 2016 than in the same period of 2015. However, investments in the Corporation's core business, primarily through bank acquisitions, drove the increase over prior year. The largest increase was in salaries and employee benefits which increased $2.8 million, or 11.4 percent primarily due to the addition of personnel from C Financial and Ameriana.

Additionally, the Corporation recognized $1.9 million of nonrecurring acquisition and integration expenses during the first quarter of 2016. This was approximately $1.4 million more than the $549,000 of nonrecurring acquisition and integration expenses recognized in the first quarter of 2015.
 
INCOME TAXES

Income tax expense for the three months ended March 31, 2016 was $5,574,000 on pre-tax net income of $23,267,000.  For the same period in 2015, income tax expense was $5,834,000 on pre-tax net income of $22,006,000. The effective income tax rate was 24.0 percent for the first quarter of 2016 and 26.5 percent for the first quarter of 2015. The lower effective tax rate during the three months ended March 31, 2016 when compared to the same period in 2015 was the result of increases in tax-exempt interest income and earnings on life insurance.

The detailed reconciliation of federal statutory to actual tax expense is shown in NOTE 13. INCOME TAX, included within the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.

CAPITAL

Capital adequacy is an important indicator of financial stability and performance.  The Corporation and the Bank 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 four ratios that are calculated according to the regulations: total risk-based capital, tier 1 risk-based capital, common equity 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. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of total and tier 1 capital to risk-weighted assets, and of tier 1 capital to average assets, or leverage ratio, all of which are calculated as defined in the regulations.  Banks with lower capital levels are deemed to be undercapitalized, significantly undercapitalized or critically undercapitalized, depending on their actual levels.  The appropriate federal regulatory agency may also downgrade a bank to the next lower capital category upon a determination that the bank is in an unsafe or unsound practice.  Banks are required to monitor closely their capital levels and to notify their appropriate regulatory agency of any basis for a change in capital category.

Basel III was effective for the Corporation on January 1, 2015. Basel III requires the Corporation and the Bank to maintain minimum amounts and ratio of common equity tier 1 capital to risk weighted assets, as defined in the regulation. Under the new Basel III rules, in order to avoid limitations on capital distributions, including dividends, the Corporation must hold a capital conservation buffer above the adequately capitalized common equity tier 1 capital to risk-weighted assets ratio. The capital conservation buffer is being phased in from zero percent to 2.50 percent by 2019. As of January 1, 2016, the Corporation is required to hold a capital conservation buffer of 0.625 percent, increasing by that amount each successive year until 2019. Under Basel III, the Corporation and Bank elected to opt-out of including accumulated other comprehensive income in regulatory capital.


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Table of Contents
PART I: FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


As of March 31, 2016, the Bank met all capital adequacy requirements to be considered well capitalized. There is no threshold for well capitalized status for bank holding companies. The Corporation's and Bank's actual and required capital ratios as of March 31, 2016 and December 31, 2015 were as follows:



Prompt Corrective Action Thresholds
 
Actual

Adequately Capitalized

Well Capitalized
March 31, 2016
Amount

Ratio

Amount

Ratio

Amount

Ratio
Total risk-based capital to risk-weighted assets











First Merchants Corporation
$
792,030


14.79
%

$
428,466


8.00
%

N/A


N/A

First Merchants Bank
748,246


13.86


431,849


8.00


$
539,812


10.00
%
Tier 1 capital to risk-weighted assets

















First Merchants Corporation
$
664,944


12.42
%

$
321,350


6.00
%

N/A


N/A

First Merchants Bank
686,160


12.71


323,887


6.00


$
431,849


8.00
%
Common equity tier 1 capital to risk-weighted assets

















First Merchants Corporation
$
611,707


11.42
%

$
241,012


4.50
%

N/A


N/A

First Merchants Bank
686,160


12.71


242,915


4.50


$
350,878


6.50
%
Tier 1 capital to average assets











First Merchants Corporation
$
664,944


10.25
%

$
259,518


4.00
%

N/A


N/A

First Merchants Bank
686,160


10.63


258,141


4.00


$
322,676


5.00
%
  




Prompt Corrective Action Thresholds
 
Actual

Adequately Capitalized

Well Capitalized
December 31, 2015
Amount

Ratio

Amount

Ratio

Amount

Ratio
Total risk-based capital to risk-weighted assets











First Merchants Corporation
$
783.776


14.94
%

$
419,809


8.00
%

N/A


N/A

First Merchants Bank
739.793


13.98


423,242


8.00


$
529,052


10.00
%
Tier 1 capital to risk weighted assets











First Merchants Corporation
$
656,323


12.51
%

$
314,857


6.00
%

N/A


N/A

First Merchants Bank
677,340


12.80


317,431


6.00


$
423,242


8.00
%
Common equity tier 1 capital to risk-weighted assets

















First Merchants Corporation
$
603,063


11.49
%

$
236,143


4.50
%

N/A


N/A

First Merchants Bank
677,340


12.80


238,074


4.50


343,884


6.50
%
Tier 1 capital to average assets

















First Merchants Corporation
$
656,323


10.85
%

$
242,001


4.00
%

N/A


N/A

First Merchants Bank
677,340


11.22


241,423


4.00


$
301,779


5.00
%


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.

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 tables are also meaningful when considering performance measures of the Corporation.

The Corporation had a strong capital position as evidenced by the tangible common equity to tangible assets ratio of 9.35 percent at March 31, 2016, and 9.17 percent at December 31, 2015.
 
Tangible Common Equity to Tangible Assets (non-GAAP)
(Dollars in Thousands, Except Per Share Amounts)
March 31, 2016
 
December 31, 2015
Total Stockholders' Equity (GAAP)
$
867,263

 
$
850,509

Less: Cumulative preferred stock (GAAP)
(125
)
 
(125
)
Less: Intangible assets, net of tax (GAAP)
(255,046
)
 
(253,486
)
Tangible common equity (non-GAAP)
$
612,092

 
$
596,898

Total assets (GAAP)
$
6,798,539

 
$
6,761,003

Less: Intangible assets, net of tax (GAAP)
(255,046
)
 
(253,486
)
Tangible assets (non-GAAP)
$
6,543,493

 
6,507,517

Tangible common equity to tangible assets (non-GAAP)
9.35
%
 
9.17
%



44

Table of Contents
PART I: FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


The following table details and reconciles tangible earnings per share, return on tangible capital and tangible assets to traditional GAAP measures for the three months ended March 31, 2016.
 
Three Months Ended March 31,
(Dollars in Thousands, Except Per Share Amounts)
2016
 
2015
Average goodwill (GAAP)
$
244,000

 
$
202,723

Average core deposit intangible (GAAP)
18,359

 
15,647

Average deferred tax on CDI (GAAP)
(6,896
)
 
(5,958
)
Intangible adjustment (non-GAAP)
$
255,463

 
$
212,412

Average stockholders' equity (GAAP)
$
861,652

 
$
734,511

Average cumulative preferred stock (GAAP)
(125
)
 
(125
)
Intangible adjustment (non-GAAP)
(255,463
)
 
(212,412
)
Average tangible capital (non-GAAP)
$
606,064

 
$
521,974

Average assets (GAAP)
$
6,743,315

 
$
5,821,074

Intangible adjustment (non-GAAP)
(255,463
)
 
(212,412
)
Average tangible assets (non-GAAP)
$
6,487,852

 
$
5,608,662

Net income available to common stockholders (GAAP)
$
17,693

 
$
16,172

CDI amortization, net of tax (GAAP)
635

 
418

Tangible net income available to common stockholders (non-GAAP)
$
18,328

 
$
16,590

Per Share Data:
 
 
 
Diluted net income available to common stockholders (GAAP)
$
0.43

 
$
0.43

Diluted tangible net income available to common stockholders (non-GAAP)
$
0.45

 
$
0.44

Ratios:
 
 
 
Return on average GAAP capital (ROE)
8.21
%
 
8.81
%
Return on average tangible capital
12.10
%
 
12.71
%
Return on average assets (ROA)
1.05
%
 
1.11
%
Return on average tangible assets
1.13
%
 
1.18
%


Return on average tangible capital is tangible net income available to common stockholders (annualized) expressed as a percentage of average tangible capital.  Return on average tangible assets is tangible net income available to common stockholders (annualized) expressed as a percentage of average tangible assets.

LOAN QUALITY/PROVISION FOR LOAN LOSSES

The Corporation’s primary lending focus is small business and middle market commercial, commercial real estate, residential real estate and small consumer lending, which results in portfolio diversification.  Commercial loans are individually underwritten and judgmentally risk rated.  They are periodically monitored and prompt corrective actions are taken on deteriorating loans.  Retail loans are typically underwritten with statistical decision-making tools and are managed throughout their life cycle on a portfolio basis.

Loan Quality

The quality and amount of non-performing loans may increase or decrease going forward as a result of acquisitions, organic portfolio growth, 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 internal factors specific to a particular borrower, such as the actions of a customer's management.

At March 31, 2016, non performing loans totaled $37,734,000, an increase of $4,422,000 from the December 31, 2015 balance of $33,312,000. Non-accrual loans increased $5,330,000 to $36,719,000, from the December 31, 2015 balance of $31,389,000. The Corporation’s coverage ratio of allowance for loan losses to non-accrual loans decreased from 199.0 percent at December 31, 2015 to 169.1 percent at March 31, 2016. See additional information regarding the allowance for loan losses in the “Provision for Loan Losses” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included as ITEM 2 of this Quarterly Report on Form 10-Q.

Other real estate owned, totaling $15,626,000 at March 31, 2016, declined $1,631,000 from the December 31, 2015 balance of $17,257,000.  For other real estate owned, current appraisals are obtained to determine fair value as management continues to aggressively market these real estate assets.

Accruing loans delinquent 90 or more days of $963,000 at March 31, 2016 increased $56,000 from the December 31, 2015 balance of $907,000. Residential real estate loans accounted for 72.0 percent of the total at March 31, 2016.

Commercial impaired loans include all non-accrual loans, loans accounted for under ASC 310 as well as substandard, doubtful and loss grade loans that were still accruing but deemed impaired according to guidance set forth in ASC 310.  Also included in impaired loans are accruing loans that are contractually past due 90 days or more and troubled debt restructurings.


45

Table of Contents
PART I: FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


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 substantially within the contractual terms of the note.  At March 31, 2016, commercial impaired loans totaled $93,949,000 a decrease of $3,578,000 from the December 31, 2015 balance of $97,527,000. At March 31, 2016, a specific allowance for losses was not deemed necessary for commercial impaired loans totaling $88,827,000 as there was no identified loss on these credits. A specific allowance of $1,373,000 was recorded for the remaining balance of these impaired loans totaling $5,122,000 and is included in the Corporation’s allowance for loan losses.

At March 31, 2016, non-performing assets, which includes non-accrual loans, renegotiated loans, and other real estate owned, plus loans 90-days delinquent, totaled $54,323,000; an increase of $2,847,000 from December 31, 2015 as noted in the table below.
(Dollars in Thousands)

March 31, 2016

December 31, 2015
Non-Performing Assets:

 


 

Non-accrual loans

$
36,719


$
31,389

Renegotiated loans

1,015


1,923

Non-performing loans (NPL)

37,734


33,312

Other real estate owned

15,626


17,257

Non-performing assets (NPA)

53,360


50,569

90+ days delinquent and still accruing

963


907

Non-performing assets plus 90+ days delinquent

$
54,323


$
51,476

Impaired Loans

$
93,949


$
97,527



The composition of non-performing assets plus loans 90-days or more delinquent is reflected in the following table for the periods indicated.
(Dollars in Thousands)
March 31, 2016

December 31, 2015
Non-Performing Assets and 90+ Days Delinquent:
 

 
Commercial and industrial loans
$
3,754


$
5,544

Agricultural production financing and other loans to farmers
1,866


827

Real estate loans:
 

 
Construction
9,849


9,345

Commercial and farmland
21,550


18,243

Residential
14,341


14,528

Home Equity
2,625


2,665

Individuals' loans for household and other personal expenditures
338


324

Non-performing assets plus 90+ days delinquent
$
54,323


$
51,476



Although the Corporation believes its underwriting and loan review procedures are appropriate for the various kinds of loans it makes, its results of operations and financial condition could be adversely affected in the event the quality of its loan portfolio declines.  Deterioration in the economic environment including residential and commercial real estate values may result in increased levels of loan delinquencies and credit losses.

Provision for Loan Losses

The allowance for loan losses is maintained through the provision for loan losses, which is a charge against earnings. The amount actually provided for loan losses in any period may be greater than or less than net loan losses, based on management’s judgment as to the appropriate level of the allowance for loan losses. 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 ongoing 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.

In conformance with ASC 805 and ASC 820, loans purchased after December 31, 2008, are recorded at the acquisition date fair value. Such loans are only included in the allowance when deemed impaired in accordance with ASC 310-30.

At March 31, 2016, the allowance for loan losses was $62,086,000, a decrease of $367,000 from December 31, 2015. As a percent of loans, the allowance was 1.32 percent at March 31, 2016, compared to 1.33 percent at December 31, 2015. The provision for loan losses for the three months ended March 31, 2016 was $550,000. Comparatively, the provision for loan losses for the three months ended March 31, 2015 was zero. Specific reserves on impaired loans decreased $469,000 from $1,842,000 at December 31, 2015, to $1,373,000 at March 31, 2016.


46

Table of Contents
PART I: FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


Net charge offs for the three months ended March 31, 2016, were $917,000. Comparatively, the same period in 2015 had net charge offs of $1,163,000.  For the three months ended March 31, 2016, there were two charge offs greater than $500,000 totaling $1,489,000 and one recovery for $604,000. The distribution of the net charge offs or recoveries for the three months ended March 31, 2016 and 2015 are reflected in the following table:

Three Months Ended March 31,
(Dollars in Thousands)
2016

2015
Net Charge Offs (Recoveries):
 

 
Commercial and industrial loans
$
331


$
(76
)
Agricultural production financing and other loans to farmers
23


731

Real estate loans:
 

 
Construction
(3
)

4

Commercial and farmland
45


44

Residential
387


214

Home Equity
60


203

Individuals' loans for household and other personal expenditures
75


47

Other commercial loans
(1
)

(4
)
Total Net Charge Offs
$
917


$
1,163


 
Management continually evaluates the commercial loan portfolio by including consideration of specific borrower cash flow analysis and estimated collateral values, types and amounts on non-performing loans, past and anticipated loan loss experience, changes in the composition of the loan portfolio, and the current condition and amount of loans outstanding. The determination of the provision for loan losses 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.

LIQUIDITY

Liquidity management is the process by which the Corporation ensures that adequate liquid funds are available for the holding company and its subsidiaries. These funds are necessary in order to meet financial commitments on a timely basis. These commitments include withdrawals by depositors, funding credit obligations to borrowers, paying dividends to stockholders, paying operating expenses, funding capital expenditures, and maintaining deposit reserve requirements. Liquidity is monitored and closely managed by the asset/liability committee.
 
The Corporation’s liquidity is dependent upon the receipt of dividends from the Bank, which is subject to certain regulatory limitations and access to other funding sources.  Liquidity of the Bank 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 principal source of asset-funded liquidity is investment securities classified as available for sale, the market values of which totaled $636,785,000 at March 31, 2016, a decrease of $21,615,000, or 3.3 percent, from December 31, 2015.  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 $2,533,000 at March 31, 2016. In addition, other types of assets such as cash and interest-bearing deposits with other banks, federal funds sold and loans maturing within one year are sources of liquidity.

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.  Federal funds purchased and securities sold under agreements to repurchase are also considered a source of liquidity. In addition, Federal Home Loan Bank (“FHLB”) advances are utilized as funding sources.  At March 31, 2016, total borrowings from the FHLB were $263,588,000. The Bank has pledged certain mortgage loans and investments to the FHLB. The total available remaining borrowing capacity from the FHLB at March 31, 2016 was $395,795,000.

On April 11, 2014, the Corporation entered into a line of credit agreement with U.S. Bank, N.A. with a maximum borrowing capacity of $20 million. As of March 31, 2016, there was no outstanding balance on the line of credit. The line of credit matured on April 8, 2016 and the agreement was not renewed. Interest was payable quarterly based on one-month LIBOR plus 2.00 percent. The line of credit had a quarterly facility fee of 0.25 percent on the unused balance. The line of credit agreement contained certain customary representations and warranties and financial and negative covenants. As of March 31, 2016, the Corporation was in compliance with these covenants.

In the normal course of business, the Bank 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 our consolidated financial statements.  Such activities include traditional off-balance sheet credit-related financial instruments, commitments under operating leases and long-term debt.


47

Table of Contents
PART I: FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


The Bank provides customers with off-balance sheet credit support through loan commitments and standby and commercial letters of credit. Summarized credit-related financial instruments at March 31, 2016 are as follows:
(Dollars in Thousands)
March 31, 2016
Amounts of commitments:
 
Loan commitments to extend credit
$
1,928,850

Standby and commercial letters of credit
46,707

 
$
1,975,557

 
 
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 ongoing activities.  The required payments under such commitments and borrowings at March 31, 2016, are as follows:
(Dollars in Thousands)
Remaining
2016
 
2017
 
2018
 
2019
 
2020
 
2021
 
2022 and
after
 
ASC 805 fair value adjustments at acquisition
 
Total
Operating leases
$
2,436

 
$
2,588

 
$
1,602

 
$
1,406

 
$
1,244

 
$
922

 
$
5,787

 
 
 
$
15,985

Federal funds purchased
602

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
602

Securities sold under repurchase agreements
150,134

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
150,134

Federal Home Loan Bank advances
119,413

 
37,186

 
26,851

 
13,828

 
31,310

 


 
35,000

 
 
 
263,588

Subordinated debentures and term loans
275

 
 
 
 
 
 
 
 
 
 
 
132,012

 
(4,764
)
 
127,523

Total
$
272,860

 
$
39,774

 
$
28,453

 
$
15,234

 
$
32,554

 
$
922

 
$
172,799

 
$
(4,764
)
 
$
557,832



INTEREST SENSITIVITY AND DISCLOSURE 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.

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 certain 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.


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Table of Contents
PART I: FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


The comparative rising 200 basis points and falling 100 basis points scenarios below, as of March 31, 2016, 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:
 

March 31, 2016
 

RISING

FALLING
Driver Rates

(200 Basis Points)

(100 Basis Points)
Prime

200

(25
)
Federal funds

200

(25
)
One-year CMT

200

(53
)
Three-year CMT

200

(63
)
Five-year CMT

200

(70
)
CD's

200

(21
)
FHLB advances

200

(51
)
 

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 March 31, 2016. 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.
 

March 31, 2016
 

 

RISING

FALLING
(Dollars in Thousands)

Base

(200 Basis Points)

(100 Basis Points)
Net interest income

$
209,175


$
228,030


$
200,686

Variance from base

 

$
18,855


$
(8,489
)
Percent of change from base

 

9.0
%

(4.1
)%
 
 
The comparative rising 200 basis points and falling 100 basis points scenarios below, as of December 31, 2015, 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:
 

December 31, 2015
 

RISING

FALLING
Driver Rates

(200 Basis Points)

(100 Basis Points)
Prime

200

(25
)
Federal funds

200

(25
)
One-year CMT

200

(56
)
Three-year CMT

200

(100
)
Five-year CMT

200

(100
)
CD's

200

(21
)
FHLB advances

200

(83
)


Results for the base, rising 200 basis points, and falling 100 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.
 

December 31, 2015
 

 

RISING

FALLING
(Dollars in Thousands)

Base

(200 Basis Points)

(100 Basis Points)
Net interest income

$
198,711


$
213,758


$
188,921

Variance from base

 

$
15,047


$
(9,790
)
Percent of change from base

 

7.6
%

(4.9
)%



49

Table of Contents
PART I: FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


EARNING ASSETS

The following table presents the earning asset mix as of March 31, 2016, and December 31, 2015. Earning assets increased by $48,655,000 during the three months ended March 31, 2016.  Interest-bearing time deposits increased $45,138,000, while investment securities decreased by approximately $6,222,000. Loans and loans held for sale increased by $9,819,000. The three loan classes experiencing the largest increase from December 31, 2015, were real estate construction, real estate home equity and commercial and industrial loans. These increases were primarily offset by decreases in real estate residential and agricultural production financing.
(Dollars in Thousands)

March 31, 2016

December 31, 2015
Interest-bearing time deposits

$
77,453


$
32,315

Investment securities available for sale

636,785


658,400

Investment securities held to maturity

633,992


618,599

Mortgage loans held for sale

3,628


9,894

Loans

4,709,907


4,693,822

Federal Reserve and Federal Home Loan Bank stock

37,553


37,633

Total

$
6,099,318


$
6,050,663


 
OTHER

The Securities and Exchange Commission maintains a web site 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).


50

Table of Contents
PART I: FINANCIAL INFORMATION
ITEM 3. QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK


ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information required under this item is included as part of Management’s Discussion and Analysis of Financial Condition and Results of Operations, under the headings “LIQUIDITY” and “INTEREST SENSITIVITY AND DISCLOSURE ABOUT MARKET RISK”.

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Table of Contents
PART I: FINANCIAL INFORMATION
ITEM 4. CONTROLS AND PROCEDURES


ITEM 4.  CONTROLS AND PROCEDURES

At the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our 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 our reports filed or submitted under the Securities Exchange Act of 1934 are recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

There have been no changes in the Corporation’s internal control over financial reporting identified in connection with the evaluation discussed 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.


52

Table of Contents
PART II: OTHER INFORMATION
ITEM 1., ITEM 1A., ITEM 2., ITEM 3., ITEM 4. AND ITEM 5.
(table dollar amounts in thousands, except share data)


ITEM 1.  LEGAL PROCEEDINGS

There are no pending legal proceedings, other than litigation incidental to the ordinary 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 are no material legal proceedings 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 1A.  RISK FACTORS

There have been no material changes to the risk factors previously disclosed in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2015,

ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

a. None

b. None

c. Issuer Purchases of Equity Securities

The following table presents information relating to our purchases of equity securities during the three months ended March 31, 2016.
Period

Total Number
of Shares
Purchased

Average
Price Paid
per Share

Total Number of Shares
Purchased as part of Publicly announced Plans or Programs

Maximum Number of Shares
that may yet be Purchased
Under the Plans or Programs
January, 2016









February, 2016

747


$23.64




March, 2016

35,819


$22.16






The shares were purchased in connection with the exercise of certain outstanding stock options or restricted stock.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4.  MINE SAFETY DISCLOSURES

Not Applicable 

ITEM 5.  OTHER INFORMATION

a. None

b. None


53

Table of Contents

PART II: OTHER INFORMATION
ITEM 6. EXHIBITS


ITEM 6.  EXHIBITS
 
Exhibit No:
Description of Exhibits:
 
 
3.1
First Merchants Corporation Articles of Incorporation, as amended (Incorporated by reference to registrant’s Form 10-Q filed on November 9, 2011) (SEC No. 000-17071)
3.2
Bylaws of First Merchants Corporation dated October 28, 2009 (Incorporated by reference to registrant’s Form 10-Q filed on November 9, 2009) (SEC No. 000-17071)
3.3
First Merchants Corporation Articles of Amendment of the Articles of Incorporation for the Series B Preferred Stock (Incorporated by reference to registrant's Form 8-K filed on September 23, 2011) (SEC No. 000-17071)
4.1
First Merchants Corporation Amended and Restated Declaration of Trust of First Merchants Capital Trust II dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.2
Indenture dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.3
Guarantee Agreement dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.4
Form of Capital Securities Certification of First Merchants Capital Trust II (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.5
First Merchants Corporation Dividend Reinvestment and Stock Purchase Plan (Incorporated by reference to registrant’s Post-Effective Amendment No. 1 to Form S-3 filed on August 21, 2009) (SEC No. 033-45393)
4.6
Upon request, the registrant agrees to furnish supplementally to the Commission a copy of the instruments defining the rights of holders of its (a) 5.00% Fixed-to-Floating Rate Senior Notes due 2028 in the aggregate principal amount of $5 million and (b) 6.75% Fixed-to-Floating Rate Subordinated Notes due 2028 in aggregate principal amount of $65 million.
10.1
First Merchants Corporation Senior Management Incentive Compensation Program, dated March 7, 2016 (1)
31.1
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 (1)
31.2
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 (1)
32
Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (1)
101.INS
XBRL Instance Document (2)
101.SCH
XBRL Taxonomy Extension Schema Document (2)
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document (2)
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document (2)
101.LAB
XBRL Taxonomy Extension Label Linkbase Document (2)
101.PRE
XBRL Taxonomy Extension Presentation Linkebase Document (2)
 
 
 
 
 
(1) Filed herewith.
 
(2) Furnished herewith.



54

Table of Contents

PART II: OTHER INFORMATION
ITEM 6. EXHIBITS


SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
First Merchants Corporation
 
(Registrant)
 
 
 
 
Date: May 9, 2016
by /s/ Michael C. Rechin
 
Michael C. Rechin
 
President and Chief Executive Officer
 
(Principal Executive Officer)
 
 
Date: May 9, 2016
by /s/ Mark K. Hardwick
 
Mark K. Hardwick
 
Executive Vice President,
 
Chief Financial Officer and Chief Operating Officer
 
(Principal Financial and Accounting Officer)


55

Table of Contents

PART II: OTHER INFORMATION
ITEM 6. EXHIBITS


INDEX TO EXHIBITS
 
Exhibit No:
Description of Exhibits:
 
 
3.1
First Merchants Corporation Articles of Incorporation, as amended (Incorporated by reference to registrant’s Form 10-Q filed on November 9, 2011) (SEC No. 000-17071)
3.2
Bylaws of First Merchants Corporation dated October 28, 2009 (Incorporated by reference to registrant’s Form 10-Q filed on November 9, 2009) (SEC No. 000-17071)
3.3
First Merchants Corporation Articles of Amendment of the Articles of Incorporation for the Series B Preferred Stock (Incorporated by reference to registrant's Form 8-K filed on September 23, 2011) (SEC No. 000-17071)
4.1
First Merchants Corporation Amended and Restated Declaration of Trust of First Merchants Capital Trust II dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.2
Indenture dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.3
Guarantee Agreement dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.4
Form of Capital Securities Certification of First Merchants Capital Trust II (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.5
First Merchants Corporation Dividend Reinvestment and Stock Purchase Plan (Incorporated by reference to registrant’s Post-Effective Amendment No. 1 to Form S-3 filed on August 21, 2009) (SEC No. 033-45393)
4.6
Upon request, the registrant agrees to furnish supplementally to the Commission a copy of the instruments defining the rights of holders of its (a) 5.00% Fixed-to-Floating Rate Senior Notes due 2028 in the aggregate principal amount of $5 million and (b) 6.75% Fixed-to-Floating Rate Subordinated Notes due 2028 in aggregate principal amount of $65 million.
10.1
First Merchants Corporation Senior Management Incentive Compensation Program, dated March 7, 2016 (1)
31.1
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 (1)
31.2
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 (1)
32
Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (1)
101.INS
XBRL Instance Document (2)
101.SCH
XBRL Taxonomy Extension Schema Document (2)
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document (2)
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document (2)
101.LAB
XBRL Taxonomy Extension Label Linkbase Document (2)
101.PRE
XBRL Taxonomy Extension Presentation Linkebase Document (2)
 
 
 
 
 
(1) Filed herewith.
 
(2) Furnished herewith.


56