1ST SOURCE CORP — Interim / Quarterly Report 2009

Oct 22, 2009

10-Q 1 form10_q.htm 1ST SOURCE CORP FORM 10Q 9/30/09 form10_q.htm Licensed to: 1st Source Document Created using EDGARizer 5.1.4.0 Copyright 1995 - 2009 Thomson Reuters. All rights reserved.

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009

OR

o 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 0-6233

(Exact name of registrant as specified in its charter)

INDIANA	35-1068133
(State
or other jurisdiction of incorporation or organization)	(I.R.S.
Employer Identification No.)

| 100 North Michigan Street |
| --- |
| (Address
of principal executive offices) (Zip
Code) |

(574) 235-2000

(Registrant’s telephone number, including area code)

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. x Yes o 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). o Yes o 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 o Accelerated filer x

Non-accelerated filer ( Do not check if a smaller reporting company) o Smaller reporting company o

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

Number of shares of common stock outstanding as of October 16, 2009 – 24,141,456 shares

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TABLE OF CONTENTS

| PART
I. FINANCIAL INFORMATION | | |
| --- | --- | --- |
| | | Page |
| Item
1. | Financial
Statements (Unaudited) | |
| | Consolidated statements of financial condition – September 30,
2009, and December 31, 2008 | 3 |
| | Consolidated statements of income -- three months and nine months
ended September 30, 2009 and 2008 | 4 |
| | Consolidated statements of changes in shareholders’ equity --
nine months ended September 30, 2009 and 2008 | 5 |
| | Consolidated statements of cash flows -- nine months ended
September 30, 2009 and 2008 | 6 |
| | Notes to the Consolidated Financial
Statements | 7 |
| Item
2. | Management’s Discussion and Analysis of Financial Condition and
Results of Operations | 21 |
| Item
3. | Quantitative and Qualitative Disclosures About Market
Risk | 30 |
| Item
4. | Controls and Procedures | 31 |
| PART
II. OTHER INFORMATION | | |
| Item
1. | Legal Proceedings | 31 |
| Item
1A. | Risk Factors | 31 |
| Item
2. | Unregistered Sales of Equity Securities and Use of
Proceeds | 31 |
| Item
3. | Defaults Upon Senior Securities | 31 |
| Item
4. | Submission of Matters to a Vote of Security
Holders | 32 |
| Item
5. | Other Information | 32 |
| Item
6. | Exhibits | 32 |
| SIGNATURES | | 33 |
| CERTIFICATIONS | | |
| Exhibit 31.1 | | |
| Exhibit 31.2 | | |
| Exhibit 32.1 | | |
| Exhibit 32.2 | | |

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table of contents

| 1st
SOURCE CORPORATION | | | | |
| --- | --- | --- | --- | --- |
| CONSOLIDATED
STATEMENTS OF FINANCIAL CONDITION | | | | |
| (Unaudited
- Dollars in thousands, except share amounts) | | | | |
| | September
30, | December
31, | | |
| | 2009 | 2008 | | |
| ASSETS | | | | |
| Cash
and due from banks | $ 56,408 | $ | 119,771 | |
| Federal
funds sold and | | | | |
| interest
bearing deposits with other banks | 65,307 | | 6,951 | |
| Investment
securities available-for-sale | | | | |
| (amortized
cost of $871,266 and $715,380 | | | | |
| at
September 30, 2009 and December 31, 2008, respectively) | 886,777 | | 724,754 | |
| Other
investments | 21,012 | | 18,612 | |
| Trading
account securities | 117 | | 100 | |
| Mortgages
held for sale | 39,364 | | 46,686 | |
| Loans
and leases - net of unearned discount | | | | |
| Commercial
and agricultural loans | 567,476 | | 643,440 | |
| Auto,
light truck and environmental equipment | 313,808 | | 353,838 | |
| Medium
and heavy duty truck | 219,762 | | 243,375 | |
| Aircraft
financing | 633,552 | | 632,121 | |
| Construction
equipment financing | 326,858 | | 375,983 | |
| Loans
secured by real estate | 917,754 | | 918,749 | |
| Consumer
loans | 114,820 | | 130,706 | |
| Total
loans and leases | 3,094,030 | | 3,298,212 | |
| Reserve
for loan and lease losses | (85,504 | ) | (79,776 | ) |
| Net
loans and leases | 3,008,526 | | 3,218,436 | |
| Equipment
owned under operating leases, net | 91,538 | | 83,062 | |
| Net
premises and equipment | 38,552 | | 40,491 | |
| Goodwill
and intangible assets | 90,669 | | 91,691 | |
| Accrued
income and other assets | 114,890 | | 113,620 | |
| Total
assets | $ 4,413,160 | $ | 4,464,174 | |
| LIABILITIES | | | | |
| Deposits: | | | | |
| Noninterest
bearing | $ 425,742 | $ | 416,960 | |
| Interest
bearing | 3,060,972 | | 3,097,582 | |
| Total
deposits | 3,486,714 | | 3,514,542 | |
| Federal
funds purchased and securities | | | | |
| sold
under agreements to repurchase | 129,707 | | 272,529 | |
| Other
short-term borrowings | 25,272 | | 23,646 | |
| Long-term
debt and mandatorily redeemable securities | 20,046 | | 29,832 | |
| Subordinated
notes | 89,692 | | 89,692 | |
| Accrued
expenses and other liabilities | 87,399 | | 80,269 | |
| Total
liabilities | 3,838,830 | | 4,010,510 | |
| SHAREHOLDERS'
EQUITY | | | | |
| Preferred
stock; no par value | | | | |
| Authorized
10,000,000 shares; issued 111,000 at September 30, 2009 | | | | |
| and
none at December 31, 2008 | 104,612 | | - | |
| Common
stock; no par value | | | | |
| Authorized
40,000,000 shares; issued 25,894,879 at September 30, 2009 | | | | |
| and
25,895,505 at December 31, 2008, less unearned shares | | | | |
| (251,373
at September 30, 2009 and 251,999 at December 31, 2008) | 350,266 | | 342,982 | |
| Retained
earnings | 141,758 | | 136,877 | |
| Cost
of common stock in treasury (1,502,050 shares at September 30, 2009,
and | | | | |
| 1,532,576
shares at December 31, 2008) | (31,943 | ) | (32,019 | ) |
| Accumulated
other comprehensive income | 9,637 | | 5,824 | |
| Total
shareholders' equity | 574,330 | | 453,664 | |
| Total
liabilities and shareholders' equity | $ 4,413,160 | $ | 4,464,174 | |
| The
accompanying notes are a part of the consolidated financial
statements. | | | | |

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table of contents

| 1st
SOURCE CORPORATION | | | | | | | | |
| --- | --- | --- | --- | --- | --- | --- | --- | --- |
| CONSOLIDATED STATEMENTS OF
INCOME | | | | | | | | |
| (Unaudited
- Dollars in thousands, except per share amounts) | | | | | | | | |
| | Three
Months Ended | | | Nine
Months Ended | | | | |
| | September
30, | | | September
30, | | | | |
| | 2009 | 2008 | | 2009 | | 2008 | | |
| Interest
income: | | | | | | | | |
| Loans
and leases | $ 43,436 | $ | 50,979 | $ | 132,507 | $ | 154,590 | |
| Investment
securities, taxable | 4,357 | | 4,896 | | 12,600 | | 17,288 | |
| Investment
securities, tax-exempt | 1,651 | | 1,873 | | 5,046 | | 5,904 | |
| Other | 297 | | 317 | | 894 | | 986 | |
| Total
interest income | 49,741 | | 58,065 | | 151,047 | | 178,768 | |
| Interest
expense: | | | | | | | | |
| Deposits | 15,460 | | 20,347 | | 49,662 | | 67,116 | |
| Short-term
borrowings | 265 | | 2,255 | | 909 | | 6,434 | |
| Subordinated
notes | 1,648 | | 1,648 | | 4,942 | | 5,067 | |
| Long-term
debt and mandatorily redeemable securities | 322 | | 418 | | 853 | | 1,333 | |
| Total
interest expense | 17,695 | | 24,668 | | 56,366 | | 79,950 | |
| Net
interest income | 32,046 | | 33,397 | | 94,681 | | 98,818 | |
| Provision
for loan and lease losses | 6,469 | | 3,571 | | 22,741 | | 9,603 | |
| Net
interest income after provision for | | | | | | | | |
| loan
and lease losses | 25,577 | | 29,826 | | 71,940 | | 89,215 | |
| Noninterest
income: | | | | | | | | |
| Trust
fees | 3,782 | | 4,939 | | 11,473 | | 14,155 | |
| Service
charges on deposit accounts | 5,402 | | 5,761 | | 15,367 | | 16,633 | |
| Mortgage
banking income | 965 | | 959 | | 6,874 | | 3,493 | |
| Insurance
commissions | 1,022 | | 1,084 | | 3,614 | | 4,122 | |
| Equipment
rental income | 6,347 | | 6,285 | | 18,896 | | 17,794 | |
| Other
income | 2,022 | | 2,168 | | 6,613 | | 6,836 | |
| Investment
securities and other investment gains (losses) | 716 | | (8,816 | ) | 673 | | (9,259 | ) |
| Total
noninterest income | 20,256 | | 12,380 | | 63,510 | | 53,774 | |
| Noninterest
expense: | | | | | | | | |
| Salaries
and employee benefits | 18,425 | | 19,297 | | 55,340 | | 58,996 | |
| Net
occupancy expense | 2,221 | | 2,332 | | 7,095 | | 7,289 | |
| Furniture
and equipment expense | 3,241 | | 3,694 | | 10,487 | | 11,555 | |
| Depreciation
- leased equipment | 5,021 | | 5,041 | | 15,065 | | 14,266 | |
| Professional
fees | 1,020 | | 2,773 | | 2,897 | | 6,453 | |
| Supplies
and communication | 1,473 | | 1,812 | | 4,468 | | 5,163 | |
| FDIC
and other insurance | 1,582 | | 713 | | 6,851 | | 1,396 | |
| Other
expense | 3,587 | | 2,655 | | 10,356 | | 9,495 | |
| Total
noninterest expense | 36,570 | | 38,317 | | 112,559 | | 114,613 | |
| Income
before income taxes | 9,263 | | 3,889 | | 22,891 | | 28,376 | |
| Income
tax expense (benefit) | 2,530 | | (583 | ) | 3,624 | | 7,305 | |
| Net
income | 6,733 | | 4,472 | | 19,267 | | 21,071 | |
| Preferred
stock dividends and discount accretion | (1,701 | ) | - | | (4,710 | ) | - | |
| Net
income available to common shareholders | $ 5,032 | $ | 4,472 | $ | 14,557 | $ | 21,071 | |
| Per
common share | | | | | | | | |
| Basic
net income per common share | $ 0.21 | $ | 0.19 | $ | 0.60 | $ | 0.87 | |
| Diluted
net income per common share | $ 0.21 | $ | 0.18 | $ | 0.60 | $ | 0.86 | |
| Dividends | $ 0.15 | $ | 0.14 | $ | 0.43 | $ | 0.42 | |
| Basic
weighted average common shares outstanding | 24,164,884 | | 24,109,960 | | 24,166,887 | | 24,104,015 | |
| Diluted
weighted average common shares outstanding | 24,212,042 | | 24,381,657 | | 24,215,542 | | 24,374,811 | |
| The
accompanying notes are a part of the consolidated financial
statements. | | | | | | | | |

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table of contents

1st SOURCE CORPORATION
STATEMENT OF CHANGES IN SHAREHOLDERS'
EQUITY
(Unaudited
- Dollars in thousands, except per share amounts)
									Net
									Unrealized
									Appreciation
						Cost
of			(Depreciation)
						Common			of
Securities
		Preferred		Common	Retained	Stock			Available-
	Total	Stock		Stock	Earnings	in
Treasury			For-Sale
Balance
at January 1, 2008	$ 430,504	$	-	$ 342,840	$ 117,373	$	(32,231	)	$ 2,522
Comprehensive
Income, net of tax:
Net
Income	21,071		-	-	21,071		-		-
Change
in unrealized appreciation
of
available-for-sale securities, net of tax	(900	)	-	-	-		-		(900	)
Total
Comprehensive Income	20,171		-	-	-		-		-
Issuance
of 18,820 common shares
under
stock based compensation awards,
including
related tax effects	342		-	-	130		212		-
Stock-based
compensation	139		-	139
Common
stock dividend ($0.42 per share)	(10,146	)	-	-	(10,146	)	-		-
Balance
at September 30, 2008	$ 441,010	$	-	$ 342,979	$ 128,428	$	(32,019	)	$ 1,622
Balance
at January 1, 2009	$ 453,664	$	-	$ 342,982	$ 136,877	$	(32,019	)	$ 5,824
Comprehensive
Income, net of tax:
Net
Income	19,267		-	-	19,267		-		-
Change
in unrealized appreciation
of
available-for-sale securities, net of tax	3,813		-	-	-		-		3,813
Total
Comprehensive Income	23,080		-	-	-		-		-
Issuance
of 83,402 common shares
under
stock based compensation awards,
including
related tax effects	1,663		-	-	725		938		-
Cost
of 52,876 shares of common
stock
acquired for treasury	(862	)	-	-	-		(862	)	-
Issuance
of preferred stock	103,725		103,725	-			-		-
Preferred
stock discount accretion	-		887	-	(887	)	-		-
Issuance
of warrants to purchase common stock	7,275		-	7,275	-		-		-
Preferred
stock dividend paid and/or accrued	(3,823	)	-	-	(3,823	)	-		-
Common
stock dividend ($0.43 per share)	(10,401	)	-	-	(10,401	)	-		-
Stock
based compensation	9		-	9	-		-		-
Balance
at September 30, 2009	$ 574,330	$	104,612	$ 350,266	$ 141,758	$	(31,943	)	$ 9,637
The
accompanying notes are a part of the consolidated financial
statements.

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table of contents

1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF CASH
FLOWS
(Unaudited
- Dollars in thousands)
	Nine
Months Ended September 30,
	2009	2008
Operating
activities:
Net
income	$ 19,267	$	21,071
Adjustments
to reconcile net income to net cash
provided
(used) by operating activities:
Provision
for loan and lease losses	22,741		9,603
Depreciation
of premises and equipment	3,515		4,088
Depreciation
of equipment owned and leased to others	15,065		14,266
Amortization
of investment security premiums
and
accretion of discounts, net	4,477		1,328
Amortization
of mortgage servicing rights	2,517		2,234
Mortgage
servicing asset impairment (recovery) charges	(1,793	)	56
Deferred
income taxes	3,460		(11,558	)
Realized
investment securities (gains) losses	(673	)	9,259
Originations/purchases
of loans held for sale, net of principal collected	(512,286	)	(300,404	)
Proceeds
from the sales of loans held for sale	522,780		288,878
Net
gain on sale of loans held for sale	(3,170	)	(1,253	)
Change
in trading account securities	(17	)	-
Change
in interest receivable	1,352		438
Change
in interest payable	2,173		(5,853	)
Change
in other assets	(8,109	)	1,984
Change
in other liabilities	4,249		2,539
Other	754		2,988
Net
change in operating activities	76,302		39,664
Investing
activities:
Proceeds
from sales of investment securities	147,658		8,237
Proceeds
from maturities of investment securities	323,295		390,303
Purchases
of investment securities	(630,642	)	(289,498	)
Net
change in short-term investments	(60,757	)	(36,948	)
Loans
sold or participated to others	13,482		-
Net
change in loans and leases	173,687		(124,021	)
Net
change in equipment owned under operating leases	(23,541	)	(19,712	)
Purchases
of premises and equipment	(1,772	)	(2,403	)
Net
change in investing activities	(58,590	)	(74,042	)
Financing
activities:
Net
change in demand deposits, NOW
accounts
and savings accounts	74,639		(96,857	)
Net
change in certificates of deposit	(102,468	)	(22,394	)
Net
change in short-term borrowings	(141,197	)	96,832
Proceeds
from issuance of long-term debt	240		10,024
Payments
on subordinated notes	-		(10,310	)
Payments
on long-term debt	(10,392	)	(10,371	)
Net
proceeds from issuance of treasury stock	1,663		341
Acquisition
of treasury stock	(862	)	-
Proceeds
from issuance of preferred stock & common stock
warrants	111,000		-
Cash
dividends	(13,698	)	(10,320	)
Net
change in financing activities	(81,075	)	(43,055	)
Net
change in cash and cash equivalents	(63,363	)	(77,433	)
Cash
and cash equivalents, beginning of year	119,771		153,137
Cash
and cash equivalents, end of period	$ 56,408	$	75,704
The
accompanying notes are a part of the consolidated financial
statements.

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table of contents

1ST SOURCE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Basis of Presentation

The accompanying unaudited consolidated financial statements reflect all adjustments (all of which are normal and recurring in nature) which are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, the results of operations, changes in shareholders’ equity, and cash flows for the periods presented. These unaudited consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and footnote disclosures normally included in financial statements prepared in accordance with U. S. generally accepted accounting principles (GAAP) have been omitted. The Notes to the Consolidated Financial Statements appearing in 1st Source Corporation’s Annual Report on Form 10-K (2008 Annual Report), which include descriptions of significant accounting policies, should be read in conjunction with these interim financial statements. The balance sheet at December 31, 2008 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by U. S. generally accepted accounting principles for complete financial statements. Certain amounts in the prior period consolidated financial statements have been reclassified to conform with the current year presentation.

Note 2. Other Activity

On January 23, 2009, we entered into a Letter Agreement with the United States Department of the Treasury (“Treasury”), pursuant to which we issued and sold (i) 111,000 shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 837,947 shares of our common stock, without par value (the “Common Stock”), for an aggregate purchase price of $111,000,000 in cash.

The Series A Preferred Stock qualifies as Tier 1 capital and pays cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The Series A Preferred Stock is non-voting except with respect to certain matters affecting the rights of the holders thereof, and may be redeemed by us after notice to the Treasury and our primary federal regulator, the Board of Governors of the Federal Reserve System (“Federal Reserve Bank”) and subject to consultation between the Treasury and Federal Reserve Bank. At the time of redemption, if we do not choose to exercise our option to repurchase the warrants, the Secretary of Treasury intends to sell the warrants through an auction process.

The Warrant has a 10-year term and is immediately exercisable upon its issuance, with an exercise price, subject to anti-dilution adjustments, equal to $19.87 per share of the Common Stock.

In addition, we may not increase the quarterly dividend we pay on our common stock above $0.16 per share during the three-year period ending January 23, 2012, without consent of the Treasury, unless the Treasury no longer holds shares of the Series A Preferred Stock.

On December 12, 2008, 1st Source Corporation Investment Advisors, Inc. (“1st Source Investment Advisors”), a wholly-owned subsidiary of 1st Source Bank and second tier subsidiary of 1st Source Corporation, finalized a Purchase and Sale Agreement with WA Holdings, Inc. (“Buyer”) whereby 1st Source Investment Advisors sold certain assets to Buyer and entered into a long-term strategic partnership with Buyer (the “Transaction”). Under terms of the Purchase and Sale Agreement, we received a one time payment of $11.70 million at closing and will receive performance payments (“earnout fees”) over the next ten years based on the

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net growth and investment performance returns of the Funds. Pursuant to the Purchase and Sale Agreement, Buyer and its wholly-owned subsidiary, Wasatch Advisors, Inc., investment advisor of the Wasatch Funds, Inc., acquired assets of 1st Source Investment Advisors related to the management of the 1st Source Monogram Mutual Funds - the Income Equity Fund, the Long/Short Fund and the Income Fund. The 1st Source Monogram Mutual Funds were reorganized into the Wasatch - 1st Source Income Equity Fund, the Wasatch - 1st Source Long/Short Fund, and the Wasatch - 1st Source Income Fund.

Note 3. Recent Accounting Pronouncements

Investments in Certain Entities that Calculate Net Asset Value per Share : In September 2009, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2009-12, “Fair Value Measurements and Disclosures (Topic 820) – Investments in Certain Entities that Calculate Net Asset Value per Share (or its Equivalent)” . This ASU permits, as a practical expedient, a reporting entity to measure the fair value of an investment that is within the scope of the amendments in this ASU on the basis of the net asset value per share of the investment (or its equivalent) if the net asset value of the investment (or its equivalent) is calculated in a manner consistent with the measurement principles of Topic 946 as of the reporting entity’s measurement date. The ASU also requires disclosures by major category of investment about the attributes of investments within the scope of the Update. ASU 2009-12 is effective for interim and annual periods ending after December 15, 2009. We are assessing the impact of ASU 2009-05 on our financial condition, results of operations, and disclosures.

Measuring Liabilities at Fair Value: In August 2009, the FASB issued ASU No. 2009-05, “Fair Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at Fair Value” . This ASU provides amendments for fair value measurements of liabilities. It provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more techniques. ASU 2009-05 also clarifies that when estimating a fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability. ASU 2009-05 is effective for the first reporting period (including interim periods) beginning after issuance or fourth quarter 2009. We are assessing the impact of ASU 2009-05 on our financial condition, results of operations, and disclosures.

FASB Accounting Standards Codification ™ (ASC or Codification): In June 2009, the FASB issued ASU No. 2009-01 (formerly Statement No. 168), “Topic 105 - Generally Accepted Accounting Principles - FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles .” The Codification is the single source of authoritative nongovernmental U.S. generally accepted accounting principles (GAAP). The Codification does not change current GAAP, but is intended to simplify user access to all authoritative GAAP by providing all the authoritative literature related to a particular topic in one place. All existing accounting standard documents are superseded and all other accounting literature not included in the Codification is considered nonauthoritative. The Codification is effective for interim or annual reporting periods ending after September 15, 2009. We have made the appropriate changes to GAAP references in our financial statements.

Amendments to FASB Interpretation No. 46(R): In June 2009, the FASB issued Statement No. 167, “Amendments to FASB Interpretation No. 46(R)” (SFAS 167). SFAS 167 amends the consolidation guidance applicable to variable interest entities. The amendments to the consolidation guidance affect all entities currently within the scope of FIN 46(R), as well as qualifying special-purpose entities (QSPEs) that are currently excluded from the scope of FIN 46(R). SFAS 167 is effective as of the beginning of the first annual reporting period that begins after November 15, 2009. We are assessing the impact of SFAS 167 on our financial condition, results of operations, and disclosures.

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Accounting for Transfers of Financial Assets: In June 2009, the FASB issued Statement No. 166, “Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140” (SFAS No. 166). SFAS 166 amends the derecognition accounting and disclosure guidance relating to SFAS 140. SFAS 166 eliminates the exemption from consolidation for QSPEs, it also requires a transferor to evaluate all existing QSPEs to determine whether it must be consolidated in accordance with SFAS 167. SFAS 166 is effective as of the beginning of the first annual reporting period that begins after November 15, 2009. We are assessing the impact of SFAS 166 on our financial condition, results of operations, and disclosures.

Subsequent Events: In May 2009, the FASB issued ASC 855 (formerly Statement No. 165), “Subsequent Events” . ASC 855 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or available to be issued. ASC 855 is effective for interim or annual periods ending after June 15, 2009. We adopted the provisions of ASC 855 and this change is reflected in Note 10 - Subsequent Events.

FASB Amends Disclosures about Fair Value of Financial Instruments: In April 2009, the FASB issued ASC 825 (formerly FASB Staff Position (FSP) 107-1 and APB 28-1), “Interim Disclosures about Fair Value of Financial Instruments.” ASC 825 requires a public entity to provide disclosures about fair value of financial instruments in interim financial information. ASC 825 is effective for interim and annual financial periods ending after June 15, 2009. We adopted the provisions of ASC 825 on April 1, 2009 and the impact on our disclosures is more fully discussed in Note 9 – Fair Value.

FASB Clarifies Other-Than-Temporary Impairment: In April 2009, the FASB issued ASC 320 (formerly FSP FAS 115-2, FAS124-2 and EITF 99-20-2), “Recognition and Presentation of Other-Than-Temporary-Impairment.” ASC 320 (i) changes existing guidance for determining whether an impairment is other than temporary to debt securities and (ii) replaces the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert: (a) it does not have the intent to sell the security; and (b) it is more likely than not it will not have to sell the security before recovery of its cost basis. Under ASC 320, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of impairment related to other factors is recognized in other comprehensive income. ASC 320 is effective for interim and annual periods ending after June 15, 2009. We adopted the provisions of ASC 320 on April 1, 2009. Details related to the adoption of ASC 320 and the impact on our disclosures are more fully discussed in Note 4 – Investment Securities. The provisions of ASC 320 did not have an impact on our financial condition and results of operations.

FASB Clarifies Application of Fair Value Accounting: In April 2009, the FASB issued ASC 820 (formerly FSP FAS 157-4), “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.” ASC 820 affirms the objective of fair value when a market is not active, clarifies and includes additional factors for determining whether there has been a significant decrease in market activity, eliminates the presumption that all transactions are distressed unless proven otherwise, and requires an entity to disclose a change in valuation technique. ASC 820 is effective for interim and annual periods ending after June 15, 2009. We adopted the provisions of ASC 820 on April 1, 2009. The provisions of ASC 820 did not have a material impact on our financial condition and results of operations.

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Earnings Per Share (EPS): In June 2008, the FASB issued ASC 260 (formerly FSP EITF 03-6-1), “ Determining Whether Instruments Granted in Shared-Based Payment Transaction are Participating Securities.” ASC 260 clarifies that unvested share-based payment awards with a right to receive nonforfeitable dividends are participating securities. ASC 260 also provides guidance on how to allocate earnings to participating securities and compute EPS using the two-class method. ASC 260 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. All prior-period EPS data presented shall be adjusted retrospectively (including interim financial statements, summaries of earnings, and selected financial data) to conform with the provisions of ASC 260. The provisions of ASC 260 did not have a material impact on our EPS calculation.

Disclosures About Derivative Instruments and Hedging Activities : In March 2008, the FASB issued ASC 815 (formerly Statement No. 161), “ Disclosures About Derivative Instruments and Hedging Activities” . ASC 815 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. ASC 815 is effective for fiscal years beginning after November 15, 2008. We adopted the provisions of ASC 815 on January 1, 2009. The required disclosures are included in Note 6– Financial Instruments with Off-Balance Sheet Risk and Derivative Transactions.

Noncontrolling Interests in Consolidated Financial Statements : In December 2007, the FASB issued ASC 810 (formerly Statement No. 160), “ Noncontrolling Interests in Consolidated Financial Statements . ASC 810 requires that a noncontrolling interest in a subsidiary be reported separately within equity and the amount of consolidated net income specifically attributable to the noncontrolling interest be identified in the consolidated financial statements. It also calls for consistency in the manner of reporting changes in the parent’s ownership interest and requires fair value measurement of any noncontrolling equity investment retained in a deconsolidation. ASC 810 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. We adopted the provisions of ASC 810 on January 1, 2009. The provisions of ASC 810 did not have an impact on our financial condition and results of operations.

Business Combinations : In December 2007, the FASB issued ASC 805 (formerly Statement No. 141R), “Business Combinations”. ASC 805 broadens the guidance and , extends its applicability to all transactions and other events in which one entity obtains control over one or more other businesses. It broadens the fair value measurement and recognition of assets acquired, liabilities assumed, and interests transferred as a result of business combinations. ASC 805 expands on required disclosures to improve the statement users’ abilities to evaluate the nature and financial effects of business combinations. ASC 805 is effective for the first annual reporting period beginning on or after December 15, 2008. In April 2009, the FASB amended the guidance in ASC 805 and is effective for the first annual reporting period beginning on or after December 15, 2008. The provisions of ASC 805 will only impact us if we are party to a business combination closing on or after January 1, 2009.

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Note 4. Investment Securities

Investment securities available-for-sale were as follows:

| (Dollars
in thousands) | Amortized — Cost | Gross — Unrealized
Gains | Gross — Unrealized
Losses | | Fair
Value |
| --- | --- | --- | --- | --- | --- |
| September
30, 2009 | | | | | |
| U.S.
Treasury and Federal agencies securities | $ 393,345 | $ 2,055 | $ (20 | ) | $ 395,380 |
| U.S.
State and political subdivisions securities | 202,265 | 7,396 | (2,034 | ) | 207,627 |
| Mortgage-backed
securities - Federal agencies | 254,715 | 6,797 | (934 | ) | 260,578 |
| Corporate
debt securities | 18,978 | 200 | - | | 19,178 |
| Foreign
government securities | 675 | - | - | | 675 |
| Total
debt securities | 869,978 | 16,448 | (2,988 | ) | 883,438 |
| Marketable
equity securities | 1,288 | 2,076 | (25 | ) | 3,339 |
| Total
investment securities available-for-sale | $ 871,266 | $ 18,524 | $ (3,013 | ) | $ 886,777 |
| December
31, 2008 | | | | | |
| U.S.
Treasury and Federal agencies securities | $ 293,461 | $ 2,892 | $ (2 | ) | $ 296,351 |
| U.S.
State and political subdivisions securities | 198,640 | 3,995 | (1,686 | ) | 200,949 |
| Mortgage-backed
securities - Federal agencies | 207,954 | 3,553 | (1,499 | ) | 210,008 |
| Corporate
debt securities | 10,000 | 50 | - | | 10,050 |
| Foreign
government and other securities | 929 | - | - | | 929 |
| Total
debt securities | 710,984 | 10,490 | (3,187 | ) | 718,287 |
| Marketable
equity securities | 4,396 | 2,092 | (21 | ) | 6,467 |
| Total
investment securities available-for-sale | $ 715,380 | $ 12,582 | $ (3,208 | ) | $ 724,754 |

The contractual maturities of debt securities available-for-sale at September 30, 2009, are shown below. Expected maturities will differ from contractual maturities, because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

| (Dollars
in thousands) | Amortized
Cost | Fair
Value |
| --- | --- | --- |
| Due
in one year or less | $ 120,555 | $ 120,914 |
| Due
after one year through five years | 334,454 | 339,827 |
| Due
after five years through ten years | 141,996 | 145,527 |
| Due
after ten years | 18,258 | 16,592 |
| Mortgage
backed securities | 254,715 | 260,578 |
| Total
debt securities available-for-sale | $ 869,978 | $ 883,438 |

At September 30, 2009, the mortgage-backed securities we held consisted primarily of GNMA, FNMA and FHLMC pass-through certificates which are guaranteed by those respective agencies of the United States government.

The following table shows the gross realized gains and losses on sale of securities from the securities available-for-sale portfolio, including marketable equity securities. The gross gains in the third quarter of 2009 reflect gains on the sale of our remaining FHLMC preferred stock. The gross losses in the third quarter and year-to-date 2008 reflect other-than-temporary impairment (“OTTI”) writedowns of $9.00 million and $10.26 million, respectively, on FNMA, FHLMC and other corporate preferred stock. There have been no OTTI writedowns in 2009. There were net gains of $27 thousand and $0 recorded on $0.12 million and $0.10 million in trading securities outstanding at September 30, 2009, and December 31, 2008, respectively.

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| (Dollars
in thousands) | Three
Months Ended | | | Nine
Months Ended | | | |
| --- | --- | --- | --- | --- | --- | --- | --- |
| | September
30, | | | September
30, | | | |
| | 2009 | 2008 | | 2009 | 2008 | | |
| Gross
realized gains | $ 356 | $ - | | $ 1,010 | $ | 826 | |
| Gross
realized losses | - | (8,999 | ) | (707 | ) | (10,456 | ) |
| Net
realized gains (losses) | $ 356 | $ (8,999 | ) | $ 303 | $ | (9,630 | ) |

The following tables summarize our gross unrealized losses and fair value by investment category and age:

| | Less
than 12 Months — Fair | Unrealized | | 12
months or Longer — Fair | Unrealized | | Total — Fair | Unrealized | |
| --- | --- | --- | --- | --- | --- | --- | --- | --- | --- |
| (Dollars
in thousands) | Value | Losses | | Value | Losses | | Value | Losses | |
| September
30, 2009 | | | | | | | | | |
| U.S.
Treasury and Federal agencies securities | $ 30,166 | $ (20 | ) | $ - | $ - | | $ 30,166 | $ (20 | ) |
| U.S.
State and political subdivisions securities | 1,717 | (29 | ) | 17,121 | (2,005 | ) | 18,838 | (2,034 | ) |
| Mortgage-backed
securities - Federal agencies | 31,140 | (324 | ) | 30,388 | (610 | ) | 61,528 | (934 | ) |
| Total
debt securities | 63,023 | (373 | ) | 47,509 | (2,615 | ) | 110,532 | (2,988 | ) |
| Marketable
equity securities | 2 | (1 | ) | 5 | (24 | ) | 7 | (25 | ) |
| Total
investment securities available-for-sale | $ 63,025 | $ (374 | ) | $ 47,514 | $ (2,639 | ) | $ 110,539 | $ (3,013 | ) |
| December
31, 2008 | | | | | | | | | |
| U.S.
Treasury and Federal agencies securities | $ 19,998 | $ (2 | ) | $ - | $ - | | $ 19,998 | $ (2 | ) |
| U.S.
State and political subdivisions securities | 29,594 | (1,686 | ) | - | - | | 29,594 | (1,686 | ) |
| Mortgage-backed
securities - Federal agencies | 14,840 | (229 | ) | 34,721 | (1,270 | ) | 49,561 | (1,499 | ) |
| Foreign
government and other securities | 493 | (1 | ) | - | - | | 493 | (1 | ) |
| Total
debt securities | 64,925 | (1,918 | ) | 34,721 | (1,270 | ) | 99,646 | (3,188 | ) |
| Marketable
equity securities | 11 | (18 | ) | 2 | (2 | ) | 13 | (20 | ) |
| Total
investment securities available-for-sale | $ 64,936 | $ (1,936 | ) | $ 34,723 | $ (1,272 | ) | $ 99,659 | $ (3,208 | ) |

The initial indication of OTTI for both debt and equity securities is a decline in fair value below amortized cost. Quarterly, the impaired securities are analyzed on a qualitative and quantitative basis in determining OTTI. Declines in the fair value of available-for-sale debt securities below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of impairment related to other factors is recognized in other comprehensive income. In estimating OTTI impairment losses, we consider among other things, (i) the length of time and the extent to which fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) whether it is more likely than not that we will not have to sell any such securities before a recovery of cost.

At September 30, 2009, we do not have the intent to sell any of the available-for-sale securities in the table above and believe that it is more likely than not that we will not have to sell any such securities before a recovery of cost. The unrealized losses are due to increases in market interest rates over the yields available at the time the underlying securities were purchased and market illiquidity on adjustable rate coupon securities. The fair value is expected to recover on all debt securities as they approach their maturity date or repricing date or if market yields for such investments decline. We do not believe any of the securities are impaired due to reasons of credit quality. Accordingly, as of September 30, 2009, we believe the impairments detailed in the table above are temporary and no impairment loss has been realized in our consolidated income statement.

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Note 5. Reserve for Loan and Lease Losses

The reserve for loan and lease losses is maintained at a level believed to be adequate by management to absorb probable losses inherent in the loan and lease portfolio. The determination of the reserve requires significant judgment reflecting management’s best estimate of probable loan and lease losses related to specifically identified loans and leases as well as probable losses in the remainder of the various loan and lease portfolios. The methodology for assessing the appropriateness of the reserve consists of several key elements, which include: specific reserves for impaired loans, percentage allocations for special attention loans and leases (classified loans and leases and internal watch list credits) without specific reserves, formula reserves for each business lending division portfolio, and reserves for pooled homogeneous loans and leases. Management’s evaluation is based upon a continuing review of these portfolios, estimates of customer performance, collateral values and dispositions, and assessments of economic and geopolitical events, all of which are subject to judgment and will change.

Note 6. Financial Instruments with Off-Balance-Sheet Risk and Derivative Transactions

To meet the financing needs of our customers, 1st Source Corporation and its subsidiaries are parties to financial instruments with off-balance-sheet risk in the normal course of business. These off-balance-sheet financial instruments include commitments to originate, purchase and sell loans and standby letters of credit. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. Our exposure to credit loss in the event of nonperformance by the other party to the financial instruments for loan commitments and standby letters of credit is represented by the dollar amount of those instruments. We use the same credit policies and collateral requirements in making commitments and conditional obligations as we do for on-balance-sheet instruments.

We have certain interest rate derivative positions that relate to transactions in which we enter into an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution. In connection with each transaction, we agree to pay interest to the client on a notional amount at a variable interest rate and receive interest from the client on the same notional amount at a fixed interest rate. At the same time, we agree to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows our client to effectively convert a variable rate loan to a fixed rate. Because the terms of the swaps with our customers and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact our results of operations. Changes in the fair value are included in other expense. The fair value of interest rate swap positions is determined by a third-party pricing agent using an income approach and utilizing models that use as their basis readily observable market parameters. This valuation process considers various factors including interest rate yield curves, time value and volatility factors.

1st Source Bank (Bank), a subsidiary of 1st Source Corporation, grants mortgage loan commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan commitments is managed by entering into contracts for future deliveries of loans. Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Commitments to originate or purchase residential mortgage loans held for sale and forward commitments to sell residential mortgage loans are considered derivative instruments and changes in the fair value are recorded to mortgage banking income. Fair value of mortgage loan commitments is determined using a market value approach and utilizing an appropriate current market yield and a loan commitment closing rate based on historical analysis.

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| Fair
values of derivative instruments as of September 30, 2009: — (Dollars
in thousands) | | Asset
derivatives | | Liability
derivatives | |
| --- | --- | --- | --- | --- | --- |
| | Notional
or | Balance | | Balance | |
| | contractual | sheet | Fair | sheet | Fair |
| | amount | location | value | location | value |
| Derivatives
not designated as | | | | | |
| hedging
instruments | | | | | |
| Interest
rate swap contracts | $ 436,801 | Other
assets | $ 16,507 | Other
liabilities | $ 16,900 |
| Loan
commitments | 51,421 | Mortgages
held for sale | 305 | N/A | - |
| Forward
contracts | 55,119 | N/A | - | Mortgages held for
sale | 671 |
| Total | | | $ 16,812 | | $ 17,571 |

We issue letters of credit which are conditional commitments that guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers. Standby letters of credit totaled $45.89 million and $82.18 million at September 30, 2009, and December 31, 2008, respectively. Standby letters of credit generally have terms ranging from six months to one year.

Note 7. Stock-Based Compensation

As of September 30, 2009, we had five stock-based employee compensation plans, which are more fully described in Note L of the Consolidated Financial Statements in 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2008. These plans include two stock option plans, the Employee Stock Purchase Plan, the Executive Incentive Plan, and the Restricted Stock Award Plan.

Stock-based compensation expense for all stock-based compensation awards granted is based on the grant-date fair value. For all awards except stock option awards, the grant date fair value is either the fair market value per share or book value per share (corresponding to the type of stock awarded) as of the grant date. For stock option awards, the grant date fair value is estimated using the Black-Scholes option pricing model. For all awards we recognize these compensation costs only for those shares expected to vest on a straight-line basis over the requisite service period of the award, for which we use the related vesting term. We estimate forfeiture rates based on historical employee option exercise and employee termination experience. We have identified separate groups of awardees that exhibit similar option exercise behavior and employee termination experience and have considered them as separate groups in the valuation models and expense estimates.

The stock-based compensation expense recognized in the condensed consolidated statement of operations for the nine months ended September 30, 2009 and 2008 was based on awards ultimately expected to vest, and accordingly has been adjusted by the amount of estimated forfeitures. GAAP requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based partially on historical experience.

The aggregate intrinsic value in the table below represents the total pretax intrinsic value (the difference between 1st Source’s closing stock price on the last trading day of the third quarter of 2009 (September 30, 2009)

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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 options on September 30, 2009. This amount changes based on the fair market value of 1st Source’s stock. Total fair value of options vested and expensed was $9 thousand and $12 thousand, net of tax, for the nine months ended September 30, 2009 and 2008, respectively.

			Average
		Weighted	Remaining	Total
		Average	Contractual	Intrinsic
Number
of		Exercise	Term	Value
Shares		Price	(in
years)	(in
000's)
Options
outstanding, beginning of year	80,948	$ 18.51
Granted	-	-
Exercised	-	-
Forfeited	-	-
Options
outstanding, September 30, 2009	80,948	$ 18.51	2.09	$ 94
Vested
and expected to vest at September 30, 2009	80,948	$ 18.51	2.09	$ 94
Exercisable
at September 30, 2009	75,448	$ 18.99	1.98	$ 70

No options were granted during the nine months ended September 30, 2009.

As of September 30, 2009, there was $2.41 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 3.46 years.

The following table summarizes information about stock options outstanding at September 30, 2009:

| | Options
Outstanding | | | Options
Exercisable | |
| --- | --- | --- | --- | --- | --- |
| | | Weighted | | | |
| | | Average | Weighted | | Weighted |
| Range
of | Number | Remaining | Average | Number | Average |
| Exercise | of
shares | Contractual | Exercise | of
shares | Exercise |
| Prices | Outstanding | Life | Price | Exercisable | Price |
| $12.04
to $17.99 | 29,508 | 2.99 | $13.38 | 24,008 | $13.69 |
| $18.00
to $26.99 | 45,885 | 1.51 | 20.55 | 45,885 | 20.55 |
| $27.00
to $29.46 | 5,555 | 2.06 | 28.95 | 5,555 | 28.95 |

The fair value of each stock option was estimated on the date of grant using the Black-Scholes option-pricing model.

Note 8. Income Taxes

The total amount of unrecognized tax benefits that would affect the effective tax rate if recognized was $1.19 million at September 30, 2009 and $4.19 million at December 31, 2008. Interest and penalties were recognized through the income tax provision. For the nine months ending September 30, 2009 and the twelve months ending December 31, 2008, we recognized approximately ($0.76) million and $0.14 million in interest, net of tax effect, and penalties, respectively. Interest and penalties of approximately $0.52 million and $1.27 million were accrued at September 30, 2009 and December 31, 2008, respectively.

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Tax years that remain open and subject to audit include the federal 2006-2008 years and the Indiana 2005-2008 years. Additionally, during the first quarter of 2009 we reached a resolution of audit examinations for the 2002-2007 years and as a result recorded a reduction of unrecognized tax benefits in the amount of $4.80 million that affected the effective tax rate and increased earnings in the amount of $2.60 million. We do not anticipate a significant change in the amount of uncertain tax positions within the next 12 months.

Note 9. Fair Value

As of January 1, 2008, we adopted “Fair Value Measurements” and “Fair Value Option for Financial Assets and Financial Liabilities”. Fair Value Measurements does not change existing guidance as to whether or not an asset or liability is carried at fair value. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. Fair Value Option for Financial Assets and Financial Liabilities generally permits the measurement of selected eligible financial instruments at fair value at specified election dates, subject to the conditions set forth in the standard.

We also deferred until January 1, 2009 the application of Fair Value Measurements to nonfinancial assets and nonfinancial liabilities not recognized or disclosed at least annually at fair value. Items affected by this deferral included goodwill, repossessions and other real estate, all for which any necessary impairment analyses are performed using fair value measurements.

We elected to adopt Fair Value Option for Financial Assets and Financial Liabilities for mortgages held for sale (MHFS) at fair value prospectively for new MHFS originations starting on January 1, 2008. We believe the fair value election for MHFS (which are now hedged with free-standing derivatives (economic hedges)) will reduce certain timing differences and better match changes in the value of these assets with changes in the value of derivatives used as economic hedges for these assets. There was no transition adjustment required upon adoption because we continued to account for MHFS originated prior to January 1, 2008 at the lower of cost or fair value. At September 30, 2009, all MHFS are carried at fair value.

We group our financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

§ Level 1 – Quoted prices are available in active markets for identical assets or liabilities as of the reported date.

§ Level 2 – Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities include items for which quoted prices are available but traded less frequently, and items that are fair valued using other financial instruments, the parameters of which can be directly observed.

§ Level 3 – Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

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The table below presents the balance of assets and liabilities at September 30, 2009 measured at fair value on a recurring basis:

| (Dollars
in thousands) | Level
1 | Level
2 | Level
3 | Total |
| --- | --- | --- | --- | --- |
| Assets: | | | | |
| Investment
securities available for sale: | | | | |
| U.S.
Treasury and Federal agencies securities | $ 46,216 | $ 349,164 | $ - | 395,380 |
| U.S.
State and political subdivisions securities | - | 180,022 | 27,605 | 207,627 |
| Mortgage-backed
securities - Federal agencies | - | 260,578 | - | 260,578 |
| Corporate
debt securities | - | 19,178 | - | 19,178 |
| Foreign
government securities | - | - | 675 | 675 |
| Total
debt securities | 46,216 | 808,942 | 28,280 | 883,438 |
| Marketable
equity securities | 3,330 | - | 9 | 3,339 |
| Total
investment securities available for sale | 49,546 | 808,942 | 28,289 | 886,777 |
| Trading
account securities | 117 | - | - | 117 |
| Mortgages
held for sale | - | 39,364 | - | 39,364 |
| Accrued
income and other assets (Interest rate swap agreements) | - | 16,507 | - | 16,507 |
| Total | $ 49,663 | $ 864,813 | $ 28,289 | $ 942,765 |
| Liabilities: | | | | - |
| Accrued
expenses and other liabilities (Interest rate swap
agreements) | $ - | $ 16,900 | $ - | $ 16,900 |
| Total | $ - | $ 16,900 | $ - | $ 16,900 |

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:

| | Quarter
ended | | | | | | |
| --- | --- | --- | --- | --- | --- | --- | --- |
| (Dollars
in thousands) | September
30, 2009 | | | | | | |
| | U.S.
State and political subdivisions securities | Foreign
government securities | | Marketable
equity securities | | Investment
securities available for sale | |
| Beginning
balance July 1, 2009 | $ 28,725 | $ | 775 | $ | 9 | $ 29,509 | |
| Total
gains or losses (realized/unrealized): | | | | | | | |
| Included
in earnings | - | | - | | - | - | |
| Included
in other comprehensive income | 147 | | - | | - | 147 | |
| Purchases
and issuances | 8 | | - | | - | 8 | |
| Settlements | - | | - | | - | - | |
| Expirations | (1,275 | ) | (100 | ) | - | (1,375 | ) |
| Transfers
in and/or out of Level 3 | - | | - | | - | - | |
| Ending
balance September 30, 2009 | $ 27,605 | $ | 675 | $ | 9 | $ 28,289 | |

There were no gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at September 30, 2009.

We may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with GAAP. These other financial assets include loans measured for impairment, venture capital partnership investments, mortgage servicing rights, goodwill, repossessions and other real estate.

Impaired loans and related write-downs are based on the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are estimated using customized discounting criteria, appraisals and dealer and trade magazine quotes which are used in a market valuation approach. Repossessions are similarly valued. Venture capital partnership investments and the adjustments to fair value primarily result from application of lower-of-cost-or-fair value accounting. The partnership investments are priced using financial statements provided by the partnerships.

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Mortgage servicing rights (MSRs) and related adjustments to fair value result from application of lower-of-cost-or-fair value accounting. Fair value measurements for mortgage servicing rights are derived based on a variety of inputs including prepayment speeds, discount rates, scheduled servicing cash flows, delinquency rates and other assumptions. MSRs do not trade in an active, open market with readily observable prices and though sales of MSRs do occur, precise terms and conditions typically are not readily available and the characteristics of our servicing portfolio may differ from those of any servicing portfolios that do trade. Goodwill is reviewed for impairment at least annually, or on an interim basis if an event occurs or circumstances change that would more likely than not reduce the carrying amount. Goodwill is allocated into two reporting units. Fair value for each reporting unit is estimated using stock price multiples or revenue multiples. We do not believe there is a reasonable possibility that either of our reporting units are at risk of failing a future Step 1 impairment test. Other real estate (ORE) is based on the fair value of the underlying collateral less expected selling costs. Collateral values are estimated primarily using appraisals and reflect a market value approach.

For assets measured at fair value on a nonrecurring basis the following represents impairment charges (recoveries) recognized on these assets during the quarter ended September 30, 2009: impaired loans - $3.33 million; venture capital partnership investments - $(0.33) million; mortgage servicing rights - $(0.29) million; goodwill - $0.00 million; repossessions - $0.11 million, and other real estate - $0.00 million.

For assets measured at fair value on a nonrecurring basis on hand at September 30, 2009, the following table provides the level of valuation assumptions used to determine each valuation and the carrying value of the related assets:

| (Dollars
in thousands) | Level
1 | Level
2 | Level
3 | Total |
| --- | --- | --- | --- | --- |
| Loans | $ - | $ - | $ 72,595 | $ 72,595 |
| Accrued
income and other assets (venture capital partnership
investments) | - | - | 2,764 | 2,764 |
| Accrued
income and other assets (mortgage servicing rights) | - | - | 9,165 | 9,165 |
| Goodwill
and intangible assets (goodwill) | - | 83,329 | - | 83,329 |
| Accrued
income and other assets (repossessions) | - | - | 5,672 | 5,672 |
| Accrued
income and other assets (other real estate) | - | - | 7,169 | 7,169 |
| | $ - | $ 83,329 | $ 97,365 | $ 180,694 |

The following table reflects the differences between the carrying amount of mortgages held for sale carried at fair value and the aggregate unpaid principal amount we are contractually entitled to receive at maturity on September 30, 2009:

| (Dollars
in thousands) | Fair
value carrying amount | Aggregate
unpaid principal | Excess
of fair value carrrying amount over (under) unpaid
principal |
| --- | --- | --- | --- |
| Mortgages
held for sale reported at fair value: | | | |
| Total
loans | $ 39,364 | $ 38,634 | $ 730
(1) |
| Nonaccrual
loans | - | - | - |
| Loans
90 days or more past due and still accruing | - | - | - |
| (1)
The excess of fair value carrying amount over unpaid principal includes
changes in fair value recorded at and subsequent to funding, gains and
losses on the related loan | | | |
| commitment
prior to funding, and premiums on acquired loans included
in mortgage banking
income. | | | |

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The fair values of our financial instruments as of September 30, 2009, and December 31, 2008, are summarized in the table below.

| | September
30, 2009 — Carrying
or | | December
31, 2008 — Carrying
or | |
| --- | --- | --- | --- | --- |
| (Dollars
in thousands) | Contract
Value | Fair
Value | Contract
Value | Fair
Value |
| Assets: | | | | |
| Cash
and due from banks | $ 56,408 | $ 56,408 | $ 119,771 | $ 119,771 |
| Federal
funds sold and interest bearing deposits with other banks | 65,307 | 65,307 | 6,951 | 6,951 |
| Investment
securities, available-for-sale | 886,777 | 886,777 | 724,754 | 724,754 |
| Other
investments and trading account securities | 21,129 | 21,129 | 18,712 | 18,712 |
| Mortgages
held for sale | 39,364 | 39,364 | 46,686 | 46,686 |
| Loans
and leases, net of reserve for loan and lease losses | 3,008,526 | 3,046,714 | 3,218,436 | 3,239,567 |
| Cash
surrender value of life insurance policies | 39,836 | 39,836 | 38,837 | 38,837 |
| Mortgage
servicing rights | 9,165 | 9,648 | 4,635 | 4,715 |
| Interest
rate swaps | 16,507 | 16,507 | 22,663 | 22,663 |
| Liabilities: | | | | |
| Deposits | $ 3,486,714 | $ 3,528,917 | $ 3,514,542 | $ 3,486,609 |
| Short-term
borrowings | 154,979 | 154,979 | 296,175 | 296,175 |
| Long-term
debt and mandatorily redeemable securities | 20,046 | 20,071 | 29,832 | 29,674 |
| Subordinated
notes | 89,692 | 74,236 | 89,692 | 73,972 |
| Interest
rate swaps | 16,900 | 16,900 | 23,003 | 23,003 |
| Off-balance-sheet
instruments * | - | 276 | - | 297 |
| *
Represents estimated cash outflows required to currently settle the
obligations at current market rates. | | | | |

GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring or non-recurring basis. The methodologies for estimating fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above. The estimated fair value approximates carrying value for cash and cash equivalents and cash surrender value of life insurance policies. The methodologies for other financial assets and financial liabilities are discussed below:

Loans and Leases — For variable rate loans and leases that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values of loans and leases are estimated using discounted cash flow analyses which use interest rates currently being offered for loans and leases with similar terms to borrowers of similar credit quality (except as noted in the following sentence). As of December 31, 2008, the fair values for certain real estate loans (e.g., one-to-four family residential mortgage loans) are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics.

Deposits — The fair values for all deposits other than time deposits are equal to the amounts payable on demand (the carrying value). Fair values of variable rate time deposits are equal to their carrying values. Fair values for fixed rate time deposits are estimated using discounted cash flow analyses using interest rates currently being offered for deposits with similar remaining maturities.

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Short-Term Borrowings — The carrying values of Federal funds purchased, securities sold under repurchase agreements, and other short-term borrowings, including our liability related to mortgage loans available for repurchase under GNMA optional repurchase programs, approximate their fair values.

Long-Term Debt and Mandatorily Redeemable Securities — The fair values of long-term debt are estimated using discounted cash flow analyses, based on our current estimated incremental borrowing rates for similar types of borrowing arrangements. The carrying values of mandatorily redeemable securities are based on approximate fair values.

Subordinated Notes — Fair values are based on quoted market prices, where available. If quoted market prices are not available, fair values are estimated based on calculated market prices of comparable securities.

Off-Balance-Sheet Instruments — Contract and fair values for certain of our off-balance-sheet financial instruments (guarantees) are estimated based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

Limitations — Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments. Because no market exists for a significant portion of our financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other such factors.

These estimates do not reflect any premium or discount that could result from offering for sale at one time our entire holdings of a particular financial instrument. These estimates are subjective in nature and require considerable judgment to interpret market data. Accordingly, the estimates presented herein are not necessarily indicative of the amounts we could realize in a current market exchange, nor are they intended to represent the fair value of 1st Source as a whole. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The fair value estimates presented herein are based on pertinent information available to management as of the respective balance sheet date. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.

Other significant assets, such as premises and equipment, other assets, and liabilities not defined as financial instruments, are not included in the above disclosures. Also, the fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.

Note 10. Subsequent Events

We have evaluated subsequent events through the date our financial statements were issued, or October 22, 2009. We do not believe any subsequent events have occurred that would require further disclosure or adjustment to our financial statements.

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ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Except for historical information contained herein, the matters discussed in this document express “forward-looking statements.” Generally, the words “believe,” “contemplate,” “seek,” “plan,” “possible,” “assume,” “expect,” “intend,” “targeted,” “continue,” “remain,” “estimate,” “anticipate,” “project,” “will,” “should,” “indicate,” “would,” “may” and similar expressions indicate forward-looking statements. Those statements, including statements, projections, estimates or assumptions concerning future events or performance, and other statements that are other than statements of historical fact, are subject to material risks and uncertainties. We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made. We may make other written or oral forward-looking statements from time to time. Readers are advised that various important factors could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected in such forward-looking statements. Such factors include, but are not limited to, changes in law, regulations or U. S. generally accepted accounting principles; our competitive position within the markets we serve; increasing consolidation within the banking industry; unforeseen changes in interest rates; unforeseen changes in loan prepayment assumptions; unforeseen downturns in or major events affecting the local, regional or national economies or the industries in which we have credit concentrations; and other matters discussed in our filings with the SEC, including our Annual Report on Form 10-K for 2008, which filings are available from the SEC. We undertake no obligation to publicly update or revise any forward-looking statements.

The following management’s discussion and analysis is presented to provide information concerning our financial condition as of September 30, 2009, as compared to December 31, 2008, and the results of operations for the three and nine months ended September 30, 2009 and 2008. This discussion and analysis should be read in conjunction with our consolidated financial statements and the financial and statistical data appearing elsewhere in this report and our 2008 Annual Report.

FINANCIAL CONDITION

Our total assets at September 30, 2009, were $4.41 billion, a decrease of $51.01 million or 1.14% from December 31, 2008. Total loans and leases were $3.09 billion, a decrease of $204.18 million or 6.19% from December 31, 2008. Mortgages held for sale were $39.36 million, a decrease of $7.32 million or 15.68% from December 31, 2008. Total investment securities, available for sale were $886.78 million which represented an increase of $162.02 million or 22.36% and total deposits were $3.49 billion, a decrease of $27.83 million or 0.79% over the comparable figures at the end of 2008.

Nonperforming assets at September 30, 2009, were $94.40 million, which was an increase of $50.23 million or 113.73% from the $44.17 million reported at December 31, 2008. At September 30, 2009, nonperforming assets were 2.95% of net loans and leases compared to 1.30% at December 31, 2008.

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Accrued income and other assets were as follows:

| (Dollars
in Thousands) | September
30, | December
31, |
| --- | --- | --- |
| | 2009 | 2008 |
| Accrued
income and other assets: | | |
| Bank
owned life insurance cash surrender value | $ 39,836 | $ 38,837 |
| Accrued
interest receivable | 16,558 | 17,910 |
| Mortgage
servicing assets | 9,165 | 4,635 |
| Other
real estate | 4,074 | 1,381 |
| Former
bank premises held for sale | 3,095 | 3,356 |
| Repossessions | 5,672 | 1,669 |
| All
other assets | 36,490 | 45,832 |
| Total
accrued income and other assets | $ 114,890 | $ 113,620 |

CAPITAL

As of September 30, 2009, total shareholders' equity was $574.33 million, up $120.67 million or 26.60% from the $453.66 million at December 31, 2008. In addition to net income of $19.27 million, other significant changes in shareholders’ equity during the first nine months of 2009 included $111.00 million from the issuance of preferred stock and common stock warrants to the Treasury as part of the Treasury’s Capital Purchase Program and $14.22 million of dividends paid and/or accrued. The accumulated other comprehensive income/(loss) component of shareholders’ equity totaled $9.64 million at September 30, 2009, compared to $5.82 million at December 31, 2008. The increase in accumulated other comprehensive income/(loss) during 2009 was primarily a result of changes in unrealized gain/(loss) on securities in the available-for-sale portfolio. Our equity-to-assets ratio was 13.01% as of September 30, 2009, compared to 10.16% at December 31, 2008. Book value per common share rose to $19.46 at September 30, 2009, up from $18.82 at December 31, 2008.

We declared and paid dividends per common share of $0.15 during the third quarter of 2009. The trailing four quarters dividend payout ratio, representing dividends per common share divided by diluted earnings per common share, was 53.15%. The dividend payout is continually reviewed by management and the Board of Directors subject to the Corporation’s capital and dividend policy.

The banking regulators have established guidelines for leverage capital requirements, expressed in terms of Tier 1 or core capital as a percentage of average assets, to measure the soundness of a financial institution. In addition, banking regulators have established risk-based capital guidelines for U.S. banking organizations. The actual capital amounts and ratios of 1st Source Corporation and 1st Source Bank as of September 30, 2009, are presented in the table below:

| | | | | | To
Be Well | |
| --- | --- | --- | --- | --- | --- | --- |
| | | | | | Capitalized
Under | |
| | | | Minimum
Capital | | Prompt
Corrective | |
| | Actual | | Adequacy | | Action
Provisions | |
| (Dollars
in thousands) | Amount | Ratio | Amount | Ratio | Amount | Ratio |
| Total
Capital (To Risk-Weighted Assets): | | | | | | |
| 1st
Source Corporation | $ 605,775 | 17.43 % | $ 278,089 | 8.00 % | $ 347,611 | 10.00 % |
| 1st
Source Bank | 570,560 | 16.48 | 276,909 | 8.00 | 346,137 | 10.00 |
| Tier
1 Capital (to Risk-Weighted Assets): | | | | | | |
| 1st
Source Corporation | 560,881 | 16.14 | 139,045 | 4.00 | 208,567 | 6.00 |
| 1st
Source Bank | 526,753 | 15.22 | 138,455 | 4.00 | 207,682 | 6.00 |
| Tier
1 Capital (to Average Assets): | | | | | | |
| 1st
Source Corporation | 560,881 | 12.82 | 174,990 | 4.00 | 218,738 | 5.00 |
| 1st
Source Bank | 526,753 | 12.10 | 174,140 | 4.00 | 217,675 | 5.00 |

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LIQUIDITY AND INTEREST RATE SENSITIVITY

Effective liquidity management ensures that the cash flow requirements of depositors and borrowers, as well as the operating cash needs of 1st Source Corporation, are met. Funds are available from a number of sources, including the securities portfolio, the core deposit base, Federal Home Loan Bank borrowings, Federal Reserve Bank borrowings, and the capability to package loans for sale. Our loan to asset ratio was 70.11% at September 30, 2009 compared to 73.88% at December 31, 2008 and 75.17% at September 30, 2008. Cash and cash equivalents totaled $56.41 million at September 30, 2009 compared to $119.77 million at December 31, 2008 and $75.70 million at September 30, 2008. The decrease in cash and cash equivalents is the result of making short term interest bearing investments at the Federal Reserve Bank. At September 30, 2009, the consolidated statement of financial condition was rate sensitive by $69.08 million more liabilities than assets scheduled to reprice within one year, or approximately 0.97%.

In September 2009, the Board of Directors of the Federal Deposit Insurance Corporation (FDIC) adopted a Notice of Proposed Rulemaking (NPR) that would require insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter 2009 and all of 2010, 2011, and 2012. We have estimated our prepayment costs to be $21.57 million. Management believes that the present funding sources provide adequate liquidity to meet our cash flow needs.

RESULTS OF OPERATIONS

Net income for the three and nine month periods ended September 30, 2009, was $6.73 million and $19.27 million respectively, compared to $4.47 million and $21.07 million for the same periods in 2008. Diluted net income per common share was $0.21 and $0.60 respectively, for the three and nine month periods ended September 30, 2009, compared to $0.18 and $0.86 for the same periods in 2008. Return on average common shareholders' equity was 4.16% for the nine months ended September 30, 2009, compared to 6.35% in 2008. The return on total average assets was 0.57% for the nine months ended September 30, 2009, compared to 0.64% in 2008.

The decrease in net income for the nine months ended September 30, 2009, over the first nine months of 2008, was primarily the result of an increase in provision for loan and leases losses. This negative impact to net income was partially offset by an increase in noninterest income. Details of the changes in the various components of net income are discussed further below.

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NET INTEREST INCOME

The taxable equivalent net interest income for the three months ended September 30, 2009, was $33.03 million, a decrease of 3.59% over the same period in 2008. The net interest margin on a fully taxable equivalent basis was 3.15% for the three months ended September 30, 2009, compared to 3.34% for the three months ended September 30, 2008. The taxable equivalent net interest income for the nine months ended September 30, 2009 was $97.51 million, a decrease of 3.94% over 2008, resulting in a net yield of 3.10%, compared to a net yield of 3.35% for the same period in 2008.

During the three and nine month periods ended September 30, 2009, average earning assets increased $83.78 million or 2.06% and $159.37 million or 3.94%, respectively, over the comparable periods in 2008. Average interest-bearing liabilities decreased $126.89 million or 3.61% and $39.39 million or 1.13% respectively, for the three and nine month periods ended September 30, 2009, over the comparable periods one year ago. The yield on average earning assets decreased 91 basis points to 4.84% for the third quarter of 2009 from 5.75% for the third quarter of 2008. The yield on average earning assets for the nine month period ended September 30, 2009 decreased 110 basis points to 4.89% from 5.99% for the nine month period ended September 30, 2008. The rate earned on assets decreased due to the reduction in short-term market interest rates from a year ago. Total cost of average interest-bearing liabilities decreased 72 basis points to 2.07% for the third quarter 2009 from 2.79% for the third quarter 2008. Total cost of average interest-bearing liabilities decreased 88 basis points to 2.18% for the nine months ended September 30, 2009, from 3.06% for the nine months ended September 30, 2008. The cost of interest-bearing liabilities was also affected by short-term market interest rate decreases. The result to the net interest margin, or the difference between interest income on earning assets and interest expense on interest-bearing liabilities, was a decrease of 19 basis points and 25 basis points respectively, for the three and nine month periods ended September 30, 2009 from September 30, 2008.

The largest contributor to the decrease in the yield on average earning assets for the three and nine months ended September 30, 2009, compared to the three and nine months ended September 30, 2008, was a decline in the yield on net loans and leases of 65 basis points and 87 basis points respectively. Total average investment securities increased 21.19% and 12.85% respectively, for the three and nine month periods over one year ago. Average mortgages held for sale increased 120.40% and 165.57% for the three and nine month periods ended September 30, 2009, over comparable periods a year ago primarily due to an increase in refinance activity. Average other investments, which include federal funds sold, time deposits with other banks, Federal Reserve Bank excess balances, Federal Reserve Bank and Federal Home Loan Bank stock and commercial paper, increased 244.43% for the three month period ended September 30, 2009, from the same period a year ago and 211.72% for the nine month period ended September 30, 2009, over one year ago as excess funds were invested.

Average interest-bearing deposits increased $139.32 million or 4.70% and $158.32 million or 5.29% respectively, for the third quarter of 2009 and first nine months of 2009, over the same periods in 2008. The effective rate paid on average interest-bearing deposits decreased 75 basis points to 1.98% for the third quarter 2009 compared to 2.73% for the third quarter 2008. The effective rate paid on average interest-bearing deposits decreased 89 basis points to 2.11% for the first nine months of 2009 compared to 3.00% for the first nine months of 2008. The decline in the average cost of interest-bearing deposits during the third quarter and first nine months of 2009 as compared to the third quarter and first nine months of 2008 was primarily the result of decreases in interest rates offered on deposit products due to decreases in market interest rates.

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Average short-term borrowings decreased $251.32 million or 58.73% and $182.00 million or 48.63% respectively, for the third quarter of 2009 and the first nine months of 2009, compared to the same periods in 2008. The decrease in average short-term borrowings was primarily due to lower repurchase agreements and lower Federal Home Loan Bank borrowings. Interest paid on short-term borrowings decreased 150 basis points for the third quarter of 2009 and 166 basis points for the first nine months of 2009 due to the interest rate decrease on adjustable rate borrowings. Average subordinated notes decreased $1.69 million for the first nine months of 2009, compared to the same period in 2008. Average long-term debt decreased $14.89 million or 42.77% during the third quarter of 2009 as compared to the third quarter of 2008 and decreased $14.02 million or 40.49% during the first nine months of 2009 as compared to the first nine months of 2008. The majority of the decrease in long-term debt consisted of Federal Home Loan Bank borrowings.

Average demand deposits increased $55.66 million and $43.48 million respectively, during the third quarter and first nine months of 2009, compared to the same periods one year ago.

The following table provides an analysis of net interest income and illustrates the interest earned and interest expense charged for each major component of interest-earning assets and interest-bearing liabilities. Yields/rates are computed on a tax-equivalent basis, using a 35% rate. Nonaccrual loans and leases are included in the average loan and lease balance outstanding.

| DISTRIBUTION OF ASSETS, LIABILITIES AND
SHAREHOLDERS' EQUITY | | | | | | | | | | | | |
| --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- |
| INTEREST
RATES AND INTEREST DIFFERENTIAL | | | | | | | | | | | | |
| (Dollars
in thousands) | | | | | | | | | | | | |
| | Three months ended September
30, | | | | | | Nine months ended September
30, | | | | | |
| | 2009 | | | 2008 | | | 2009 | | | 2008 | | |
| | | Interest | | | Interest | | | Interest | | | Interest | |
| | Average | Income/ | Yield/ | Average | Income/ | Yield/ | Average | Income/ | Yield/ | Average | Income/ | Yield/ |
| | Balance | Expense | Rate | Balance | Expense | Rate | Balance | Expense | Rate | Balance | Expense | Rate |
| ASSETS: | | | | | | | | | | | | |
| Investment
securities: | | | | | | | | | | | | |
| Taxable | $ 622,975 | $ 4,357 | 2.78 % | $ 461,448 | $ 4,896 | 4.22 % | $ 611,456 | $ 12,600 | 2.76 % | $ 498,066 | $ 17,288 | 4.64 % |
| Tax
exempt | 203,493 | 2,464 | 4.80 % | 220,524 | 2,573 | 4.64 % | 207,042 | 7,366 | 4.76 % | 227,235 | 8,156 | 4.79 % |
| Mortgages
- held for sale | 72,278 | 933 | 5.12 % | 32,794 | 523 | 6.34 % | 89,942 | 3,459 | 5.14 % | 33,868 | 1,544 | 6.09 % |
| Net
loans and leases | 3,130,362 | 42,673 | 5.41 % | 3,322,970 | 50,617 | 6.06 % | 3,184,394 | 129,559 | 5.44 % | 3,251,499 | 153,484 | 6.31 % |
| Other
investments | 130,210 | 297 | 0.90 % | 37,805 | 317 | 3.34 % | 113,664 | 894 | 1.05 % | 36,463 | 986 | 3.61 % |
| Total
Earning Assets | 4,159,318 | 50,724 | 4.84 % | 4,075,541 | 58,926 | 5.75 % | 4,206,498 | 153,878 | 4.89 % | 4,047,131 | 181,458 | 5.99 % |
| Cash
and due from banks | 57,028 | | | 79,943 | | | 58,807 | | | 88,126 | | |
| Reserve
for loan and lease losses | (84,382 | ) | | (73,187 | ) | | (84,240 | ) | | (69,490 | ) | |
| Other
assets | 331,360 | | | 317,712 | | | 327,137 | | | 318,181 | | |
| Total | $ 4,463,324 | | | $ 4,400,009 | | | $ 4,508,202 | | | $ 4,383,948 | | |
| LIABILITIES
AND SHAREHOLDERS' EQUITY: | | | | | | | | | | | | |
| Interest-bearing
deposits | $ 3,104,240 | $ 15,460 | 1.98 % | $ 2,964,923 | $ 20,347 | 2.73 % | $ 3,151,071 | $ 49,662 | 2.11 % | $ 2,992,747 | $ 67,116 | 3.00 % |
| Short-term
borrowings | 176,580 | 265 | 0.60 % | 427,895 | 2,255 | 2.10 % | 192,245 | 909 | 0.63 % | 374,246 | 6,434 | 2.30 % |
| Subordinated
notes | 89,692 | 1,648 | 7.29 % | 89,692 | 1,648 | 7.31 % | 89,692 | 4,942 | 7.37 % | 91,385 | 5,067 | 7.41 % |
| Long-term
debt and | | | | | | | | | | | | |
| mandatorily
redeemable securities | 19,928 | 322 | 6.42 % | 34,820 | 418 | 4.78 % | 20,610 | 853 | 5.53 % | 34,635 | 1,333 | 5.14 % |
| Total
Interest-Bearing Liabilities | 3,390,440 | 17,695 | 2.07 % | 3,517,330 | 24,668 | 2.79 % | 3,453,618 | 56,366 | 2.18 % | 3,493,013 | 79,950 | 3.06 % |
| Noninterest-bearing deposits | 431,773 | | | 376,112 | | | 420,209 | | | 376,727 | | |
| Other
liabilities | 67,292 | | | 62,348 | | | 71,212 | | | 71,046 | | |
| Shareholders'
equity | 573,819 | | | 444,219 | | | 563,163 | | | 443,162 | | |
| Total | $ 4,463,324 | | | $ 4,400,009 | | | $ 4,508,202 | | | $ 4,383,948 | | |
| Net
Interest Income | | $ 33,029 | | | $ 34,258 | | | $ 97,512 | | | $ 101,508 | |
| Net
Yield on Earning Assets on a Taxable Equivalent Basis | | | 3.15 % | | | 3.34 % | | | 3.10 % | | | 3.35 % |

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PROVISION AND RESERVE FOR LOAN AND LEASE LOSSES

The provision for loan and lease losses for the three and nine month periods ended September 30, 2009, was $6.47 million and $22.74 million respectively, compared to a provision for loan and lease losses in the three and nine month periods ended September 30, 2008, of $3.57 million and $9.60 million respectively. Net charge-offs of $4.09 million were recorded for the third quarter 2009, compared to net recoveries of $0.34 million for the same quarter a year ago. Year-to-date net charge-offs of $17.01 million have been recorded in 2009, compared to $0.60 million through September 2008.

On September 30, 2009, 30 day and over loan and lease delinquencies were 0.91% as compared to 0.83% on September 30, 2008. The change in delinquencies was primarily in medium and heavy duty trucks and construction equipment financing. The reserve for loan and lease losses as a percentage of loans and leases outstanding at the end of the period was 2.76% as compared to 2.28% one year ago and 2.42% at December 31, 2008. A summary of loan and lease loss experience during the three and nine month periods ended September 30, 2009 and 2008 is provided below.

| | Summary
of Reserve for Loan and Lease Losses | | | | | | | |
| --- | --- | --- | --- | --- | --- | --- | --- | --- |
| | (Dollars
in thousands) | | | | | | | |
| | Three
Months Ended | | | Nine
Months Ended | | | | |
| | September
30, | | | September
30, | | | | |
| | 2009 | 2008 | | 2009 | | 2008 | | |
| Reserve
for loan and lease losses - beginning balance | $ 83,124 | $ | 71,698 | $ | 79,776 | $ | 66,602 | |
| Charge-offs | (4,701 | ) | (1,006 | ) | (20,156 | ) | (3,921 | ) |
| Recoveries | 612 | | 1,343 | | 3,143 | | 3,322 | |
| Net
(charge-offs)/recoveries | (4,089 | ) | 337 | | (17,013 | ) | (599 | ) |
| Provision
for loan and lease losses | 6,469 | | 3,571 | | 22,741 | | 9,603 | |
| Reserve
for loan and lease losses - ending balance | $ 85,504 | $ | 75,606 | $ | 85,504 | $ | 75,606 | |
| Loans
and leases outstanding at end of period | $ 3,094,030 | $ | 3,314,863 | $ | 3,094,030 | $ | 3,314,863 | |
| Average
loans and leases outstanding during period | 3,130,362 | | 3,322,970 | | 3,184,394 | | 3,251,499 | |
| Reserve
for loan and lease losses as a percentage of | | | | | | | | |
| loans
and leases outstanding at end of period | 2.76 | % | 2.28 | % | 2.76 | % | 2.28 | % |
| Ratio
of net charge-offs/(recoveries) during period to | | | | | | | | |
| average
loans and leases outstanding | 0.52 | % | -0.04 | % | 0.71 | % | 0.02 | % |

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NONPERFORMING ASSETS

Nonperforming assets were as follows:

| (Dollars
in thousands) | September
30, | December
31, | September
30, |
| --- | --- | --- | --- |
| | 2009 | 2008 | 2008 |
| Loans
and leases past due 90 days or more | $ 1,125 | $ 1,022 | $ 1,476 |
| Nonaccrual
and restructured loans and leases | 80,361 | 36,555 | 22,812 |
| Other
real estate | 4,074 | 1,381 | 1,615 |
| Former
bank premises held for sale | 3,095 | 3,356 | 3,821 |
| Repossessions | 5,672 | 1,669 | 234 |
| Equipment
owned under operating leases | 74 | 185 | 40 |
| Total
nonperforming assets | $ 94,401 | $ 44,168 | $ 29,998 |

Nonperforming assets totaled $94.40 million at September 30, 2009, an increase of 113.73% from the $44.17 million reported at December 31, 2008, and a 214.69% increase from the $30.00 million reported at September 30, 2008. The increase during the first nine months of 2009 compared to the same period in 2008 and compared to December 31, 2008 was primarily related to nonaccrual and restructured loans and leases and repossessions.

The increase in nonaccrual and restructured loans and leases was spread among the various loan portfolios. The largest dollar increases during the most recent quarter occurred in the commercial and aircraft portfolios. We have limited exposure to commercial real estate. However, our borrowers with commercial real estate exposure, whether they be local market developers in our commercial portfolio or customers in our niche portfolios such as aircraft whose underlying business is dependent on developing, marketing and managing real estate properties, have suffered as a result of declining values and minimal sales activity. Furthermore, aircraft values have begun to decline, increasing the risk in aircraft secured transactions.

The increase in other real estate is due to foreclosing on well situated real estate in the local market for which we have a current appraisal and are well secured. The increase in repossessions related primarily to aircraft. Nonperforming assets as a percentage of total loans and leases were 2.95% at September 30, 2009, 1.30% at December 31, 2008, and 0.88% at September 30, 2008.

Repossessions consisted mainly of aircraft and construction equipment at September 30, 2009. At the time of repossession, the recorded amount of the loan or lease is written down, if necessary, to the estimated value of the equipment or vehicle by a charge to the reserve for loan and lease losses, unless the equipment is in the process of immediate sale. Any subsequent write-downs are included in noninterest expense.

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Supplemental Loan and Lease Information as of September 30, 2009

table of contents

| (Dollars
in thousands) | | Nonaccrual | Other
real estate | Year-to-date |
| --- | --- | --- | --- | --- |
| | Loans
and leases | and | owned
and | net
credit losses/ |
| | outstanding | restructured
loans | repossessions | (recoveries) |
| Commercial
and agricultural loans | $ 567,476 | $ 8,648 | $ 165 | $ 6,490 |
| Auto,
light truck and environmental equipment | 313,808 | 11,585 | 419 | 2,343 |
| Medium
and heavy duty truck | 219,762 | 12,336 | 12 | 2,408 |
| Aircraft
financing | 633,552 | 12,031 | 4,536 | 3,125 |
| Construction
equipment financing | 326,858 | 5,241 | 513 | 871 |
| Loans
secured by real estate | 917,754 | 30,378 | 4,074 | 1,100 |
| Consumer
loans | 114,820 | 142 | 27 | 1,449 |
| Total | $ 3,094,030 | $ 80,361 | $ 9,746 | $ 17,786 |

For financial statement purposes, nonaccrual loans and leases are included in loan and lease outstandings, whereas repossessions and other real estate are included in other assets. Net credit losses include net charge-offs on loans and leases and valuation adjustments and gains and losses on disposition of repossessions and defaulted operating leases.

NONINTEREST INCOME

Noninterest income for the three month period ended September 30, 2009 and 2008 was $20.26 million and $12.38 million, respectively. Noninterest income for the nine month period ended September 30, 2009 and 2008 was $63.51 million and $53.77 million, respectively. Details of noninterest income follow:

| (Dollars
in thousands) | Three
Months Ended | | | | | |
| --- | --- | --- | --- | --- | --- | --- |
| | September
30, | | September
30, | | | |
| | 2009 | 2008 | 2009 | | 2008 | |
| Noninterest
income: | | | | | | |
| Trust
fees | $ 3,782 | $ 4,939 | $ | 11,473 | $ 14,155 | |
| Service
charges on deposit accounts | 5,402 | 5,761 | | 15,367 | 16,633 | |
| Mortgage
banking income | 965 | 959 | | 6,874 | 3,493 | |
| Insurance
commissions | 1,022 | 1,084 | | 3,614 | 4,122 | |
| Equipment
rental income | 6,347 | 6,285 | | 18,896 | 17,794 | |
| Other
income | 2,022 | 2,168 | | 6,613 | 6,836 | |
| Investment
securities and other investment gains (losses) | 716 | (8,816 | ) | 673 | (9,259 | ) |
| Total
noninterest income | $ 20,256 | $ 12,380 | $ | 63,510 | $ 53,774 | |

Noninterest income decreased in all categories for the third quarter and year-to-date 2009 as compared to the same periods in 2008 except mortgage banking income, equipment rental income and investment gains (losses). Trust fees decreased $1.16 million, or 23.43%, during the third quarter of 2009 as compared to the third quarter of 2008, and $2.68 million or 18.95% for the first nine months of 2009 as compared to the first nine months of 2008. This decrease was primarily due a reduction in our investment advisory management fees received from the 1st Source Monogram Funds due to the sale of assets of 1st Source Investment Advisors related to the management of such funds in December 2008. The reduction in investment advisory management fees is partially offset by earnout fees on the sale which are reflected in other income. Service charges on deposit accounts decreased $0.36 million or 6.23% and $1.27 million or 7.61% during the first three and nine months of 2009, respectively as compared to the same periods in 2008. The decline in service charges on deposit accounts reflects a lower volume of fee income on overdraft and nonsufficient fund transactions.

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Mortgage banking income was flat in the third quarter of 2009 as compared to the third quarter of 2008 and increased $3.38 million or 96.79% for the nine months ended September 30, 2009 over the same period one year ago. This increase was due to recoveries of mortgage servicing rights impairment charges, gains on the sales of mortgage loans, and underwriting fees. Insurance commissions remained relatively stable for the third quarter and decreased $0.51 million, or 12.32% during the first nine months of 2009 as compared to the first nine months of 2008, mainly due to lower premiums as a result of market conditions and a reduction in customer accounts. Equipment rental income generated from operating leases increased during the first three and nine months of 2009 as compared to the first three and nine months of 2008 due to an increase in the operating lease portfolio from one year ago.

Other income decreased slightly for the three and nine month periods ended September 30, 2009 as compared to the same periods in 2008, mainly due to a reduction in fees generated from customer-related interest rate swaps and in credit card merchant fees which were offset by earnout fees on the sale of assets of 1st Source Investment Advisors related to the management of the 1st Source Monogram Funds in December 2008. The increase in investment securities and other investments (losses) gains was due to partnership gains and a reduction in other than temporary impairment of securities in the three and nine months ended September 30, 2009 as compared to the same periods one year ago.

NONINTEREST EXPENSE

Noninterest expense for the three month periods ended September 30, 2009 and 2008 was $36.57 million and $38.32 million, respectively. Noninterest expense for the nine month periods ended September 30, 2009 and 2008 was $112.56 million and $114.61 million, respectively. Details of noninterest expense follow:

| (Dollars
in thousands) | Three
Months Ended | | | | |
| --- | --- | --- | --- | --- | --- |
| | September
30, | | September
30, | | |
| | 2009 | 2008 | 2009 | | 2008 |
| Noninterest
expense: | | | | | |
| Salaries
and employee benefits | $ 18,425 | $ 19,297 | $ | 55,340 | $ 58,996 |
| Net
occupancy expense | 2,221 | 2,332 | | 7,095 | 7,289 |
| Furniture
and equipment expense | 3,241 | 3,694 | | 10,487 | 11,555 |
| Depreciation
- leased equipment | 5,021 | 5,041 | | 15,065 | 14,266 |
| Professional
fees | 1,020 | 2,773 | | 2,897 | 6,453 |
| Supplies
and communication | 1,473 | 1,812 | | 4,468 | 5,163 |
| Business
development and marketing expense | 655 | 881 | | 1,934 | 2,524 |
| Intangible
asset amortization | 340 | 351 | | 1,022 | 1,052 |
| Loan
and lease collection and repossession expense | 1,147 | (130 | ) | 2,776 | 672 |
| FDIC
and other insurance | 1,582 | 713 | | 6,851 | 1,396 |
| Other
expense | 1,445 | 1,553 | | 4,624 | 5,249 |
| Total
noninterest expense | $ 36,570 | $ 38,317 | $ | 112,559 | $ 114,613 |

During the third quarter of 2009, salaries and employee benefits decreased $0.87 million or 4.52% compared to the third quarter of 2008. The third quarter decrease was primarily a result of lower group insurance costs. For the first nine months of 2009, salaries and employee benefits decreased $3.66 million or 6.20% compared to the first nine months of 2008. This decrease was due to a reversal of post retirement benefit obligations, lower group insurance costs and reduced executive incentive provisions, offset by lower deferred salary expense. Furniture and equipment expense declined in the third quarter 2009, by $0.45 million or 12.25%, and in the first nine months of 2009, by $1.07 million or 9.24% as compared to the same periods in 2008. The decrease was primarily attributed to lower depreciation expense, computer processing charges and software costs.

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Leased equipment depreciation expense increased in conjunction with the increase in equipment rental income for the nine months ended September 30, 2009 as compared to the same period in 2008. Net occupancy, supplies and communication, business development and marketing, intangible asset amortization, and other expense all decreased slightly in 2009 over the same periods in 2008.

Professional fees decreased $1.75 million or 63.22% and $3.56 million or 55.11% for the three and nine month periods ended September 30, 2009 as compared to the three and nine month periods ended September 30, 2008, respectively. The decrease in professional fees in 2009 is the result of higher fees in 2008 due to a May 2008 systems security breach. Loan and lease collection and repossession expense increased $1.28 million for the third quarter and $2.10 million or for the first nine months of 2009 as compared to the same periods in 2008 due to increased collection and repossession activity.

FDIC and other insurance expense increased $0.87 million or 121.88% for the third quarter 2009 compared to the same period a year earlier, and $5.46 million or 390.76% for the first nine months of 2009 compared to the same period a year earlier due to higher Federal Deposit Insurance Corporation (FDIC) insurance premiums and a special FDIC insurance assessment of 5 basis points of assets minus tier 1 capital recorded in the second quarter 2009. In September 2009, the Board of Directors of the Federal Deposit Insurance Corporation (FDIC) adopted a Notice of Proposed Rulemaking (NPR) that would require insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter 2009 and all of 2010, 2011, and 2012. We have estimated our prepayment costs to be $21.57 million.

INCOME TAXES

The provision(benefit) for income taxes for the three and nine month periods ended September 30, 2009 was $2.53 million and $3.62 million respectively, compared to $(0.58) million and $7.31 million for the same periods in 2008. The effective tax rates were 27.31% and (14.99)% for the third quarters ended September 30, 2009 and 2008, respectively, and 15.83% and 25.74% for the nine months ended September 30, 2009 and 2008, respectively. The provision for income taxes for the nine months ended September 30, 2009 included a one time benefit of $2.60 million which resulted in the lower effective tax rate for the nine months ended September 30, 2009. This benefit was the result of a reduction in our tax contingency reserve due to the resolution of tax audits. The decrease in the effective tax rate in 2008 was mainly due to an increase in tax-exempt interest in relation to taxable income. Taxable income declined mainly due to the other than temporary impairment charge on investment securities.

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no material changes in market risks faced by 1st Source since December 31, 2008. For information regarding our market risk, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2008.

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ITEM 4.

CONTROLS AND PROCEDURES

As of the end of the period covered by this report an evaluation was carried out, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, at September 30, 2009, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by 1st Source in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and are designed to ensure that information required to be disclosed in those reports is accumulated and communicated to management as appropriate to allow timely decisions regarding required disclosure.

In addition, there were no changes in our internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the third fiscal quarter of 2009 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. Legal Proceedings.

1st Source and its subsidiaries are involved in various legal proceedings incidental to the conduct of our businesses. Management does not expect that the outcome of any such proceedings will have a material adverse effect on our consolidated financial position or results of operations.

ITEM 1A. Risk Factors.

There have been no material changes in risks faced by 1st Source since December 31, 2008. For information regarding our risk factors, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2008.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

ISSUER PURCHASES OF EQUITY SECURITIES

| | Total
number | Average | Total
number of — shares
purchased | Maximum
number (or approximate — dollar
value) of shares |
| --- | --- | --- | --- | --- |
| | of
shares | price
paid per | as
part of publicly announced | that
may yet be purchased under |
| Period | purchased | share | plans
or programs (1) | the
plans or programs |
| July
01 - 31, 2009 | - | - | - | 1,433,965 |
| August
01 - 31, 2009 | 19,347 | 16.41 | 19,347 | 1,414,618 |
| September
01 - 30, 2009 | 20,046 | 15.61 | 20,046 | 1,394,572 |
| (1) 1st
Source maintains a stock repurchase plan that was authorized by the Board
of Directors on April 26, 2007. Under the terms of the plan, 1st Source
may repurchase up to | | | | |
| 2,000,000 shares of its common stock when favorable conditions exist
on the open market or through private transactions at various prices from
time to time. Since the inception of | | | | |
| the
plan, 1st Source has repurchased a total of 605,428
shares. | | | | |

ITEM 3. Defaults Upon Senior Securities.

None

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ITEM 4. Submission of Matters to a Vote of Security Holders.

None

ITEM 5. Other Information.

None

ITEM 6. Exhibits

The following exhibits are filed with this report:

31.1 Certification of Chief Executive Officer required by Rule 13a-14(a).

31.2 Certification of Chief Financial Officer required by Rule 13a-14(a).

32.1 Certification pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer.

32.2 Certification pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer.

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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.

1st Source Corporation

DATE October 22, 2009 /s/CHRISTOPHER J. MURPHY III

Christopher J. Murphy III

Chairman of the Board, President and CEO

DATE October 22, 2009 /s/LARRY E. LENTYCH

Larry E. Lentych

Treasurer and Chief Financial Officer

Principal Accounting Officer

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