UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 2006
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________to_________
Commission file number 0-17071
FIRST MERCHANTS CORPORATION
(Exact name of registrant as specified in its charter)
Indiana 35-1544218
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
200 East Jackson
Muncie, Indiana 47305-2814
(Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (765) 747-1500
Securities registered pursuant to Section 12 (b) of the Act: None
Securities registered pursuant to Section 12 (g) of the Act:
Common Stock, $.125 stated value per share
(Title of class)
Indicate by check mark if the registrant is a well-known seasoned
issuer, as defined in Rule 405 of the Securities Act. Yes [ ] No [X]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X]
Indicate by check mark whether the registrant(1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act. Large accelerated filer[ ] Accelerated filer[X] Non-accelerated filer[ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Act). Yes [ ] No[X]
The aggregate market value (not necessarily a reliable indication of
the price at which more than a limited number of shares would trade) of the
voting stock held by non-affiliates of the registrant was $430,736,000 as of the
last business day of the registrant's most recently completed second fiscal
quarter (June 30, 2006).
As of March 8, 2007 there were 18,519,393 outstanding common shares,
without par value, of the registrant.
DOCUMENTS INCORPORATED BY REFERENCE
Part of Form 10-K
Documents Into Which Incorporated
Portions of the Registrant's Annual Part I (Item 1)
Report to Shareholders for the year
ended December 31, 2006 Part II (Items 5, 6, 7, 7A, and 8)
Portions of the Registrant's Part III (Items 10 through 14)
Definitive Proxy Statement for
Annual Meeting of Shareholders
to be held April 24, 2007
FORM 10-K TABLE OF CONTENTS
Form 10-K
Page
Number
STATEMENT REGARDING FORWARD-LOOKING STATEMENTS.................................3
PART I
Item 1 - Business............................................................4
Item 1A- Risk Factors.......................................................23
Item 1B- Unresolved Staff Comments..........................................26
Item 2 - Properties.........................................................27
Item 3 - Legal Proceedings..................................................27
Item 4 - Submission of Matters to a Vote of Security Holders................27
Supplemental Information - Executive Officers of the Registrant.............28
PART II
Item 5 - Market For the Registrant's Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity
Securities........................................................29
Item 6 - Selected Financial Data...........................................30
Item 7 - Management's Discussion and Analysis of Financial
Condition and Results of Operations...............................30
Item 7A- Quantitative and Qualitative Disclosures About Market Risk........30
Item 8 - Financial Statements and Supplementary Data.......................31
Item 9 - Changes In and Disagreements With Accountants on
Accounting and Financial Disclosure...............................31
Item 9A- Controls and Procedures...........................................31
Item 9B- Other Information.................................................32
PART III
Item 10- Directors and Executive Officers of the Registrant.................33
Item 11- Executive Compensation.............................................33
Item 12- Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters.....................34
Item 13- Certain Relationships and Related Transactions.....................34
Item 14- Principal Accounting Fees and Services.............................34
PART IV
Item 15- Exhibits and Financial Statement Schedules.........................35
Signatures.........................................................37
Exhibit Index......................................................38
Page 2
STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
The Corporation from time to time includes forward-looking statements in
its oral and written communication. The Corporation may include forward-looking
statements in filings with the Securities and Exchange Commission, such as this
Form 10-K, in other written materials and in oral statements made by senior
management to analysts, investors, representatives of the media and others. The
Corporation intends these forward-looking statements to be covered by the safe
harbor provisions for forward-looking statements contained in the Private
Securities Litigation Reform Act of 1995, and the Corporation is including this
statement for purposes of these safe harbor provisions. Forward-looking
statements can often be identified by the use of words like "believe",
"continue", "pattern", "estimate", "project", "intend", "anticipate", "expect"
and similar expressions or future or conditional verbs such as "will", "would",
"should", "could", "might", "can", "may", or similar expressions. These
forward-looking statements include:
* statements of the Corporation's goals, intentions and expectations;
* statements regarding the Corporation's business plan and growth
strategies;
* statements regarding the asset quality of the Corporation's loan and
investment portfolios; and
* estimates of the Corporation's risks and future costs and benefits.
These forward-looking statements are subject to significant risks,
assumptions and uncertainties, including, among other things, the following
important factors which could affect the actual outcome of future events:
* fluctuations in market rates of interest and loan and deposit pricing,
which could negatively affect the Corporation's net interest margin,
asset valuations and expense expectations;
* adverse changes in the economy, which might affect the Corporation's
business prospects and could cause credit-related losses and expenses;
* adverse developments in the Corporation's loan and investment
portfolios;
* competitive factors in the banking industry, such as the trend towards
consolidation in the Corporation's market;
* changes in the banking legislation or the regulatory requirements of
federal and state agencies applicable to bank holding companies and
banks like the Corporation's affiliate banks;
* acquisitions of other businesses by the Corporation and integration of
such acquired businesses;
* changes in market, economic, operational, liquidity, credit and interest
rate risks associated with the Corporation's business; and
* the continued availability of earnings and excess capital sufficient
for the lawful and prudent declaration and payment of cash dividends.
Because of these and other uncertainties, the Corporation's actual future
results may be materially different from the results indicated by these forward-
looking statements. In addition, the Corporation's past results of operations do
not necessarily indicate its future results.
Page 3
PART I
Item 1. BUSINESS
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GENERAL
First Merchants Corporation (the "Corporation") is a financial holding
company headquartered in Muncie, Indiana. The Corporation's Common Stock is
traded on NASDAQ's National Market System under the symbol FRME and was
organized in September 1982. Since its organization, the Corporation has grown
to include eight affiliate banks with over sixty-five locations in seventeen
Indiana and three Ohio counties, a trust company, a multi-line insurance agency,
a reinsurance agency, and a title agency.
The bank subsidiaries of the Corporation include the following:
* First Merchants Bank, National Association in Delaware and Hamilton
counties;
* The Madison Community Bank, National Association in Madison County;
* United Communities National Bank with locations in Randolph, Union,
Fayette, Wayne and Butler (OH) counties;
* The First National Bank of Portland in Jay County;
* Decatur Bank & Trust Company, National Association in Adams County;
* Frances Slocum Bank & Trust Company, National Association in Wabash,
Howard, and Miami counties;
* Lafayette Bank and Trust Company, National Association in Tippecanoe,
Carroll, Jasper, and White counties; and
* Commerce National Bank in Franklin and Hamilton counties in Ohio.
The Corporation approved on January 23, 2007, the combination of five of
its bank charters into one. Subject to the approval of the Office of the
Comptroller of the Currency (OCC), Frances Slocum Bank & Trust Company, N.A.,
Decatur Bank & Trust Company, N.A., First National Bank and United Communities
National Bank will combine with First Merchants Bank, N.A. The anticipated
effective date of the combinations is April 1, 2007. The Corporation also
approved, subject to OCC approval, the purchase by The Madison Community Bank of
five branches of First Merchants Bank located in Hamilton County, Indiana. The
anticipated effective date of the branch purchases is June 1, 2007. In
conjunction with the branch purchases, the name of The Madison Community Bank
will be changed to First Merchants Bank of Central Indiana, National Association
on April 1, 2007. As a result of these combinations, the Corporation will hold
four bank charters: First Merchants Bank, N.A., First Merchants Bank of Central
Indiana, N.A., Lafayette Bank and Trust Company, N.A. and Commerce National
Bank.
The Corporation also operates First Merchants Insurance Services, Inc. a
full- service property, casualty, personal lines, and health care insurance
agency headquartered in Muncie, Indiana. On September 1, 2005, Trustcorp
Financial Services of Greenville, Inc. merged with and into First Merchants
Insurance Services, Inc. The Corporation is also the majority owner of the
Indiana Title Insurance Company LLC, a full-service title insurance agency;
operates First Merchants Reinsurance Co. Ltd., a reinsurance agency; and
wholly-owns Merchants Trust Company, National Association, a trust and asset
management services company.
As of December 31, 2006, the Corporation had consolidated assets of
$3.6 billion, consolidated deposits of $2.8 billion and stockholders' equity of
$327 million. The Corporation is presently engaged in conducting commercial
banking business through the offices of its eight banking subsidiaries. As of
December 31, 2006, the Corporation and its subsidiaries had 1,131 full-time
equivalent employees.
Through its bank subsidiaries, the Corporation offers a broad range of
financial services, including: accepting time, savings and demand deposits;
making consumer, commercial, agri-business and real estate mortgage loans;
renting safe deposit facilities; providing personal and corporate trust
services; providing full service brokerage; and providing other corporate
services, letters of credit and repurchase agreements. Through various nonbank
subsidiaries, the Corporation also offers personal and commercial lines of
insurance and engages in the title agency business and the reinsurance of credit
life, accident, and health insurance.
Page 4
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GENERAL continued
The Corporation makes its Annual Report on Form 10-K, Quarterly Reports on
Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or
furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of
1934, as amended, available on its website at www.firstmerchants.com without
charge, as soon as reasonably practicable after such reports are electronically
filed with, or furnished to, the Securities and Exchange Commission. These
documents can also be read and copied at the Securities and Exchange
Commission's Public Reference Room at 450 Fifth Street, N.W., Washington, D.C.
20549. Please call the Securities and Exchange Commission at 1-800-SEC-0330 for
further information on the public reference room. Our SEC filings are also
available to the public at the Securities and Exchange Commission's web site at
http://www.sec.gov. Additionally, the Corporation will also provide without
charge, a copy of its Form 10-K to any shareholder by mail. Requests should be
sent to Mr. Brian Edwards, Shareholder Relations Officer, First Merchants
Corporation, P.O. Box 792, Muncie, IN 47308-0792.
ACQUISITION POLICY
The Corporation anticipates that it will continue its policy of geographic
expansion of its banking business through the acquisition of banks whose
operations are consistent with its community banking philosophy. Management
routinely explores opportunities to acquire financial institutions and other
financial services-related businesses and to enter into strategic alliances to
expand the scope of its services and its customer base.
COMPETITION
The Corporation's banking subsidiaries are located in Indiana and Ohio
counties where other financial services companies provide similar banking
services. In addition to the competition provided by the lending and deposit
gathering subsidiaries of national manufacturers, retailers, insurance companies
and investment brokers, the banking subsidiaries compete vigorously with other
banks, thrift institutions, credit unions and finance companies located within
their service areas.
REGULATION AND SUPERVISION
OF FIRST MERCHANTS CORPORATION AND SUBSIDIARIES
BANK HOLDING COMPANY REGULATION
The Corporation is registered as a bank holding company and has elected to
be a financial holding company. It is subject to the supervision of, and
regulation by the Board of Governors of the Federal Reserve System ("Federal
Reserve") under the Bank Holding Company Act of 1956, as amended (the "BHC
Act"). Bank holding companies are required to file periodic reports with and are
subject to periodic examination by the Federal Reserve. The Federal Reserve has
issued regulations under the BHC Act requiring a bank holding company to serve
as a source of financial and managerial strength to its subsidiary banks. Thus,
it is the policy of the Federal Reserve that a bank holding company should
stand ready to use its resources to provide adequate capital funds to its
subsidiary banks during periods of financial stress or adversity. Additionally,
under the Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA"), a bank holding company is required to guarantee the compliance of
any subsidiary bank that may become "undercapitalized" (as defined in the FDICIA
section of this Form 10-K) with the terms of any capital restoration plan filed
by such subsidiary with its appropriate federal banking agency. Under the BHC
Act, the Federal Reserve has the authority to require a bank holding company to
terminate any activity or relinquish control of a nonbank subsidiary (other than
a nonbank subsidiary of a bank) upon the determination that such activity
constitutes a serious risk to the financial stability of any bank subsidiary.
The BHC Act requires the Corporation to obtain the prior approval of the
Federal Reserve before:
1. Acquiring direct or indirect control or ownership of any voting shares of
any bank or bank holding company if, after such acquisition, the bank
holding company will directly or indirectly own or control more than 5% of
the voting shares of the bank or bank holding company.
2. Merging or consolidating with another bank holding company; or
3. Acquiring substantially all of the assets of any bank.
The BHC Act generally prohibits bank holding companies that have not become
financial holding companies from (i) engaging in activities other than banking
or managing or controlling banks or other permissible subsidiaries, and (ii)
acquiring or retaining direct or indirect control of any company engaged in the
activities other than those activities determined by the Federal Reserve to be
closely related to banking or managing or controlling banks.
The BHC Act does not place territorial restrictions on such nonbanking-
related activities.
Page 5
CAPITAL ADEQUACY GUIDELINES FOR BANK HOLDING COMPANIES
The Corporation is required to comply with the Federal Reserve's
risk-based capital guidelines. These guidelines require a minimum ratio of
capital to risk-weighted assets of 8% (including certain off-balance sheet
activities such as standby letters of credit). At least half of the total
required capital must be "Tier 1 capital," consisting principally of
stockholders' equity, noncumulative perpetual preferred stock, a limited amount
of cumulative perpetual preferred stock and minority interest in the equity
accounts of consolidated subsidiaries, less certain goodwill items. The
remainder may consist of a limited amount of subordinate debt and
intermediate-term preferred stock, certain hybrid capital instruments and other
debt securities, cumulative perpetual preferred stock, and a limited amount of
the general loan loss allowance.
In addition to the risk-based capital guidelines, the Federal Reserve has
adopted a Tier 1 (leverage) capital ratio under which the Corporation must
maintain a minimum level of Tier 1 capital to average total consolidated assets.
The ratio is 3% in the case of bank holding companies which have the highest
regulatory examination ratings and are not contemplating significant growth or
expansion. All other bank holding companies are expected to maintain a ratio of
at least 1% to 2% above the stated minimum.
The following are the Corporation's regulatory capital ratios as of
December 31, 2006:
Regulatory Minimum
Corporation Requirement
Tier 1 Capital: 9.2% 4.0%
(to risk-weighted assets)
Total Capital: 11.1% 8.0%
BANK REGULATION
Each of the Corporation's bank subsidiaries are national banks and are
supervised, regulated and examined by the Office of the Comptroller of the
Currency (the "OCC"). The OCC has the authority to issue cease-and-desist orders
if it determines that activities of the bank regularly represent an unsafe and
unsound banking practice or a violation of law. Federal law extensively
regulates various aspects of the banking business such as reserve requirements,
truth-in-lending and truth-in-savings disclosures, equal credit opportunity,
fair credit reporting, trading in securities and other aspects of banking
operations. Current federal law also requires banks, among other things, to make
deposited funds available within specified time periods.
Page 6
BANK CAPITAL REQUIREMENTS
The OCC has adopted risk-based capital ratio guidelines to which national
banks are subject. The guidelines establish a framework that makes regulatory
capital requirements more sensitive to differences in risk profiles. Risk-based
capital ratios are determined by allocating assets and specified off-balance
sheet commitments to four risk-weighted categories, with higher levels of
capital being required for the categories perceived as representing greater
risk.
Like the capital guidelines established by the Federal Reserve, these
guidelines divide a bank's capital into tiers. Banks are required to maintain a
total risk-based capital ratio of 8%. The OCC may, however, set higher capital
requirements when a bank's particular circumstances warrant. Banks experiencing
or anticipating significant growth are expected to maintain capital ratios,
including tangible capital positions, well above the minimum levels.
In addition, the OCC established guidelines prescribing a minimum Tier 1
leverage ratio (Tier 1 capital to adjusted total assets as specified in the
guidelines). These guidelines provide for a minimum Tier 1 leverage ratio of 3%
for banks that meet specified criteria, including that they have the highest
regulatory rating and are not experiencing or anticipating significant growth.
All other banks are required to maintain a Tier 1 leverage ratio of 3% plus an
additional 100 to 200 basis points.
All of the Corporation's affiliate banks exceed the risk-based capital
guidelines of the OCC as of December 31, 2006.
The Federal Reserve and the OCC have adopted rules to incorporate
market and interest rate risk components into their risk-based capital
standards. Amendments to the risk-based capital requirements, incorporating
market risk, became effective January 1, 1998. Under the new market risk
requirements, capital will be allocated to support the amount of market risk
related to a financial institution's ongoing trading activities.
FDIC IMPROVEMENT ACT OF 1991
The Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA") requires, among other things, federal bank regulatory authorities to
take "prompt corrective action" with respect to banks which do not meet minimum
capital requirements. For these purposes, FDICIA establishes five capital tiers:
well capitalized, adequately capitalized, undercapitalized, significantly
undercapitalized and critically undercapitalized. The FDIC has adopted
regulations to implement the prompt corrective action provisions of FDICIA.
"Undercapitalized" banks are subject to growth limitations and are
required to submit a capital restoration plan. A bank's compliance with such
plan is required to be guaranteed by the bank's parent holding company. If an
"undercapitalized" bank fails to submit an acceptable plan, it is treated as if
it is significantly undercapitalized. "Significantly undercapitalized" banks are
subject to one or more restrictions, including an order by the FDIC to sell
sufficient voting stock to become adequately capitalized, requirements to reduce
total assets and cease receipt of deposits from correspondent banks, and
restrictions on compensation of executive officers. "Critically
undercapitalized" institutions may not, beginning 60 days after becoming
"critically undercapitalized," make any payment of principal or interest on
certain subordinated debt or extend credit for a highly leveraged transaction or
enter into any transaction outside the ordinary course of business. In addition,
"critically undercapitalized" institutions are subject to appointment of a
receiver or conservator.
Page 7
FDICIA continued
As of December 31, 2006, each bank subsidiary of First Merchants is
"well capitalized" based on the "prompt corrective action" ratios and deadlines
described above. It should be noted, however, that a bank's capital category is
determined solely for the purpose of applying the OCC's "prompt corrective
action" regulations and that the capital category may not constitute an accurate
representation of the bank's overall financial condition or prospects.
DEPOSIT INSURANCE
The Corporation's affiliated banks are insured up to regulatory limits by
the FDIC and, accordingly, are subject to deposit insurance assessments to
maintain the Bank Insurance Fund (the "BIF") and the Savings Association
Insurance Fund ("SAIF") administered by the FDIC. The FDIC has adopted
regulations establishing a permanent risk-related deposit insurance assessment
system. Under this system, the FDIC places each insured bank in one of nine risk
categories based on (i) the bank's capitalization, and (ii) supervisory
evaluations provided to the FDIC by the institution's primary federal regulator.
Each insured bank's insurance assessment rate is then determined by the risk
category in which it is classified by the FDIC.
The Deposit Insurance Funds Act of 1996 provides for assessments to be
imposed on insured depository institutions with respect to deposits insured by
the BIF and the SAIF (in addition to assessments currently imposed on depository
institutions with respect to BIF- and SAIF-insured deposits) to pay for the cost
of Financing Corporation ("FICO") funding. The FICO assessments do not vary
depending upon a depository institution's capitalization or supervisory
evaluations.
DIVIDEND LIMITATIONS
National banking laws restrict the amount of dividends that an affiliate
bank may declare in a year without obtaining prior regulatory approval. National
banks are limited to the bank's retained net income (as defined) for the current
year plus those for the previous two years. At December 31, 2006, the
Corporation's affiliate banks had a total of $34,149,000 retained net profits
available for 2007 dividends to the Corporation without prior regulatory
approval.
BROKERED DEPOSITS
Under FDIC regulations, no FDIC-insured depository institution can
accept brokered deposits unless it (i) is well capitalized, or (ii) is
adequately capitalized and received a waiver from the FDIC. In addition, these
regulations prohibit any depository institution that is not well capitalized
from (a) paying an interest rate on deposits in excess of 76 basis points over
certain prevailing market rates or (b) offering "pass through" deposit insurance
on certain employee benefit plan accounts unless it provides certain notice to
affected depositors.
INTERSTATE BANKING AND BRANCHING
Under the Riegle-Neal Interstate Banking and Branching Efficiency Act
of 1994 ("Riegle-Neal") subject to certain concentration limits, required
regulatory approvals and other requirements, (i) financial holding companies
such as the Corporation are permitted to acquire banks and bank holding
companies located in any state; (ii) any bank that is a subsidiary of a bank
holding company is permitted to receive deposits, renew time deposits, close
loans, service loans and receive loan payments as an agent for any other bank
subsidiary of that holding company; and (iii) banks are permitted to acquire
branch offices outside their home states by merging with out-of-state banks,
purchasing branches in other states, and establishing de novo branch offices in
other states.
Page 8
FINANCIAL SERVICES MODERNIZATION ACT
The Gramm-Leach-Bliley Act of 1999 (the "Financial Services Modernization
Act") establishes a comprehensive framework to permit affiliations among
commercial banks, insurance companies, securities firms, and other financial
service providers by revising and expanding the existing BHC Act. Under this
legislation, bank holding companies would be permitted to conduct essentially
unlimited securities and insurance activities as well as other activities
determined by the Federal Reserve Board to be financial in nature or related to
financial services. As a result, the Corporation is able to provide securities
and insurance services. Furthermore, under this legislation, the Corporation is
able to acquire, or be acquired by, brokerage and securities firms and insurance
underwriters. In addition, the Financial Services Modernization Act broadens the
activities that may be conducted by national banks through the formation of
financial subsidiaries. Finally, the Financial Services Modernization Act
modifies the laws governing the implementation of the Community Reinvestment Act
and addresses a variety of other legal and regulatory issues affecting both
day-to-day operations and long-term activities of financial institutions.
A bank holding company may become a financial holding company if each of
its subsidiary banks is well capitalized, is well managed and has at least a
satisfactory rating under the Community Reinvestment Act, by filing a
declaration that the bank holding company wishes to become a financial holding
company. Also effective March 11, 2000, no regulatory approval is required for a
financial holding company to acquire a company, other than a bank or savings
association, engaged in activities that are financial in nature or incidental to
activities that are financial in nature, as determined by the Federal Reserve
Board. The Federal Reserve Bank of Chicago approved the Corporation's
application to become a Financial Holding Company effective September 13, 2000.
USA PATRIOT ACT
As part of the USA Patriot Act, signed into law on October 26, 2001,
Congress adopted the International Money Laundering Abatement and Financial
Anti-Terrorism Act of 2001 (the "Act"). The Act authorizes the Secretary of the
Treasury, in consultation with the heads of other government agencies, to adopt
special measures applicable to financial institutions such as banks, bank
holding companies, broker-dealers and insurance companies. Among its other
provisions, the Act requires each financial institution: (i) to establish an
anti-money laundering program; (ii) to establish due diligence policies,
procedures and controls that are reasonably designed to detect and report
instances of money laundering in United States private banking accounts and
correspondent accounts maintained for non-United States persons or their
representatives; and (iii) to avoid establishing, maintaining, administering, or
managing correspondent accounts in the United States for, or on behalf of, a
foreign shell bank that does not have a physical presence in any country. In
addition, the Act expands the circumstances under which funds in a bank account
may be forfeited and requires covered financial institutions to respond under
certain circumstances to requests for information from federal banking agencies
within 120 hours.
Treasury regulations implementing the due diligence requirements were
issued in 2002. These regulations required minimum standards to verify customer
identity, encouraged cooperation among financial institutions, federal banking
agencies, and law enforcement authorities regarding possible money laundering or
terrorist activities, prohibited the anonymous use of "concentration accounts,"
and required all covered financial institutions to have in place an anti-money
laundering compliance program.
The Act also amended the Bank Holding Company Act and the Bank Merger Act
to require the federal banking agencies to consider the effectiveness of a
financial institution's anti-money laundering activities when reviewing an
application under these acts.
Page 9
THE SARBANES-OXLEY ACT
The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act"), which became law on
July 30, 2002, added new legal requirements for public companies affecting
corporate governance, accounting and corporate reporting. The Sarbanes-Oxley Act
provides for, among other things:
* a prohibition on personal loans made or arranged by the issuer to its
directors and executive officers (except for loans made by a bank
subject to Regulation O);
* independence requirements for audit committee members;
* independence requirements for company auditors;
* certification of financial statements on Forms 10-K and 10-Q reports by
the chief executive officer and the chief financial officer;
* the forfeiture by the chief executive officer and chief financial
officer of bonuses or other incentive-based compensation and profits
from the sale of an issuer's securities by such officers in the
twelve month period following initial publication of any financial
statements that later require restatement due to corporate misconduct;
* disclosure of off-balance sheet transactions;
* two-business day filing requirements for insiders filing Form 4s;
* disclosure of a code of ethics for financial officers and filing a
Form 8-K for a change in or waiver of such code;
* the reporting of securities violations "up the ladder" by both in-house
and outside attorneys;
* restrictions on the use of non-GAAP financial measures in press releases
and SEC filings;
* the formation of a public accounting oversight board; and
* various increased criminal penalties for violations of securities laws.
The Sarbanes-Oxley Act contains provisions which became effective upon
enactment on July 30, 2002,including provisions which became effective from
within 30 days to one year from enactment. The SEC has been delegated the task
of enacting rules to implement various provisions. In addition, each of the
national stock exchanges developed new corporate governance rules, including
rules strengthening director independence requirements for boards, the adoption
of corporate governance codes and charters for the nominating, corporate
governance and audit committees.
ADDITIONAL MATTERS
The Corporation and its affiliate banks are subject to the Federal Reserve
Act, which restricts financial transactions between banks and affiliated
companies. The statute limits credit transactions between banks, affiliated
companies and its executive officers and its affiliates. The statute prescribes
terms and conditions for bank affiliate transactions deemed to be consistent
with safe and sound banking practices, and restricts the types of collateral
security permitted in connection with the bank's extension of credit to an
affiliate. Additionally, all transactions with an affiliate must be on terms
substantially the same or at least as favorable to the institution as those
prevailing at the time for comparable transactions with non-affiliated parties.
In addition to the matters discussed above, the Corporation's affiliate
banks are subject to additional regulation of their activities, including a
variety of consumer protection regulations affecting their lending, deposit and
collection activities and regulations affecting secondary mortgage market
activities.
The earnings of financial institutions are also affected by general
economic conditions and prevailing interest rates, both domestic and foreign,
and by the monetary and fiscal policies of the United States Government and its
various agencies, particularly the Federal Reserve. The Federal Reserve
regulates the supply of credit in order to influence general economic
conditions, primarily through open market operations in United States government
obligations, varying the discount rate on financial institution borrowings,
varying reserve requirements against financial institution deposits, and
restricting certain borrowings by financial institutions and their subsidiaries.
The monetary policies of the Federal Reserve have had a significant effect on
the operating results of the bank subsidiaries in the past and are expected to
continue to do so in the future.
Additional legislation and administrative actions affecting the banking
industry may be considered by the United States Congress, state legislatures and
various regulatory agencies, including those referred to above. It cannot be
predicted with certainty whether such legislation or administrative action will
be enacted or the extent to which the banking industry in general or the
Corporation and its affiliate banks in particular would be affected.
Page 10
STATISTICAL DATA
The following tables set forth statistical data relating the Corporation and its
subsidiaries.
DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY;
INTEREST RATES AND INTEREST DIFFERENTIAL
The daily average balance sheet amounts, the related interest income or expense,
and average rates earned or paid are presented in the following table.
(Dollars in Thousands)
2006 2005 2004
------------------------------ ------------------------------ ------------------------------
Interest Interest Interest
Average Income/ Average Average Income/ Average Average Income/ Average
Balance Balance Rate Balance Balance Rate Balance Balance Rate
--------- --------- -------- --------- --------- -------- --------- --------- --------
Assets:
Federal funds sold ............ $ 6,983 $ 373 5.3% $ 8,385 $ 264 3.1% $ 7,759 $ 165 2.1%
Interest-bearing deposits...... 7,831 500 6.4 16,683 695 4.2 17,500 555 3.2
Federal Reserve and
Federal Home Loan Bank stock. 23,473 1,256 5.4 23,019 1,185 5.1 22,655 1,250 5.5
Securities: (1)
Taxable ....................... 289,692 12,316 4.3 263,435 9,612 3.6 247,930 8,371 3.4
Tax-exempt (3)................. 175,072 10,100 5.8 162,965 9,807 6.0 141,205 9,382 6.6
---------- -------- ---------- -------- ---------- --------
Total Securities............. 464,764 22,416 4.8 426,400 19,419 4.6 389,135 17,753 4.6
Mortgage loans held for sale..... 4,620 176 3.8 2,746 113 4.1 4,205 240 5.7
Loans: (2)
Commercial .................... 1,704,026 128,888 7.6 1,569,270 105,740 6.7 1,495,195 89,108 6.0
Bankers' acceptance and
Commercial paper purchased...
Real estate mortgage........... 441,407 27,813 6.3 464,426 27,334 5.9 486,377 27,969 5.8
Installment ................... 405,006 29,891 7.4 385,097 25,248 6.6 372,817 22,636 6.1
Tax-exempt (3)................. 14,788 1,274 8.6 12,595 989 7.9 10,423 894 8.6
---------- -------- ---------- -------- ---------- --------
Total loans ................. 2,569,847 188,042 7.3 2,434,134 159,424 6.5 2,369,017 140,847 5.9
---------- -------- ---------- -------- ---------- --------
Total earning assets......... 3,072,898 212,587 6.9 2,908,621 180,987 6.3 2,806,066 160,570 5.7
---------- -------- ---------- -------- ---------- --------
Net unrealized gain (loss) on securities
available for sale........... (7,353) (1,217) 4,676
Allowance for loan losses........ (26,443) (24,889) (26,093)
Cash and due from banks.......... 58,305 53,037 63,420
Premises and equipment .......... 40,227 38,284 38,397
Other assets .................... 233,752 205,628 222,638
--------- --------- ---------
Total assets ................ $3,371,386 $3,179,464 $3,109,104
========== ========== ==========
Liabilities:
Interest-bearing deposits:
NOW accounts ................ $ 396,477 6,065 1.5% $ 395,356 2,058 0.5% $ 346,525 1,779 0.5%
Money market deposit accounts 251,746 7,551 3.0 280,508 4,899 1.7 359,359 3,219 0.9
Savings deposits ............ 259,052 3,927 1.5 319,552 2,583 0.8 297,364 992 0.3
Certificates and other
time deposits ............. 1,333,408 56,771 4.3 1,149,679 36,581 3.2 1,051,092 27,854 2.7
---------- -------- ---------- -------- ---------- --------
Total interest-bearing
deposits..................... 2,240,683 74,314 3.3 2,145,095 46,121 2.2 2,054,340 33,844 1.6
Borrowings ...................... 445,806 24,197 5.4 412,091 19,959 4.8 402,776 17,741 4.4
---------- -------- ---------- -------- ---------- --------
Total interest-bearing
liabilities................. 2,686,489 98,511 3.7 2,557,186 66,080 2.6 2,457,116 51,585 2.1
Noninterest-bearing deposits..... 327,387 273,657 310,966
Other liabilities ............... 37,991 33,096 31,018
---------- ---------- ----------
Total liabilities............ 3,051,867 2,863,939 2,799,100
Stockholders' equity ............ 319,519 315,525 310,004
---------- ---------- ----------
Total liabilities and
stockholders' equity........ $3,371,386 98,511 3.2 $3,179,464 66,080 2.3 $3,109,104 51,585 1.8
========== -------- ========== -------- ========== --------
Net interest income ......... $114,076 $114,907 $108,985
======== ======== ========
Net interest margin.......... 3.7 4.0 3.9
(1) Average balance of securities is computed based on the average of the
historical amortized cost balances without the effects of the fair value
adjustment.
(2) Nonaccruing loans have been included in the average balances.
(3) Tax exempt securities and loans are presented on a fully taxable
equivalent basis, using a marginal tax rate of 35% for 2006, 2005,
and 2004.......................... $3,981 $3,778 $3,597
====== ====== ======
Page 11
STATISTICAL DATA (continued)
----------------
ANALYSIS OF CHANGES IN NET INTEREST INCOME
The following table presents net interest income components on a tax-equivalent
basis and reflects changes between periods attributable to movement in either
the average balance or average interest rate for both earning assets and
interest-bearing liabilities. The volume differences were computed as the
difference in volume between the current and prior year times the interest rate
of the prior year, while the interest rate changes were computed as the
difference in rate between the current and prior year times the volume of the
prior year. Volume/rate variances have been allocated on the basis of the
absolute relationship between volume variances and rate variances.
2006 Compared to 2005 2005 Compared to 2004
Increase (Decrease) Due To Increase (Decrease) Due To
---------------------------------------- -----------------------------------------
Volume Rate Total Volume Rate Total
------ ---- ----- ------ ---- -----
(Dollars in Thousands on Fully Taxable Equivalent Basis)
Interest income:
Federal funds sold ............... $ (50) $ 159 $ 109 $ 14 $ 85 $ 99
Interest-bearing deposits ........ (467) 272 (195) (27) 167 140
Federal Reserve and Federal
Home Loan Bank stock ........... 24 47 71 36 (101) (65)
Securities ....................... 1,809 1,188 2,997 1,697 (31) 1,666
Mortgage loans held for sale ..... 72 (9) 63 (70) (57) (127)
Loans ............................ 9,098 19,457 28,555 4,027 14,677 18,704
-------- --------- --------- -------- --------- ---------
Totals ........................... 10,486 21,114 31,600 5,677 14,740 20,417
-------- --------- --------- -------- --------- ---------
Interest expense:
NOW accounts ..................... 6 4,001 4,007 254 25 279
Money market deposit
accounts........................ (547) 3,199 2,652 (832) 2,512 1,680
Savings deposits.................. (565) 1,909 1,344 79 1,512 1,591
Certificates and other
time deposits................... 6,480 13,710 20,190 2,780 5,947 8,727
Borrowings........................ 1,713 2,525 4,238 418 1,800 2,218
-------- --------- --------- -------- --------- ---------
Totals.......................... 7,087 25,344 32,431 2,699 11,796 14,495
-------- --------- --------- -------- --------- ---------
Change in net interest
income (fully taxable
equivalent basis)................ $ 3,399 $ (4,230) (831) $ 2,978 $ 2,944 5,922
======== ========= ======== =========
Tax equivalent adjustment
using marginal rate
of 35% for 2006, 2005,
and 2004.......................... (203) (182)
---------- ----------
Change in net interest
income........................... $ (1,034) $ 5,740
========== ==========
Page 12
STATISTICAL DATA (continued)
INVESTMENT SECURITIES
The amortized cost, gross unrealized gains, gross unrealized losses and
approximate market value of the investment securities at the dates indicated
were:
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
---------------- --------------- -------------- --------------
(Dollars in Thousands)
Available for sale at December 31, 2006
U.S. Treasury ............................... $ 1,502 $ 1 $ 1,503
U.S. Government-sponsored agency securities.. 87,193 69 $ 1,284 85,978
State and municipal ......................... 168,262 2,251 892 169,621
Mortgage-backed securities .................. 195,228 600 3,983 191,845
Marketable equity securities ................ 7,296 310 6,986
-------- -------- -------- --------
Total available for sale ................. 459,481 2,921 6,469 455,933
-------- -------- -------- --------
Held to maturity at December 31, 2006
State and municipal ......................... 9,266 432 200 9,498
Mortgage-backed securities .................. 18 18
-------- -------- -------- --------
Total held to maturity ................... 9,284 432 200 9,516
-------- -------- -------- --------
Total investment securities .............. $468,765 $ 3,353 $ 6,669 $465,449
======== ======== ======== ========
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
---------------- --------------- -------------- --------------
(Dollars in Thousands)
Available for sale at December 31, 2005
U.S. Treasury ............................... $ 1,586 $ 1 $ 1,585
U.S. Government-sponsored agency securities.. 83,026 $ 1 1,836 81,191
State and municipal ......................... 167,095 2,159 1,131 168,123
Mortgage-backed securities .................. 168,019 139 5,656 162,502
Other asset-backed securities ............... 1 1
Marketable equity securities ................ 9,660 435 9,225
-------- -------- -------- --------
Total available for sale ................. 429,387 2,299 9,059 422,627
-------- -------- -------- --------
Held to maturity at December 31, 2005
State and municipal ......................... 11,609 283 412 11,480
Mortgage-backed securities .................. 30 30
-------- -------- -------- --------
Total held to maturity ................... 11,639 283 412 11,510
-------- -------- -------- --------
Total investment securities .............. $441,026 $ 2,582 $ 9,471 $434,137
======== ======== ======== ========
Page 13
--------------------------------------------------------------------------------
STATISTICAL DATA (continued)
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
---------------- --------------- -------------- --------------
(Dollars in Thousands)
Available for sale at December 31, 2004
U.S. Treasury ............................... $ 1,745 $ 1 $ 1,744
U.S. Government-sponsored agency securities.. 65,325 $ 73 332 65,066
State and municipal ......................... 150,284 5,243 82 155,445
Mortgage-backed securities .................. 183,200 485 1,980 181,705
Other asset-backed securities ............... 18 18
Marketable equity securities ................ 12,191 8 12,199
-------- -------- -------- --------
Total available for sale ................. 412,763 5,809 2,395 416,177
-------- -------- -------- --------
Held to maturity at December 31, 2004
State and municipal ......................... 5,306 162 5,468
Mortgage-backed securities .................. 52 52
-------- -------- -------- --------
Total held to maturity ................... 5,358 162 5,520
-------- -------- -------- --------
Total investment securities .............. $418,121 $ 5,971 $ 2,395 $421,697
======== ======== ======== ========
Cost
----------------------------------------------------------
2006 2005 2004
---- ---- ----
(Dollars in Thousands)
Federal Reserve and Federal Home Loan
Bank stock at December 31:
Federal Reserve Bank stock .................... $ 9,091 $ 8,913 $ 8,814
Federal Home Loan Bank stock .................. 14,600 14,287 14,044
------- ------- -------
Total ..................................... $23,691 $23,200 $22,858
======= ======= =======
The fair value of Federal Reserve and Federal Home Loan Bank stock approximates
cost.
There were no issuers included in our investment security portfolio at December
31, 2006, 2005 or 2004 where the aggregate carrying value of any one issuer
exceeded 10 percent of the Corporation's stockholders' equity at those dates.
The term "issuer" excludes the U.S. Government and its sponsored agencies and
corporations.
The maturity distribution (Dollars in Thousands) and average yields for the
securities portfolio at December 31, 2006 were:
Securities available for sale December 31, 2006:
Within 1 Year 1-5 Years 5-10 Years
------------- --------- ----------
Amount Yield* Amount Yield* Amount Yield*
------ ------ ------ ------ ------ ------
U.S. Treasury................................ $ 1,503 4.8%
U.S. Government-sponsored agency securities.. $15,236 3.4% 69,864 4.1 $ 878 6.6%
State and Municipal.......................... 18,216 4.1 91,671 4.9 50,737 6.5
------- -------- -------
Total.................................... $33,452 3.8% $163,038 4.5% $51,615 6.5%
======= ======== =======
Page 14
--------------------------------------------------------------------------------
STATISTICAL DATA (continued)
Marketable Equity
and Mortgage -
Due After Ten Years Backed Securities Total
------------------- ----------------------- -----
Amount Yield* Amount Yield* Amount Yield*
------ ------ ------ ------ ------ ------
U.S. Treasury........................ $ 1,503 4.8%
U.S. Government-sponsored
agency securities................. 85,978 4.0
State and Municipal.................. $ 8,997 7.9% 169,621 5.4
Marketable equity securities......... $ 6,986 5.8% 6,986 5.8
Mortgage-backed securities........... 191,845 4.5 191,845 4.5
-------- --------- --------
Total............................ $ 8,997 7.9% $ 198,831 4.6% $455,933 4.8%
======== ========= ========
Securities held to maturity at December 31, 2006:
Within 1 Year 1-5 Years 5-10 Years
------------- --------- ----------
Amount Yield* Amount Yield* Amount Yield*
------ ------ ------ ------ ------ ------
State and municipal.................. $ 125 7.2% $ 830 7.6% $ 880 6.1%
Mortgage-Backed
Due After Ten Years Securities Total
------------------- ------------ -----
Amount Yield* Amount Yield* Amount Yield*
------ ------ ------ ------ ------ ------
State and municipal.................. $ 7,431 7.1% $ 9,266 7.0%
Other asset-backed securities........ $ 18 8.4% 18 8.4
------- ------- -------
Total............................ $ 7,431 7.1% $ 18 8.4% $ 9,284 7.0%
======= ======= =======
*Interest yields on state and municipal securities are presented on a fully
taxable equivalent basis using a 35% rate.
Page 15
STATISTICAL DATA (continued)
Federal Reserve and Federal Home Loan Bank stock at December 31, 2006:
(Dollars in Thousands)
Amount Yield
Federal Reserve Bank Stock........... $ 9,091 6.0%
Federal Home Loan Bank stock......... 14,600 4.3
-------
Total............................ $23,691 4.9%
=======
The following tables show the Corporation's gross unrealized losses and fair
value, aggregated by investment category and length of time that individual
securities have been in a continuous unrealized loss position at December 31,
2006 and 2005:
Less than 12 12 Months or Total
Months Longer
---------------------------------------------------------------------------
GROSS GROSS GROSS
FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED
VALUE LOSSES VALUE LOSSES VALUE LOSSES
---------------------------------------------------------------------------
(Dollars in Thousands)
Temporarily impaired investment
securities at December 31, 2006:
U.S. Government-sponsored agency securities........... $ 1,576 $ (3) $ 71,702 $ (1,281) $ 73,278 $ (1,284)
State and municipal .................................. 9,608 (35) 81,841 (1,057) 91,449 (1,092)
Mortgage-backed securities ........................... 7,457 (20) 126,555 (3,963) 134,012 (3,983)
Corporate obligatoins ................................ 28 (6) 28 (6)
Marketable equity securities ......................... 1,215 (304) 1,215 (304)
---------- ---------- ---------- ---------- ---------- ----------
Total temporarily impaired investment securities .. $ 19,856 $ (362) $ 280,126 $ (6,307) $299,982 $ (6,669)
========== ========== ========== ========== ========== ==========
Less than 12 12 Months or Total
Months Longer
---------------------------------------------------------------------------
GROSS GROSS GROSS
FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED
VALUE LOSSES VALUE LOSSES VALUE LOSSES
---------------------------------------------------------------------------
(Dollars in Thousands)
Temporarily impaired investment
securities at December 31, 2005:
U.S. Treasury ........................................ $ 1,487 $ (1) $ 1,487 $ (1)
U.S. Government-sponsored agency securities........... 31,692 (581) $ 45,466 $ (1,255) 77,158 (1,836)
State and municipal .................................. 90,905 (1,501) 2,124 (42) 93,029 (1,543)
Mortgage-backed securities ........................... 59,595 (1,511) 96,120 (4,141) 155,715 (5,652)
Marketable equity securities.......................... 27 (8) 1,072 (431) 1,099 (439)
---------- ---------- ---------- ---------- ---------- ----------
Total temporarily impaired investment securities .. $ 183,706 $ (3,602) $ 144,782 $ (5,869) $328,488 $ (9,471)
========== ========== ========== ========== ========== ==========
Page 16
STATISTICAL DATA (continued)
LOAN PORTFOLIO
TYPES OF LOANS
The loan portfolio at the dates indicated is presented below:
2006 2005 2004 2003 2002
---- ---- ---- ---- ----
(Dollars in Thousands)
Loans at December 31:
Commercial and industrial loans.............. $ 537,305 $ 461,102 $ 451,227 $ 435,221 $ 401,395
Agricultural production
financing and other loans to farmers....... 100,098 95,130 98,902 95,048 85,059
Real estate loans:
Construction............................... 169,491 174,783 164,738 149,865 133,896
Commercial and farmland.................... 861,429 734,865 709,163 564,578 401,561
Residential................................ 749,921 751,217 761,163 866,477 746,349
Individuals' loans for
household and other personal expenditures.. 223,504 200,139 198,532 196,093 206,083
Tax-exempt loans............................. 14,423 8,263 8,203 16,363 12,615
Lease financing receivibles,
net of unearned income .................... 8,010 8,713 11,311 7,919 5,249
Other loans.................................. 28,420 23,215 24,812 21,939 12,170
---------- ---------- ---------- ---------- ----------
Total loans........................ $2,692,601 $2,457,427 $2,428,051 $2,353,503 $2,004,377
========== ========== ========== ========== ==========
Residential Real Estate Loans Held for Sale at December 31, 2006, 2005, 2004,
2003 and 2002 were $5,413,000, $4,910,000, $3,367,000, $3,043,000, and
$21,545,000.
MATURITIES AND SENSITIVITIES OF LOANS TO CHANGES IN INTEREST RATES
Presented in the table below are the maturities of loans (excluding residential
real estate, individuals' loans for household and other personal expenditures
and lease financing) outstanding as of December 31, 2006. Also presented are the
amounts due after one year classified according to the sensitivity to changes in
interest rates.
Maturing
Within 1-5 Over
1 Year Years 5 Years Total
-------------- --------------- -------------- ------------
(Dollars in Thousands)
Commercial and industrial loans................ $ 310,241 $ 147,678 $ 79,386 $ 537,305
Agricultural production financing
and other loans to farmers................... 79,024 16,442 4,632 100,098
Real estate - Construction..................... 132,547 31,940 5,004 169,491
Real estate - Commercial and farmland.......... 231,602 446,476 183,351 861,429
Tax-exempt loans............................... 5,442 3,695 5,286 14,423
Other loans.................................... 8,250 14,449 5,721 28,420
---------- --------- --------- ----------
Total.................................... $ 767,106 $ 660,680 $283,380 $1,711,166
========== ========= ========= ==========
Page 17
STATISTICAL DATA (continued)
Maturing
---------------------------------------------------
1 - 5 Over
Years 5 Years
----- -------
(Dollars in Thousands)
Loans maturing after one year with:
Fixed rate.............................. $ 184,861 $ 177,846
Variable rate........................... 475,819 105,534
------------- ------------
Total................................. $ 660,680 $ 283,380
============= ============
NONACCRUING, CONTRACTUALLY PAST DUE 90 DAYS OR MORE
OTHER THAN NONACCRUING AND RESTRUCTURED LOANS
December 31
---------------------------------------------------------------
2006 2005 2004 2003 2002
---- ---- ---- ---- ----
(Dollars in Thousands)
Nonaccruing loans......................... $17,926 $10,030 $15,355 $19,453 $14,134
Loans contractually past due 90
days or more other than
nonaccruing............................. 2,870 3,965 1,907 6,530 6,676
Restructured loans........................ 84 310 2,019 641 2,508
------- ------- ------- ------- -------
$20,880 $14,305 $19,281 $26,624 $23,318
======= ======= ======= ======= =======
Nonaccruing loans are loans which are reclassified to a nonaccruing status when
in management's judgment the collateral value and financial condition of the
borrower do not justify accruing interest. Interest previously recorded, but not
deemed collectible, is reversed and charged against current income. Interest
income on these loans is then recognized when collected.
Restructured loans are loans for which the contractual interest rate has been
reduced or other concessions are granted to the borrower, because of a
deterioration in the financial condition of the borrower resulting in the
inability of the borrower to meet the original contractual terms of the loans.
Interest income of $1,365,000 for the year ended December 31, 2006, was
recognized on the nonaccruing and restructured loans listed in the table above,
whereas interest income of $1,650,000 would have been recognized under their
original loan terms.
Potential problem loans:
Management has identified certain other loans totaling $66,656,000 as of
December 31, 2006, not included in the table above, or the impaired loan table
in the footnotes to the consolidated financial statements, about which there are
doubts as to the borrowers' ability to comply with present repayment terms.
The Corporation's affiliate banks generate commercial, mortgage and consumer
loans from customers located primarily in north-central and east-central Indiana
and Butler, Franklin and Hamilton counties in Ohio. The Banks' loans are
generally secured by specific items of collateral, including real property,
consumer assets, and business assets.
Page 18
STATISTICAL DATA (continued)
----------------
SUMMARY OF LOAN LOSS EXPERIENCE
The following table summarizes the loan loss experience for the years indicated.
2006 2005 2004 2003 2002
---- ---- ---- ---- ----
(Dollars in Thousands)
Allowance for loan losses:
Balance at January 1.................... $ 25,188 $ 22,548 $ 25,493 $ 22,417 $ 15,141
Charge-offs:
Commercial and industrial(1)........... 1,369 3,763 7,455 5,023 4,711
Real estate mortgage(3)................ 3,613 2,117 1,588 2,111 800
Individuals' loans for household and
other personal expenditures,
including other loans................ 1,528 1,864 1,858 5,005 2,602
-------- -------- -------- -------- --------
Total charge-offs.................... 6,510 7,744 10,901 12,139 8,113
-------- -------- -------- -------- --------
Recoveries:
Commercial and industrial(2)........... 291 1,283 1,629 1,002 549
Real estate mortgage(4)................ 863 122 161 421 92
Individuals' loans for household and
other personal expenditures,
including other loans................ 450 625 461 588 672
-------- -------- -------- -------- --------
Total recoveries..................... 1,604 2,030 2,251 2,011 1,313
-------- -------- -------- -------- --------
Net charge-offs.......................... 4,906 5,714 8,650 10,128 6,800
-------- -------- -------- -------- --------
Provisions for loan losses............... 6,258 8,354 5,705 9,477 7,174
Allowance acquired in purchase........... 3,727 6,902
-------- -------- -------- -------- --------
Balance at December 31................... $26,540 $25,188 $22,548 $25,493 $22,417
======== ======== ======== ======== ========
(1)Category also includes the charge-offs for lease financing, loans to
financial institutions, tax-exempt loans and agricultural production
financing and other loans to farmers.
(2)Category also includes the recoveries for lease financing, loans to
financial institutions, tax-exempt loans and agricultural production
financing and other loans to farmers.
(3)Category includes the charge-offs for construction, commercial and farmland
and residential real estate loans.
(4)Category includes the recoveries for construction, commercial and farmland
and residential real estate loans.
Ratio of net charge-offs during the
period to average loans
outstanding during the period.......... .19% .23% .37% .44% .37%
Page 19
STATISTICAL DATA (continued)
----------------
The information regarding the analysis of loan loss experience on pages 8, 9 and
10 of the First Merchants Corporation - Annual Report 2006 under the caption
"ASSET QUALITY/PROVISION FOR LOAN LOSSES" is expressly incorporated herein by
reference.
Allocation of the Allowance for Loan Losses at December 31:
Presented below is an analysis of the composition of the allowance for loan
losses and percent of loans in each category to total loans:
2006 2005
------------------------- -------------------------
Amount Per Cent Amount Per Cent
-------- -------- -------- --------
(Dollars in Thousands)
Balance at December 31:
Commercial and industrial(1)................ $ 9,598 31.0% $ 7,430 31.0%
Real estate mortgage(2)..................... 12,479 60.5 13,149 60.5
Individuals' loans for household and
other personal expenditures,
including other loans..................... 4,363 8.5 4,509 8.5
Unallocated................................. 100 N/A 100 N/A
-------- ------ -------- ------
Totals...................................... $ 26,540 100.0% $ 25,188 100.0%
======== ====== ======== ======
2004 2003
------------------------- -------------------------
Amount Per Cent Amount Per Cent
-------- -------- -------- --------
(Dollars in Thousands)
Balance at December 31:
Commercial and industrial(1)................ $ 16,821 30.9% $ 17,517 29.9%
Real estate mortgage(2)..................... 1,916 60.6 4,441 60.8
Individuals' loans for household and
other personal expenditures,
including other loans..................... 3,711 8.5 3,435 9.3
Unallocated................................. 100 N/A 100 N/A
-------- ------ -------- ------
Totals...................................... $ 22,548 100.0% $ 25,493 100.0%
======== ====== ======== ======
2002
-------------------------
Amount Per Cent
-------- --------
(Dollars in Thousands)
Balance at December 31:
Commercial and industrial(1)................ $ 12,405 31.8%
Real estate mortgage(2)..................... 2,875 57.3
Individuals' loans for household and
other personal expenditures,
including other loans..................... 7,037 10.9
Unallocated. .... .......................... 100 N/A
-------- ------
Totals...................................... $ 22,417 100.0%
======== ======
(1) Category also includes the allowance for loan losses and percent of
loans for lease financing, loans to financial institutions, tax-exempt
loans, agricultural production financing and other loans to farmers and
construction real estate loans.
(2) Category includes the allowance for loan losses and percent of loans for
commercial real estate, farmland and residential real estate loans.
At December 31, 2006, the Corporation had no concentration of loans exceeding 10
percent of total loans, which are not otherwise disclosed. Loan concentrations
are considered to exist when there are amounts loaned to a multiple number of
borrowers engaged in similar activities, which would cause them to be similarly
impacted by economic or other conditions.
Page 20
STATISTICAL DATA (continued)
----------------
Loan Administration and Loan Loss Charge-off Procedures
Primary responsibility and accountability for day-to-day lending activities
rests with the Corporation's affiliate banks. Loan personnel at each bank have
the authority to extend credit under guidelines approved by the bank's board of
directors. Executive and board loan committees active at each bank serve as
vehicles for communication between the banks and for the pooling of knowledge,
judgment and experience of the Corporation's affiliate banks. These committees
provide valuable input to lending personnel, act as an approval body, and
monitor the overall quality of the banks' loan portfolios. The Corporation also
maintains a loan grading and review program for its affiliate banks, which
includes quarterly reviews of problem loans, delinquencies and charge-offs. The
purpose of this program is to evaluate loan administration, credit quality, loan
documentation and the adequacy of the allowance for loan losses.
The Corporation maintains an allowance for loan losses to cover probable credit
losses identified during its loan review process. The allowance is increased by
the provision for loan losses and decreased by charge-offs less recoveries. All
charge-offs are approved by the bank's senior loan officer and are reported to
the Banks' Boards. The Banks charge off loans when a determination is made that
all or a portion of a loan is uncollectible or as a result of examinations by
regulators and the independent auditors.
Provision for Loan Losses
In banking, loan losses are one of the costs of doing business. Although the
Banks' management emphasize the early detection and charge-off of loan losses,
it is inevitable that at any time certain losses exist in the portfolio which
have not been specifically identified. Accordingly, the provision for loan
losses is charged to earnings on an anticipatory basis, and recognized loan
losses are deducted from the allowance so established. Over time, all net loan
losses must be charged to earnings. During the year, an estimate of the loss
experience for the year serves as a starting point in determining the
appropriate level for the provision. However, the amount actually provided in
any period may be greater or less than net loan losses, based on management's
judgment as to the appropriate level of the allowance for loan losses. The
determination of the provision in any period is based on management's continuing
review and evaluation of the loan portfolio, and its judgment as to the impact
of current economic conditions on the portfolio. The evaluation by management
includes consideration of past loan loss experience, changes in the composition
of the loan portfolio, and the current condition and amount of loans
outstanding.
Impaired loans are measured by the present value of expected future cash flows,
or the fair value of the collateral of the loans, if collateral dependent.
Information on impaired loans is summarized below:
2006 2005 2004
--------------- ---------------- ---------------
(Dollars in Thousands)
As of, and for the year ending December 31:
Impaired loans with an allowance............................ $ 17,291 $ 7,540 $ 7,728
Impaired loans for which the discounted
cash flows or collateral value exceeds the
carrying value of the loan................................ 43,029 44,840 41,683
------------ ------------ ------------
Total impaired loans.................................. $ 60,320 $ 52,380 $ 49,411
============ ============ ============
Total impaired loans as a percent of total loans.............. 2.24% 2.13% 2.03%
Allowance for impaired loans (included in the
Corporation's allowance for loan losses).................. $ 4,130 $ 2,824 $ 1,673
Average balance of impaired loans........................... 66,139 44,790 59,568
Interest income recognized on impaired loans................ 5,143 3,511 3,457
Cash basis interest included above.......................... 1,364 650 796
Page 21
--------------------------------------------------------------------------------
STATISTICAL DATA (continued)
DEPOSITS
The average balances, interest income and expense and average rates on deposits
for the years ended December 2006, 2005 and 2004 are presented within the
"Distribution of Assets, Liabilities and Stockholders' Equity, Interest Rates
and Interest Differential" table on page 11 of this Form 10-K.
As of December 31, 2006, certificates of deposit and other time deposits of
$100,000 or more mature as follows:
Maturing
-------------------------------------------------
3 Months 3-6 6-12 Over 12
or less Months Months Months Total
------------- -------------- -------------- -------------- --------------
(Dollars in Thousands)
Certificates of deposit and
other time deposits.......... $201,073 $ 80,900 $ 94,968 $ 54,127 $431,068
Per cent....................... 46% 19% 22% 13% 100%
RETURN ON EQUITY AND ASSETS
The information regarding return on equity and assets presented on page 2 of the
First Merchants Corporation - Annual Report 2006 under the caption "Five - Year
Summary of Selected Financial Data" is expressly incorporated herein by
reference.
SHORT-TERM BORROWINGS
2006 2005 2004
----------------- ----------------- -----------------
(Dollars in Thousands)
Balance at December 31:
Securities sold under repurchase
agreements (short-term portion)........ $ 42,750 $ 106,415 $ 87,472
Federal funds purchased.................. 56,150 50,000 32,550
--------- --------- ---------
Total short-term borrowings...... $ 98,900 $ 156,415 $ 120,022
========= ========= =========
Securities sold under repurchase agreements are borrowings maturing within one
year and are secured by U.S. Treasury and U.S. Government-sponsored agency
securities.
Pertinent information with respect to short-term borrowings is summarized below:
2006 2005 2004
----------------- ----------------- -----------------
(Dollars in Thousands)
Weighted average interest rate on outstanding
balance at December 31:
Securities sold under repurchase
agreements(short-term portion).............. 4.4% 3.8% 1.8%
Total short-term borrowings..................... 4.9 4.3 1.9
Weighted average interest rate during the year:
Securities sold under repurchase
agreements (short-term portion)............. 4.4% 2.1% .8%
Total short-term borrowings..................... 4.6 2.3 1.0
Highest amount outstanding at any month end
during the year:
Securities sold under repurchase
agreements (short-term portion)............. $ 98,765 $ 68,198 $ 37,771
Total short-term borrowings..................... 219,337 144,898 120,019
Average amount outstanding during the year:
Securities sold under repurchase
agreements (short-term portion)............. $ 73,818 $ 77,969 $ 62,702
Total short-term borrowings..................... 109,577 95,447 81,194
Page 22
ITEM 1A. RISK FACTORS
--------------------------------------------------------------------------------
RISK FACTORS
There are a number of factors, including those specified below, that may
adversely affect the Corporation's business, financial results or stock price.
Additional risks that the Corporation currently does not know about or currently
views as immaterial may also impair the Corporation's business or adversely
impact its financial results or stock price.
INDUSTRY RISK FACTORS
* The Corporation's business and financial results are significantly affected
by general business and economic conditions.
The Corporation's business activities and earnings are affected by general
business conditions in the United States and abroad. These conditions include
short-term and long-term interest rates, inflation, monetary supply,
fluctuations in both debt and equity capital markets, and the strength of the
United States economy and the state and local economies in which the Corporation
operates. For example, an economic downturn, an increase in unemployment, or
other events that affect household and/or corporate incomes could result in a
deterioration of credit quality, a change in the allowance for loan losses, or
reduced demand for loan or fee-based products and services. Changes in the
financial performance and condition of the Corporation's borrowers could
negatively affect repayment of those borrowers' loans. In addition, changes in
securities market conditions and monetary fluctuations could adversely affect
the availability and terms of funding necessary to meet the Corporation's
liquidity needs.
* Changes in the domestic interest rate environment could reduce the
Corporation's net interest income.
The operations of financial institutions such as the Corporation are dependent
to a large degree on net interest income, which is the difference between
interest income from loans and investments and interest expense on deposits and
borrowings. An institution's net interest income is significantly affected by
market rates of interest, which in turn are affected by prevailing economic
conditions, by the fiscal and monetary policies of the federal government and by
the policies of various regulatory agencies. Like all financial institutions,
the Corporation's balance sheet is affected by fluctuations in interest rates.
Volatility in interest rates can also result in the flow of funds away from
financial institutions into direct investments. Direct investments, such as U.S.
Government and corporate securities and other investment vehicles (including
mutual funds) generally pay higher rates of return than financial institutions,
because of the absence of federal insurance premiums and reserve requirements.
* Changes in the laws, regulations and policies governing banks and financial
services companies could alter the Corporation's business environment and
adversely affect operations.
The Board of Governors of the Federal Reserve System regulates the supply of
money and credit in the United States. Its fiscal and monetary policies
determine in a large part the Corporation's cost of funds for lending and
investing and the return that can be earned on those loans and investments, both
of which affect the Corporation's net interest margin. Federal Reserve Board
policies can also materially affect the value of financial instruments that the
Corporation holds, such as debt securities. The Corporation and its bank
subsidiaries are heavily regulated at the federal and state levels. This
regulation is to protect depositors, federal deposit insurance funds and the
banking system as a whole. Congress and state legislatures and federal and state
agencies continually review banking laws, regulations and policies for possible
changes. Changes in statutes, regulations or policies could affect the
Corporation in substantial and unpredictable ways, including limiting the types
of financial services and products that the Corporation offers and/or increasing
the ability of non-banks to offer competing financial services and products. The
Corporation cannot predict whether any of this potential legislation will be
enacted, and if enacted, the effect that it or any regulations would have on the
Corporation's financial condition or results of operations.
* The banking and financial services industry is highly competitive, and
competitive pressures could intensify and adversely affect the Corporation's
financial results.
The Corporation operates in a highly competitive industry that could become even
more competitive as a result of legislative, regulatory and technological
changes and continued consolidation. The Corporation competes with other banks,
savings and loan associations, mutual savings banks, finance companies, mortgage
banking companies, credit unions and investment companies. In addition,
technology has lowered barriers to entry and made it possible for non-banks to
offer products and services traditionally provided by banks. Many of the
Corporation's competitors have fewer regulatory constraints and some have lower
cost structures. Also, the potential need to adapt to industry changes in
information technology systems, on which the Corporation and financial services
industry are highly dependent, could present operational issues and require
capital spending.
Page 23
* Acts or threats of terrorism and political or military actions taken by the
United States or other governments could adversely affect general economic or
industry conditions.
Geopolitical conditions may also affect the Corporation's earnings. Acts or
threats or terrorism and political or military actions taken by the United
States or other governments in response to terrorism, or similar activity, could
adversely affect general economic or industry conditions.
CORPORATION RISK FACTORS
* The Corporation's allowance for loan losses may not be adequate to cover
actual losses.
The Corporation maintains an allowance for loan losses to provide for loan
defaults and non-performance. The allowance for loan losses represents
management's estimate of probable losses inherent in the Corporation's loan
portfolio. The Corporation's allowance consists of three components: probable
losses estimated from individual reviews of specific loans, probable losses
estimated from historical loss rates, and probable losses resulting from
economic, environmental, qualitative or other deterioration above and beyond
what is reflected in the first two components of the allowance. The process for
determining the adequacy of the allowance for loan losses is critical to our
financial results. It requires management to make difficult, subjective and
complex judgments, as a result of the need to make estimates about the effect of
matters that are uncertain. Therefore, the allowance for loan losses,
considering current factors at the time, including economic conditions and
ongoing internal and external examination processes, will increase or decrease
as deemed necessary to ensure the allowance for loan losses remains adequate. In
addition, the allowance as a percentage of charge-offs and nonperforming loans
will change at different points in time based on credit performance, loan mix
and collateral values.
* The Corporation may suffer losses in its loan portfolio despite its
underwriting practices.
The Corporation seeks to mitigate the risks inherent in its loan portfolio by
adhering to specific underwriting practices. The Corporation's strategy for
credit risk management includes conservative credit policies and underwriting
criteria for all loans, as well as an overall credit limit for each customer
significantly below legal lending limits. The strategy also emphasizes
diversification on a geographic, industry and customer level, regular credit
quality reviews and management reviews of large credit exposures and loans
experiencing deterioration of credit quality. There is a continuous review of
the loan portfolio, including an internally administered loan "watch" list and
an independent loan review. The evaluation takes into consideration identified
credit problems, as well as the possibility of losses inherent in the loan
portfolio that are not specifically identified. Although the Corporation
believes that its underwriting criteria are appropriate for the various kinds of
loans it makes, the Corporation may incur losses on loans due to the factors
previously discussed.
* Because the nature of the financial services business involves a high volume
of transactions, the Corporation faces significant operational risks.
The Corporation operates in diverse markets and relies on the ability of its
employees and systems to process a high number of transactions. Operational risk
is the risk of loss resulting from the Corporation's operations, including, but
not limited to, the risk of fraud by employees or persons outside of the
Corporation, the execution of unauthorized transactions by employees, errors
relating to transaction processing and technology, breaches of the internal
control system and compliance requirements and business continuation and
disaster recovery. This risk of loss also includes the potential legal actions
that could arise as a result of an operational deficiency or as a result of
noncompliance with applicable regulatory standards, adverse business decisions
or their implementation, and customer attrition due to potential negative
publicity. In the event of a breakdown in the internal control system, improper
operation of systems or improper employee actions, the Corporation could suffer
financial loss, face regulatory action and suffer damage to its reputation.
Page 24
* A natural disaster could harm the Corporation's business.
Natural disasters could harm the Corporation's operations directly through
interference with communications, as well as through the destruction of
facilities and operational, financial and management information systems. These
events could prevent the Corporation from gathering deposits, originating loans
and processing and controlling its flow of business.
* The Corporation faces systems failure risks as well as security risks,
including "hacking" and "identity theft."
The computer systems and network infrastructure the Corporation uses could be
vulnerable to unforeseen problems. Our operations are dependent upon our ability
to protect computer equipment against damage from fire, power loss or
telecommunication failure. Any damage or failure that causes an interruption in
our operations could adversely affect our business and financial results. In
addition, our computer systems and network infrastructure present security
risks, and could be susceptible to hacking or identity theft.
* The Corporation relies on dividends from its subsidiaries for its liquidity
needs.
The Corporation is a separate and distinct legal entity from its bank and
non-bank subsidiaries. The Corporation receives substantially all of its cash
from dividends paid by its subsidiaries. These dividends are the principal
source of funds to pay dividends on the Corporation's stock and interest and
principal on its debt. Various federal and state laws and regulations limit the
amount of dividends that our bank subsidiaries may pay to the Corporation.
* The Corporation's reported financial results depend on management's selection
of accounting methods and certain assumptions and estimates.
The Corporation's accounting policies and methods are fundamental to how it
records and reports its financial condition and results of operations. The
Corporation's management must exercise judgment in selecting and applying many
of these accounting policies and methods, so they comply with Generally Accepted
Accounting Principles and reflect management's judgment of the most appropriate
manner to report the Corporation's financial condition and results. In some
cases, management must select the accounting policy or method to apply from two
or more alternatives, any of which might be reasonable under the circumstances
yet might result in the Corporation's reporting materially different results
than would have been reported under a different alternative. Certain accounting
policies are critical to presenting the Corporation's financial condition and
results, and require management to make difficult, subjective or complex
judgments about matters that are uncertain. Materially different amounts could
be reported under different conditions or using different assumptions or
estimates. These critical accounting policies include: the allowance for loan
losses; the valuation of investment securities; the valuation of goodwill and
intangible assets; and pension accounting. Because of the uncertainty of
estimates involved in these matters, the Corporation may be required to do one
or more of the following: significantly increase the allowance for loan losses
and/or sustain loan losses that are significantly higher than the reserve
provided; recognize significant provision for impairment of its investment
securities; recognize significant impairment on its goodwill and intangible
assets; or significantly increase its pension liability. For more information,
refer to pages 4 through 6 of the First Merchants Corporation - Annual Report
2006 under the caption "Critical Accounting Policies."
* Changes in accounting standards could materially impact the Corporation's
financial statements.
From time to time, the Financial Accounting Standards Board changes the
financial accounting and reporting standards that govern the preparation of the
Corporation's financial statements. These changes can be hard to predict and can
materially impact how the Corporation records and reports its financial
condition and results of operations. In some cases, the Corporation could be
required to apply a new or revised standard retroactively, resulting in the
Corporation's restating prior period financial statements.
Page 25
* Significant legal actions could subject the Corporation to substantial
uninsured liabilities.
The Corporation is from time to time subject to claims related to its
operations. These claims and legal actions, including supervisory actions by the
Corporation's regulators, could involve large monetary claims and significant
defense costs. To protect itself from the cost of these claims, the Corporation
maintains insurance coverage in amounts and with deductibles that it believes
are appropriate for its operations. However, the Corporation's insurance
coverage may not cover all claims against the Corporation or continue to be
available to the Corporation at a reasonable cost. As a result, the Corporation
may be exposed to substantial uninsured liabilities, which could adversely
affect the Corporation's results of operations and financial condition.
* Negative publicity could damage the Corporation's reputation and adversely
impact its business and financial results.
Reputation risk, or the risk to the Corporation's earnings and capital from
negative publicity, is inherent in the Corporation's business. Negative
publicity can result from the Corporation's actual or alleged conduct in any
number of activities, including lending practices, corporate governance and
acquisitions, and actions taken by government regulators and community
organizations in response to those activities. Negative publicity can adversely
affect the Corporation's ability to keep and attract customers and can expose
the Corporation to litigation and regulatory action. Although the Corporation
takes steps to minimize reputation risk in dealing with customers and other
constituencies, the Corporation is inherently exposed to this risk.
* Acquisitions may not produce revenue enhancements or cost savings at levels
or within timeframes originally anticipated and may result in unforeseen
integration difficulties.
The Corporation regularly explores opportunities to acquire banks, financial
institutions, or other financial services businesses or assets. The Corporation
cannot predict the number, size or timing of acquisitions. Difficulty in
integrating an acquired business or company may cause the Corporation not to
realize expected revenue increases, cost savings, increases in geographic or
product presence, and/or other projected benefits from the acquisition. The
integration could result in higher than expected deposit attrition (run-off),
loss of key employees, disruption of the Corporation's business or the business
of the acquired company, or otherwise adversely affect the Corporation's ability
to maintain relationships with customers and employees or achieve the
anticipated benefits of the acquisition. Also, the negative effect of any
divestitures required by regulatory authorities in acquisitions or business
combinations may be greater than expected.
* The Corporation's stock price can be volatile.
The Corporation's stock price can fluctuate widely in response to a variety of
factors, including: actual or anticipated variations in the Corporation's
quarterly operating results; recommendations by securities analysts; significant
acquisitions or business combinations; strategic partnerships, joint ventures or
capital commitments; operating and stock price performance of other companies
that investors deem comparable to the Corporation; new technology used or
services offered by the Corporation's competitors; news reports relating to
trends, concerns and other issues in the banking and financial services
industry, and changes in government regulations. General market fluctuations,
industry factors and general economic and political conditions and events,
including terrorist attacks, economic slowdowns or recessions, interest rate
changes, credit loss trends or currency fluctuations, could also cause the
Corporation's stock price to decrease, regardless of the Corporation's operating
results.
ITEM 1B. UNRESOLVED STAFF COMMENTS
--------------------------------------------------------------------------------
None.
Page 26
ITEM 2. PROPERTIES.
--------------------------------------------------------------------------------
The headquarters of the Corporation and First Merchants are located in a
five-story building at 200 East Jackson Street, Muncie, Indiana. The building is
owned by First Merchants.
The Corporation's affiliate banks conduct business through numerous facilities
owned and leased by the respective affiliate banks. Of the 65 banking offices
operated by the Corporation's affiliate banks, 49 are owned by the respective
banks and 16 are leased from non-affiliated third parties.
None of the properties owned by the Corporation's affiliate banks are subject to
any major encumbrances. The net investment of the Corporation and subsidiaries
in real estate and equipment at December 31, 2006 was $42,393,000.
ITEM 3. LEGAL PROCEEDINGS.
--------------------------------------------------------------------------------
There is no pending legal proceeding, other than ordinary routine litigation
incidental to the business of the Corporation or its subsidiaries, of a material
nature to which the Corporation or its subsidiaries is a party or of which any
of their properties are subject. Further, there is no material legal proceeding
in which any director, officer, principal shareholder, or affiliate of the
Corporation, or any associate of any such director, officer or principal
shareholder, is a party, or has a material interest, adverse to the Corporation
or any of its subsidiaries.
None of the routine legal proceedings, individually or in the aggregate, in
which the Corporation or its affiliates are involved are expected to have a
material adverse impact on the financial position or the results of operations
of the Corporation.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
--------------------------------------------------------------------------------
No matters were submitted during the fourth quarter of 2006 to a vote of
security holders, through the solicitation of proxies or otherwise.
Page 27
SUPPLEMENTAL INFORMATION - EXECUTIVE OFFICERS OF THE REGISTRANT.
--------------------------------------------------------------------------------
The names, ages, and positions with the Corporation and subsidiary banks of all
executive officers of the Corporation and all persons chosen to become executive
officers are listed below. The officers are elected by the Board of Directors of
the Corporation for a term of one (1) year or until the election of their
successors. There are no arrangements between any officer and any other person
pursuant to which he was selected as an officer.
Offices with the Corporation Principal Occupation
Name and Age And Subsidiary Banks During Past Five Years
------------------------------------------- ---------------------------------------- ----------------------------------------
Michael L. Cox President, Chief Executive Officer, Chief Executive Officer of the Corporation
62 Corporation since April 1999; President First Merchants
from April 1999 to September 2000; President
and Chief Operating Officer, Corporation since
August 1998 and from May 1994 to April 1999
respectively; President and Chief Operating
Officer, First Merchants from April, 1996 to
April 1999; Director, Corporation and First
Merchants since December, 1984.(1)
Michael C. Rechin Executive Vice President and Chief Executive Vice President and Chief Operating
48 Operating Officer, Corporation Officer, Corporation since November 2005;
Executive Vice President, Corporate Banking
National City Bank from 1995 to November
2005.(1)
Mark K. Hardwick Executive Vice President and Chief Executive Vice President and Chief Financial
36 Financial Officer, Corporation Officer of the Corporation since December 2005;
Senior Vice President and Chief Financial
Officer from April 2002 to December 2005;
Corporate Controller, Corporation from November
1997 to April 2002.
Robert R. Connors Senior Vice President, Chief Senior Vice President and Chief Information
57 Information Officer, Corporation Officer of the Corporation and First Merchants
and First Merchants since January 2006; Senior Vice President of
Operations and Technology, Corporation and
First Merchants from August 2002 to January
2006; Senior Vice President of Operations and
Compliance Officer at First Internet Bank of
Indiana from 1999 to 2002.
Shawn R. Blackburn Senior Vice President of Senior Vice President of Administrative
53 Administrative Services, Corporation Services, Corporation since May 2005; Senior
National Bank Examiner, Office of Comptroller
of the Currency from 1978 to 2005.
Kimberly J. Ellington Senior Vice President and Director of Senior Vice President and Director of Human
47 Human Resources, Corporation Resources since 2004; Vice President and
Director of Human Resources, Corporation from
1999 to 2004.
David W. Spade Senior Vice President and Chief Senior Vice President and Chief Credit Officer
54 Credit Officer, Corporation of First Merchants Corporation since February
2007; Vice President and Chief Credit Officer
of First Merchants Corporation from December
2006 to February 2007; Executive Vice President
and Chief Lending Officer of First Merchants
Bank from November 2005 to December 2006;
Executive Vice President and Division Chief
Credit Officer at Old National Bank from 2002
to 2005; Senior Vice President and Senior Loan
Officer at Old National Bank from 1999 to 2002.
(1) Mr. Cox will retire as the President and Chief Executive Officer of the
Corporation on April 24, 2007, the date of the Corporation's 2007 annual meeting
of shareholders. Mr. Rechin will become President and Chief Executive Officer at
that time.
Page 28
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
--------------------------------------------------------------------------------
The information on pages 19, 55 and 56 of the First Merchants Corporation -
Annual Report 2006 under the captions "Annual Meeting, Stock Price and Dividend
Information" and "Performance Graph", is expressly incorporated herein by
reference.
The following table presents information relating to the Corporation's purchases
of its equity securities during the quarter ended December 31, 2006, as
follows(1):
MAXIMUM NUMBER OF
TOTAL NUMBER OF SHARES THAT MAY YET
TOTAL NUMBER OF AVERAGE PRICE SHARES PURCHASED AS PART BE PURCHASED UNDER
PERIOD SHARES PURCHASED PAID PER SHARE OF BOARD AUTHORIZATION(1) BOARD AUTHORIZATION(1)
------ ---------------- -------------- ------------------------- -----------------------
October 1-31, 2006 0 0 0 0
November 1-30, 2006 1,095(2) 25.77 0 0
December 1-31, 2006 0 0 0 0
(1) On February 14, 2006, the Corporation's Board authorized management to
repurchase up to 250,000 shares of the Corporation's common stock. This
authorization was not publicly announced and expired February 13, 2007. There
were 30,000 remaining shares that may yet be purchased pursuant to such
authorizations as of December 31, 2006.
(2) These shares were purchased in open-market transactions pursuant to the
Board's authorization to repurchase shares.
The following table presents information relating to securities authorized under
equity compensation plans.
Equity Compensation Plan Information
Number of securities to Weighted-average Number of securities remaining
be issued upon exercise exercise price of available for future issuance under
of outstanding options, outstanding options, equity compensations plans (excluding
Plan category warrants and rights warrants and rights securities reflected in first column)
------------- ----------------------- -------------------- -------------------------------------
Equity compensation plans approved
by stockholders 1,030,897 $ 23.92 400,000 (1)
Equity compensation plans not
approved by stockholders(2) 36,350 22.33
----------------------- -------------------- -------------------------------------
Total 1,067,247 $ 23.87 400,000 (1)
======================= ==================== =====================================
(1) This number does not include shares remaining available for future issuance
under the 1999 Long-term Equity Incentive Plan, which was approved by the
Corporation's shareholders at the 1999 annual meeting. The aggregate number of
shares that are available for grants under that Plan in any calendar year is
equal to the sum of: (a) 1% of the number of common shares of the Corporation
outstanding as of the last day of the preceding calendar year; plus (b) the
number of shares that were available for grants, but not granted, under the Plan
in any previous year; but in no event will the number of shares available for
grants in any calendar year exceed 1 1/2% of the number of common shares of the
Corporation outstanding as of the last day of the preceding calendar year. The
1999 Long-term Equity Incentive Plan will expire in 2009.
(2) The only plan reflected above that was not approved by the Corporation's
stockholders relates to certain First Merchants Corporation Stock Option
Agreements ("Agreements"). These Agreements provided for non-qualified stock
options of the common stock of the Corporation, awarded between 1995 and 2002
to each director of First Merchants Bank, National Association (the "Bank") who,
on the date of the grants: (a) were serving as a director of the Bank; (b) were
not an employee of the Corporation, the Bank, or any of the Corporation's other
affiliated banks or non-bank subsidiaries; and (c) were not serving as a
director of the Corporation. The exercise price of the shares was equal to the
fair market value of the shares upon the grant of the option. Options became 100
percent vested when granted and are fully exercisable six months after the date
of the grant, for a period of ten years.
Page 29
ITEM 6. SELECTED FINANCIAL DATA.
--------------------------------------------------------------------------------
The information on page 2 of the First Merchants Corporation - Annual Report
2006 under the caption "Five-Year Summary of Selected Financial Data", is
expressly incorporated herein by reference.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
--------------------------------------------------------------------------------
The information on pages 3 through 19 of the First Merchants Corporation -
Annual Report 2006 under the caption "Management's Discussion and Analysis of
Financial Condition and Results of Operations", is expressly incorporated herein
by reference.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
--------------------------------------------------------------------------------
The information on pages 12 through 14 of the First Merchants Corporation -
Annual Report 2006 under the caption "Management's Discussion and Analysis of
Financial Condition and Results of Operations" within the section "Interest
Sensitivity and Disclosures About Market Risk", is expressly incorporated herein
by reference.
Page 30
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
--------------------------------------------------------------------------------
Pages 20 through 54 of the First Merchants Corporation - Annual Report 2006, are
expressly incorporated herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
--------------------------------------------------------------------------------
In connection with its audits for the two most recent fiscal years ended
December 31, 2006, there have been no disagreements with the Corporation's
independent registered public accounting firm on any matter of accounting
principles or practices, financial statement disclosure or audit scope or
procedure, nor have there been any changes in accountants.
ITEM 9A. CONTROLS AND PROCEDURES
--------------------------------------------------------------------------------
At the end of the period covered by this report (the "Evaluation Date"), the
Corporation carried out an evaluation, under the supervision and with the
participation of the Corporation's management, including the Corporation's Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of it's disclosure controls and procedures pursuant to Rule
13a-15(b) and 15d-15(b) of the Securities Exchange Act of 1934 ("Exchange Act").
Based upon that evaluation, the Corporation's Chief Executive Officer and Chief
Financial Officer concluded that, as of the Evaluation Date, the Corporation's
disclosure controls and procedures are effective. Disclosure controls and
procedures are controls and procedures that are designed to ensure that
information required to be disclosed in Corporation reports filed or submitted
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in the Securities and Exchange Commission's rules and
forms.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of the Corporation is responsible for establishing and maintaining
effective internal control over financial reporting as defined in Rule
13a-15(f) under the Securities Exchange Act of 1934. The Corporation's internal
control over financial reporting is designed to provide reasonable assurance to
the Corporation's management and board of directors regarding the preparation
and fair presentation of published financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Accordingly, even those systems
determined to be effective can provide only reasonable assurance with respect to
financial statement preparation and presentation.
Management assessed the effectiveness of the Corporation's internal control over
financial reporting as of December 31, 2006. In making this assessment,
management used the criteria set forth in "Internal Control - Integrated
Framework" issued by the Committee of Sponsoring Organizations (COSO) of the
Treadway Commission. Based on this assessment, management has determined that
the Corporation's internal control over financial reporting as of December 31,
2006 is effective based on the specified criteria.
Management's assessment of the effectiveness of internal control over financial
reporting as of December 31, 2006 has been audited by BKD, LLP, an independent
registered public accounting firm, as stated in their report, which appears
on the next page.
There have been no changes in the Corporation's internal controls over financial
reporting identified in connection with the evaluation referenced above that
occurred during the Corporation's last fiscal quarter that have materially
affected, or are reasonably likely to materially affect, the Corporation's
internal control over financial reporting.
Page 31
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Audit Committee, Board of Directors and Stockholders
First Merchants Corporation
Muncie, Indiana
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control over Financial Reporting, that First
Merchants Corporation maintained effective internal control over financial
reporting as of December 31, 2006, based on criteria established in Internal
Control - Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). The Corporation's management is
responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on management's
assessment and an opinion on the effectiveness of the Corporation's internal
control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. An audit includes obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control and performing such
other procedures as we consider necessary in the circumstances. We believe that
our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions or that the degree of compliance
with the policies or procedures may deteriorate.
In our opinion, management's assessment that First Merchants Corporation
maintained effective internal control over financial reporting as of December
31, 2006, is fairly stated, in all material respects, based on criteria
established in Internal Control - Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission (COSO). Also in our
opinion, First Merchants Corporation maintained, in all material respects,
effective internal control over financial reporting as of December 31, 2006,
based on criteria established in Internal Control - Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated financial
statements of First Merchants Corporation and our report dated February 6, 2007,
expressed an unqualified opinion thereon.
BKD, LLP
Indianapolis, Indiana
February 6, 2007
ITEM 9B. OTHER INFORMATION
--------------------------------------------------------------------------------
None
Page 32
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
--------------------------------------------------------------------------------
The information in the Corporation's Proxy Statement dated March 15, 2007
furnished to its stockholders in connection with an annual meeting to be held
April 24, 2007 (the "2007 Proxy Statement"), under the captions "INFORMATION
REGARDING DIRECTORS", "COMMITTEES OF THE BOARD" and "SECTION 16(a) BENEFICIAL
OWNERSHIP REPORTING COMPLIANCE", is expressly incorporated herein by reference.
The information required under this item relating to executive officers is set
forth in Part I, "Supplemental Information - Executive Officers of the
Registrant" of this annual report on Form 10-K and is expressly incorporated
herein by reference.
The Corporation has adopted a Code of Ethics that applies to its Chief Executive
Officer, Chief Operating Officer, Chief Financial Officer, Controller and
Treasurer. It is part of the Corporation's Code of Business Conduct, which
applies to all employees and directors of the Corporation and its affiliates. A
copy of the Code of Ethics may be obtained, free of charge, by writing to First
Merchants Corporation at 200 East Jackson Street, Muncie, IN 47305. In addition,
the Code of Ethics is maintained on the Corporation's web site, which can be
accessed at http://www.firstmerchants.com.
ITEM 11. EXECUTIVE COMPENSATION.
--------------------------------------------------------------------------------
The information in the Corporation's 2007 Proxy Statement, under the captions,
"COMPENSATION OF DIRECTORS", "COMPENSATION OF EXECUTIVE OFFICERS", "COMMITTEES
OF THE BOARD-Compensation and Human Resources Committee Interlocks and Insider
Participation" and "COMMITTEES OF THE BOARD-Compensation and Human Resources
Committee Report" is expressly incorporated herein by reference.
Page 33
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.
--------------------------------------------------------------------------------
The information in the Corporation's 2007 Proxy Statement, under the caption,
"VOTING SECURITIES AND PRINCIPAL HOLDERS THEREOF-Principal Holders of
Securities" is expressly incorporated herein by reference. The information
required under this item relating to equity compensation plans is set forth in
Part II, Item 5 of this annual report on Form 10-K under the table entitled
"Equity Compensation Plan Information" and is expressly incorporated herein by
reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
--------------------------------------------------------------------------------
The information in the Corporation's 2007 Proxy Statement, under the captions,
"VOTING SECURITIES AND PRINCIPAL HOLDERS THEREOF-Principal Holders of
Securities" and "TRANSACTIONS WITH RELATED PERSONS," is expressly incorporated
herein by reference.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
--------------------------------------------------------------------------------
The information in the Corporation's 2007 Proxy Statement, under the caption
"INDEPENDENT AUDITOR", is expressly incorporated herein by reference.
Page 34
PART IV
ITEM 15. FINANCIAL STATEMENT SCHEDULES AND EXHIBITS.
--------------------------------------------------------------------------------
(a) 1. Financial Statements:
Independent accountants' report
Consolidated balance sheets at
December 31, 2006 and 2005
Consolidated statements of income,
years ended December 31, 2006,
2005 and 2004
Consolidated statements of comprehensive income,
years ended December 31, 2006, 2005 and 2004
Consolidated statements of stockholders' equity,
years ended December 31, 2006, 2005 and 2004
Consolidated statements of cash flows,
years ended December 31, 2006,
2005 and 2004
Notes to consolidated financial
statements
(a) 2. Financial statement schedules:
All schedules are omitted because
they are not applicable or not required,
or because the required information is included in the
consolidated financial statements or related notes.
(a) 3. Exhibits:
Exhibit No: Description of Exhibits:
----------- ------------------------
3a First Merchants Corporation Articles of Incorporation.
(Incorporated by reference to registrant's Form 10-Q for quarter
ended June 30, 1999)
3b Bylaws of First Merchants Corporation (Incorporated by reference
to registrant's Form 10-Q for the quarter ended September 30,
2007)
4.1 Certificate of Trust of First Merchants Capital Trust I dated
December 12, 2001 (3)
4.2 Amended and Restated Trust Agreement of First Merchants Capital
Trust I dated April 17, 2002 (3)
4.3 Agreement as to Expenses and Liabilities dated April 17, 2002 (3)
4.4 Cumulative Trust Preferred Security Certificate (3)
4.5 Preferred Securities Guarantee Agreement dated April 17, 2002 (3)
4.6 Indenture dated April 17, 2002 (3)
4.7 First Supplemental Indenture dated April 17, 2002 (3)
4.8 8.75% Junior Subordinated Debenture due June 30, 2002 (3)
Page 35
ITEM 15. FINANCIAL STATEMENT SCHEDULES AND EXHIBITS (continued)
--------------------------------------------------------------------------------
10a First Merchants Corporation Senior Management Incentive
Compensation Program, dated February 8, 2007.(1)
10b First Merchants Corporation 1994 Stock Option Plan.
(Incorporated by reference to registrant's Form 10-K for year
ended December 31, 1993)(1)
10c First Merchants Corporation Change of Control Agreement, as
amended, with Mark K. Hardwick dated February 14, 2006.
(Incorporated by reference to registrant's Form 8-K filed on
March 9, 2006)(1)
10d First Merchants Corporation Change of Control Agreement with
Michael C. Rechin dated December 13, 2005. (Incorporated by
reference to registrant's Form 8-K filed on December 19,
2005)(1)
10e First Merchants Corporation Change of Control Agreement with
Shawn R. Blackburn dated May 2, 2005. (Incorporated by
reference to registrant's Form 8-K filed on May 4, 2005)(1)
10f First Merchants Corporation Change of Control Agreement with
Robert R. Connors dated August 26, 2002. (Incorporated by
reference to registrant's Form 10-Q for quarter ended
September 30, 2002)(1)
10g First Merchants Corporation Change of Control Agreement with
Michael L. Cox dated February 11, 2003. (Incorporated by
reference to registrant's Form 10-Q for quarter ended March
31, 2003)(1)
10h First Merchants Corporation Change of Control Agreement with
Kimberly J. Ellington dated January 1, 2005. (Incorporated
by reference to registrant's Form 10-K for the year ended
December 31, 2005)
10i First Merchants Corporation Supplemental Executive Retirement
Plan and amendments thereto. (Incorporated by reference to
registrant's Form 10-K for year ended December 31, 1997)(1)
10j First Merchants Corporation 1999 Long-Term Equity Incentive
Plan, as amended. (Incorporated by reference to registrant's
Form 10-Q for quarter ended September 30, 2004) (1)
10k First Merchants Corporation Letter Agreement between the
Corporation and Michael L. Cox, dated January 23, 2007.
(Incorporated by reference to registrant's Form 8-K filed on
January 24, 2007)
10l First Merchants Corporation Defined Contribution Supplemental
Retirement Plan dated January 1, 2006. (Incorporated by
reference to registrant's Form 8-K filed on February 6, 2007)
10m First Merchants Corporation Participation Agreement of
Michael C. Rechin dated January 26, 2007. (Incorporated by
reference to registrant's Form 8-K filed on February 6, 2007)
Page 36
ITEM 15. FINANCIAL STATEMENT SCHEDULES AND EXHIBITS (continued)
--------------------------------------------------------------------------------
13 First Merchants Corporation - Annual Report 2006 (except
for the pages and information expressly incorporated by
reference in this Form 10-K, the First Merchants Corporation
- Annual Report 2006 is provided solely for the information
of the Securities and Exchange Commission and is not
deemed "filed" as part of this Form 10-K)(2)
21 Subsidiaries of Registrant(2)
23 Consent of Independent Registered Public Accounting Firm(2)
24 Limited Power of Attorney(2)
31.1 Certification of Chief Executive Officer Pursuant to Section
302 of the Sarbanes - Oxley Act of 2002(2)
31.2 Certification of Chief Financial Officer Pursuant to Section
302 of the Sarbanes - Oxley Act of 2002(2)
32 Certifications Pursuant to 18 U.S.C. Section 1350,
as Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002(2)
99.1 Financial statements and independent registered public
accounting firm's report for First Merchants Corporation
Employee Stock Purchase Plan (See Exhibit 13 to this Form
10-K)(2)
(1) Management contract or compensatory plan.
(2) Filed here within.
(3) Incorporated by reference to the registrant's Form 8-K filed on
April 19, 2002.
Page 37
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) 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, on this 16th day of March,
2007.
FIRST MERCHANTS CORPORATION
By /s/ Michael L.Cox
-----------------------------
Michael L. Cox, President
and Chief Executive
Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
on Form 10-K has been signed by the following persons on behalf of the
registrant and in the capacities indicated, on this 16th day of March, 2007.
/s/ Michael L. Cox /s/ Mark K. Hardwick
-------------------------------------- --------------------------------------
Michael L. Cox President and Mark K. Hardwick Executive Vice
Chief Executive President and Chief
Officer (Principal Financial Officer
Executive Officer) (Principal Financial
and Principal
Accounting Officer)
/s/ Robert M. Smitson* /s/ Michael L. Cox
------------------------------------ ------------------------------------
Robert M. Smitson Director Michael L. Cox Director
/s/ Michael C. Rechin* /s/ Barry J. Hudson*
------------------------------------ ------------------------------------
Michael C. Rechin Director Barry J. Hudson Director
/s/Richard A. Boehning* /s/ Thomas D. McAuliffe*
------------------------------------ ------------------------------------
Richard A. Boehning Director Thomas D. McAuliffe Director
/s/ Thomas B. Clark* /s/ Charles E. Schalliol*
------------------------------------ ------------------------------------
Thomas B. Clark Director Charles E. Schalliol Director
/s/ Roderick English*
------------------------------------ ------------------------------------
Roderick English Director Terry L. Walker Director
/s/ Jean L. Wojtowicz
------------------------------------ ------------------------------------
Dr. Jo Ann M. Gora Director Jean L. Wojtowicz Director
* By Mark K. Hardwick as Attorney-in Fact pursuant to a Limited Power of
Attorney executed by the directors listed above, which Power of Attorney is
being filed with the Securities and Exchange Commission as an exhibit hereto.
By /s/ Mark K. Hardwick
------------------------------
Mark K. Hardwick
As Attorney-in-Fact
March 16, 2007
Page 38
INDEX TO EXHIBITS
--------------------------------------------------------------------------------
(a) 3. Exhibits:
Exhibit No: Description of Exhibits:
----------- ------------------------
3a First Merchants Corporation Articles of Incorporation.
(Incorporated by reference to registrant's Form 10-Q for quarter
ended June 30, 1999)
3b Bylaws of First Merchants Corporation (Incorporated by reference
to registrant's Form 10-Q for the quarter ended September 30,
2007)
4.1 Certificate of Trust of First Merchants Capital Trust I dated
December 12, 2001 (3)
4.2 Amended and Restated Trust Agreement of First Merchants Capital
Trust I dated April 17, 2002 (3)
4.3 Agreement as to Expenses and Liabilities dated April 17, 2002 (3)
4.4 Cumulative Trust Preferred Security Certificate (3)
4.5 Preferred Securities Guarantee Agreement dated April 17, 2002 (3)
4.6 Indenture dated April 17, 2002 (3)
4.7 First Supplemental Indenture dated April 17, 2002 (3)
4.8 8.75% Junior Subordinated Debenture due June 30, 2002 (3)
10a First Merchants Corporation Senior Management Incentive
Compensation Program, dated February 8, 2007.(1)
10b First Merchants Corporation 1994 Stock Option Plan.
(Incorporated by reference to registrant's Form 10-K for year
ended December 31, 1993)(1)
10c First Merchants Corporation Change of Control Agreement, as
amended, with Mark K. Hardwick dated February 14, 2006.
(Incorporated by reference to registrant's Form 8-K filed on
March 9, 2006)(1)
Page 39
INDEX TO EXHIBITS continued
--------------------------------------------------------------------------------
10d First Merchants Corporation Change of Control Agreement with
Michael C. Rechin dated December 13, 2005. (Incorporated by
reference to registrant's Form 8-K filed on December 19,
2005)(1)
10e First Merchants Corporation Change of Control Agreement with
Shawn R. Blackburn dated May 2, 2005. (Incorporated by
reference to registrant's Form 8-K filed on May 4, 2005)(1)
10f First Merchants Corporation Change of Control Agreement with
Robert R. Connors dated August 26, 2002. (Incorporated by
reference to registrant's Form 10-Q for quarter ended
September 30, 2002)(1)
10g First Merchants Corporation Change of Control Agreement with
Michael L. Cox dated February 11, 2003. (Incorporated by
reference to registrant's Form 10-Q for quarter ended March
31, 2003)(1)
10h First Merchants Corporation Change of Control Agreement with
Kimberly J. Ellington dated January 1, 2005. (Incorporated
by reference to registrant's Form 10-K for the year ended
December 31, 2005)
10i First Merchants Corporation Supplemental Executive Retirement
Plan and amendments thereto. (Incorporated by reference to
registrant's Form 10-K for year ended December 31, 1997)(1)
10j First Merchants Corporation 1999 Long-Term Equity Incentive
Plan, as amended. (Incorporated by reference to registrant's
Form 10-Q for quarter ended September 30, 2004) (1)
10k First Merchants Corporation Letter Agreement between the
Corporation and Michael L. Cox, dated January 23, 2007.
(Incorporated by reference to registrant's Form 8-K filed on
January 24, 2007)
10l First Merchants Corporation Defined Contribution Supplemental
Retirement Plan dated January 1, 2006. (Incorporated by
reference to registrant's Form 8-K filed on February 6, 2007)
10m First Merchants Corporation Participation Agreement of
Michael C. Rechin dated January 26, 2007. (Incorporated by
reference to registrant's Form 8-K filed on February 6, 2007)
13 First Merchants Corporation - Annual Report 2006 (except
for the pages and information expressly incorporated by
reference in this Form 10-K, the First Merchants Corporation
- Annual Report 2006 is provided solely for the information
of the Securities and Exchange Commission and is not
deemed "filed" as part of this Form 10-K)(2)
21 Subsidiaries of Registrant(2)
23 Consent of Independent Registered Public Accounting Firm(2)
24 Limited Power of Attorney(2)
31.1 Certification of Chief Executive Officer Pursuant to Section
302 of the Sarbanes - Oxley Act of 2002(2)
31.2 Certification of Chief Financial Officer Pursuant to Section
302 of the Sarbanes - Oxley Act of 2002(2)
32 Certifications Pursuant to 18 U.S.C. Section 1350,
as Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002(2)
99.1 Financial statements and independent registered public
accounting firm's report for First Merchants Corporation
Employee Stock Purchase Plan (See Exhibit 13 to this Form
10-K)(2)
(1) Management contract or compensatory plan.
(2) Filed here within.
(3) Incorporated by reference to the registrant's Form 8-K filed on
April 19, 2002.
Page 40
EXHIBIT-10a
First Merchants Corporation
Senior Management Incentive
Compensation Program
Approved February 8, 2007
I. Purpose
The Board of Directors of First Merchants Corporation (FMC) has established
an executive compensation program, which is designed to closely align the
interests of executives with those of our shareholders by rewarding senior
managers for achieving short-term and long-term corporate strategic
management goals, with the ultimate objective of obtaining a superior
return on the shareholders' investment.
II. Administration
This plan will be administered solely by the Compensation and Human
Resources Committee (Committee) of FMC, with supporting documentation and
recommendations provided by the Chief Executive Officer (CEO) of FMC. The
Committee will annually review the targets for applicability and
competitiveness.
The Committee will have the authority to: (a) modify the formal plan
document; (b) make the final award determinations; (c) set conditions for
eligibility and awards; (d) define extraordinary accounting events in
calculating earnings; (e) establish future payout schedules; (f) determine
circumstances/causes for which payouts can be withheld; and (g) abolish the
plan.
III. Covered Individuals by Title
A. President and Chief Executive Officer of FMC;
B. Executive Vice Presidents of FMC;
C. Senior Executives of FMC as recommended by CEO;
D. Affiliate Bank CEOs;
E. Non-Bank Affiliate CEOs;
F. Regional Presidents; and
G. Senior Executives of Affiliates as recommended by their CEO.
In order to receive an award, a participant must be employed at the time of
the award except for conditions of death, disability or retirement.
IV. Implementation Parameters
A. The FMC CEO and EVP earnings component payouts will be determined
by changes in FMC EPS calculated on a diluted GAAP basis.
Payouts to affiliate participants on their respective company earnings
component will be determined by changes in "operating earnings" (net
income plus or minus non-operating items including goodwill
amortization and corporate administrative charges.)
B. When utilized, balanced scorecards will be tailored to each unit
incorporating a specific weighting on various operating initiatives as
set by the CEO and COO.
V. Plan Structure
All payouts will be determined from the applicable schedule of percentage
change in earnings in Section VI.
A. FMC CEO
a. Target bonus: 45%
b. Maximum bonus: 90%
c. Change in diluted GAAP EPS at 100%
B. FMC COO
a. Target bonus: 40%
b. Maximum bonus: 80%
c. Change in diluted GAAP EPS at 100%
C. FMC CFO
a. Target bonus: 40%
b. Maximum bonus: 80%
c. Change in diluted GAAP EPS at 100%
D. FMC SVP
a. Target bonus: 30%
b. Maximum bonus: 51%
c. Weighting:
i. Change in diluted GAAP EPS at 70%
ii. Personal Objectives at 30%
E. Bank CEO
a. Target: 30%
b. Maximum: 52.5%
c. Balanced Scorecard
F. Regional President
a. Target bonus: 25%
b. Maximum bonus: 43.75%
c. Balanced Scorecard
G. Non-Bank Presidents
a. Target bonus: 25%
b. Maximum bonus: 50%
c. Balanced Scorecard
H. FMTC CEO
a. Target bonus: 25%
b. Weighting:
i. Change in FMTC earnings at 70%
ii. Personal Objectives at 30%
I. FMC Senior Officers
a. Target bonus: 25%
b. Maximum bonus: 42.5%
c. Weighting:
i. Change in diluted GAAP EPS at 70%
ii. Personal Objectives at 30%
J. Bank or Region SVP
a. Target bonus: 20%
b. Maximum bonus: 23.75%
c. Balanced Scorecard
K. FMTC SVP
a. Target Bonus: 20%
b. Weighting
c. Weighting:
i. Change in FMTC earnings at 70%
ii. Personal Objectives at 30%
L. FMTC Division Heads
a. Target bonus: 15%
b. Weighting:
i. Change in FMTC earnings at 70%
ii. Personal Objectives at 30%
M. FMC Division Head
a. Target bonus: 15%
b. Maximum bonus: 25.5%
c. Weighting:
i. Change in diluted GAAP EPS at 70%
ii. Personal Objectives at 30%
N. Bank or Region Division Heads
a. Target bonus: 15%
b. Maximum bonus: 17.81%
c. Balanced Scorecard
O. Bank or Region Department Heads
a. Target bonus: 10%
b. Maximum bonus: 11.88%
c. Balanced Scorecard
P. FMTC Department Heads
a. Target bonus: 10%
b. Weighting:
i. Change in FMTC earnings at 70%
ii. Personal Objectives at 30%
Q. Senior Mortgage Sales Managers
a. 5 bps on mortgage volume for bank or region
VI. Supporting Parameters
A. Where individual components are applicable, they must be measurable
with both beginning points and standard targets cited.
B. Schedule Determining both Operating earnings EPS and GAAP Payouts
for Year 2007 for FMC:
Operating Earnings % Change* Payout %
<3% 0%
3% 30%
4% 40%
5% 50%
6% 60%
7% 70%
8% 80%
9% 90%
Target 10% 100%
12% 120%
14% 140%
16% 160%
18% 180%
20% 200%
*Operating earnings adds back charges for amortization of goodwill and
other non-operating expenses as determined by the Committee.
C. Schedule Determining Operating Earnings Payouts for Year 2007 for
FMTC and FMIS:
Operating Earnings % Change* Payout %
<10% 0%
10% 40%
12.5% 50%
15% 60%
17.5% 70%
20% 80%
22.5% 90%
Target >25% 100%
*Operating earnings adds back charges for amortization of goodwill and
other non-operating expenses as determined by the Committee.
D. Schedule of Participants (referenced in Section III)
Section Company Target Name Job Title
A. FMC 45% Michael Cox Chief Executive Officer
B. FMC 40% Michael Rechin Chief Operating Officer
FMC Mark Hardwick Chief Financial Officer
C.
D. LBTC 30% Tony Albrecht Bank President & CEO
FMBCI Michael Baker Bank President & CEO
FMC Shawn Blackburn Senior Vice President
FMC Robert Connors Senior Vice President
FMC Kimberly Ellington Senior Vice President
FMB James Meinerding Bank President & CEO
CNB John Romelfanger Bank President & CEO
FMC David Spade Senior Vice President
E. Decatur Region 25% Steven Bailey Regional President
Portland Region Robert Bell Regional President
FMC Jami Cornish Vice President
Muncie Region Jack Demaree Regional President
FMC Karen Evens Vice President
Wabash Region Ron Kerby Regional President
FMTC Terri Matchett Trust President & CEO
FMIS Curt Stephenson President & CEO
F. FMBCI 20% Stephen Bill Senior Vice President
FMTC William Bittermann Senior Vice President
FMTC Terry Blaker Senior Vice President
FMB Muncie Region Tom Buczek Senior Vice President
LBTC Todd Burklow Executive Vice President
FMTC David Forbes Senior Vice President
LBTC Dan Gick Executive Vice President
FMB Wabash Region John Gouveia Senior Vice President
FMB Muncie Region Patty Hudson Senior Vice President
FMB Portland Region Chuck Huffman Senior Vice President
LBTC Sherry Keith Senior Vice President
FMBCI Kirk Klabunde Senior Vice President
FMB Richmond Region Scott McKee Senior Vice President
FMB Wabash Region Tony Millspaugh Senior Vice President
FMB Muncie Region Chris Parker Senior Vice President
FMBCI Bill Redman Senior Vice President
FMB Portland Region Duane Sautbine Senior Vice President
FMB Richmond Region Rick Tudor Senior Vice President
G. FMB Wabash Region 15% Duane Davis Vice President
FMC Stephan Fluhler First Vice President
FMC Philip Fortner Vice President
LBT David Flint Vice President
FMB Wabash Region Dennis Frieden Vice President
FMTC Pam Haager Vice President
FMTC Nichole Kinghorn Vice President
FMC Sharon Linder First Vice President
FMC Gary Marshall Vice President
FMC Pamela Miller Vice President
FMC David Ortega Vice President
FMC Gretchen Patterson Vice President
FMTC Sharon Powell Vice President
FMC Robert Rhoades Vice President
FMB Muncie Region Denby Turner Vice President
FMBCI Cindy White Vice President
FMC Brad Wise First Vice President
H. FMTC 10% Larry Anthrop Senior Vice President
FMTC Neal Barnum Vice President
FMTC Jim Keene Vice President
FMTC Jane Smith Vice President
FMB Muncie Region Tom Wiley Vice President
I. LBT 5 bps Janell Commons Vice President
FMB Richmond Region Jim Sprouse Vice President
EXHIBIT-13
FIRST MERCHANTS CORPORATION - ANNUAL REPORT 2006
EXHIBIT 13--FIRST MERCHANTS CORPORATION - ANNUAL REPORT 2006
FINANCIAL REVIEW
FIVE-YEAR SUMMARY OF
SELECTED FINANCIAL DATA 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS 3
REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM 20
CONSOLIDATED
FINANCIAL STATEMENTS 21
NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS 25
ANNUAL MEETING, STOCK PRICE AND DIVIDEND INFORMATION 55
COMMON STOCK LISTING 56
FORM 10-K, FINANCIAL INFORMATION AND CODE OF ETHICS 57
1
FIVE-YEAR SUMMARY OF SELECTED FINANCIAL DATA
(in thousands, except share data) 2006 2005 2004 2003 2002
===================================================================================================================================
Operations (3)(5)
Net Interest Income
Fully Taxable Equivalent (FTE) Basis ............ $ 114,076 $ 114,907 $ 108,986 $ 106,899 $ 96,599
Less Tax Equivalent Adjustment ..................... 3,981 3,778 3,597 3,757 3,676
---------- ---------- ---------- ---------- ----------
Net Interest Income ................................ 110,095 111,129 105,389 103,142 92,923
Provision for Loan Losses .......................... 6,258 8,354 5,705 9,477 7,174
---------- ---------- ---------- ---------- ----------
Net Interest Income
After Provision for Loan Losses ................. 103,837 102,775 99,684 93,665 85,749
Total Other Income ................................. 34,613 34,717 34,554 35,902 27,077
Total Other Expenses ............................... 96,057 93,957 91,642 91,279 71,009
---------- ---------- ---------- ---------- ----------
Income Before Income Tax Expense ................ 42,393 43,535 42,596 38,288 41,817
Income Tax Expense ................................. 12,195 13,296 13,185 10,717 13,981
---------- ---------- ---------- ---------- ----------
Net Income ......................................... $ 30,198 $ 30,239 $ 29,411 $ 27,571 $ 27,836
========== ========== ========== ========== ==========
Per share data (1)(3)(5)
Basic Net Income ................................... $ 1.64 $ 1.64 $ 1.59 $ 1.51 $ 1.70
Diluted Net Income ................................. 1.64 1.63 1.58 1.50 1.69
Cash Dividends Paid ................................ .92 .92 .92 .90 .86
December 31 Book Value ............................. 17.75 17.02 16.93 16.42 15.24
December 31 Market Value (Bid Price) ............... 27.19 26.00 28.30 25.51 21.67
Average balances (3)(5)
Total Assets ....................................... $3,371,386 $3,179,464 $3,109,104 $2,960,195 $2,406,251
Total Loans (4) .................................... 2,569,847 2,434,134 2,369,017 2,281,614 1,842,429
Total Deposits ..................................... 2,568,070 2,418,752 2,365,306 2,257,075 1,857,053
Securities Sold Under Repurchase Agreements
(long-term portion) ............................. 181 66,535
Total Federal Home Loan Bank Advances .............. 234,629 227,311 225,375 208,733 155,387
Total Subordinated Debentures, Revolving
Credit Lines and Term Loans ..................... 99,456 106,811 96,230 94,203 52,756
Total Stockholders' Equity ......................... 319,519 315,525 310,004 293,603 237,575
Year-end balances (3)(5)
Total Assets ....................................... $3,554,870 $3,237,079 $3,191,668 $3,076,812 $2,678,687
Total Loans (4) .................................... 2,698,014 2,462,337 2,431,418 2,356,546 2,025,922
Total Deposits ..................................... 2,750,538 2,382,576 2,408,150 2,362,101 2,036,688
Securities Sold Under Repurchase Agreements
(long-term portion) ............................. 320 23,632
Total Federal Home Loan Bank Advances .............. 242,408 247,865 223,663 212,779 184,677
Total Subordinated Debentures, Revolving
Credit Lines and Term Loans ..................... 83,956 103,956 97,206 97,782 72,488
Total Stockholders' Equity ......................... 327,325 313,396 314,603 303,965 261,129
Financial ratios (3)(5)
Return on Average Assets ........................... .90% .95% .95% .93% 1.16%
Return on Average Stockholders' Equity ............. 9.45 9.58 9.49 9.39 11.72
Average Earning Assets to Total Assets ............. 91.15 90.93 90.28 89.99 91.38
Allowance for Loan Losses as % of Total Loans ...... .99 1.02 .93 1.08 1.11
Dividend Payout Ratio .............................. 56.10 56.44 58.23 60.00 50.89
Average Stockholders' Equity to Average Assets ..... 9.48 9.92 9.97 9.92 9.87
Tax Equivalent Yield on Earning Assets (2) ......... 6.92 6.26 5.72 5.98 6.83
Cost of Supporting Liabilities ..................... 3.21 2.29 1.84 1.97 2.44
Net Interest Margin on Earning Assets .............. 3.71 3.97 3.88 4.01 4.39
(1) Restated for all stock dividends and stock splits.
(2) Average earning assets include the average balance of securities
classified as available for sale, computed based on the average of the
historical amortized cost balances without the effects of the fair value
adjustment.
(3) Business combinations that affect the comparability of the 2005, 2004 and
2003 information are discussed in Note 2 to the Consolidated Financial
Statements.
(4) Includes loans held for sale.
(5) On April 1, 2002, the Corporation acquired 100 percent of the outstanding
stock of Lafayette Bancorporation, the holding company of Lafayette Bank
and Trust Company, N.A. ("Lafayette"), which is located in Lafayette,
Indiana. Lafayette is a national chartered bank with branches located in
central Indiana. Lafayette Bancorporation was merged into the Corporation,
and Lafayette maintained its bank charter as a subsidiary of First
Merchants Corporation. The Corporation issued approximately 3,057,298
shares of its common stock at a cost of $21.30 per share and approximately
$50,867,000 in cash to complete the transaction. As a result of the
acquisition, the Corporation has an opportunity to increase its customer
base and continue to increase its market share. The purchase had a
recorded acquisition price of $115,978,000, including investments of
$104,717,000; loans of $552,016,000; premises and equipment of
$10,269,000; other assets of $64,074,000; deposits of $607,281,000; other
liabilities of $81,762,000 and goodwill of $57,893,000. None of the
goodwill is deductible for tax purposes. Additionally, core deposit
intangibles totaling $16,052,000 were recognized and are being amortized
over 10 years using the 150 percent declining balance method. The
combination was accounted for under the purchase method of accounting. All
assets and liabilities were recorded at their fair values as of April 1,
2002. The purchase accounting adjustments are being amortized over the
life of the respective asset or liability. Lafayette's results of
operations are included in the Corporation's consolidated results of
operations beginning April 1, 2002.
2
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
First Merchants Corporation ("Corporation") from time to time includes
forward-looking statements in its oral and written communication. The
Corporation may include forward-looking statements in filings with the
Securities and Exchange Commission, such as Form 10-K and Form 10-Q, in other
written materials and in oral statements made by senior management to analysts,
investors, representatives of the media and others. The Corporation intends
these forward-looking statements to be covered by the safe harbor provisions for
forward-looking statements contained in the Private Securities Litigation Reform
Act of 1995, and the Corporation is including this statement for purposes of
these safe harbor provisions. Forward-looking statements can often be identified
by the use of words like "believe", "continue", "pattern", "estimate",
"project", "intend", "anticipate", "expect" and similar expressions or future or
conditional verbs such as "will", "would", "should", "could", "might", "can",
"may" or similar expressions. These forward-looking statements include:
o statements of the Corporation's goals, intentions and expectations;
o statements regarding the Corporation's business plan and growth
strategies;
o statements regarding the asset quality of the Corporation's loan and
investment portfolios; and
o estimates of the Corporation's risks and future costs and benefits.
These forward-looking statements are subject to significant risks, assumptions
and uncertainties, including, among other things, the following important
factors which could affect the actual outcome of future events:
o fluctuations in market rates of interest and loan and deposit
pricing, which could negatively affect the Corporation's net
interest margin, asset valuations and expense expectations;
o adverse changes in the economy, which might affect the Corporation's
business prospects and could cause credit-related losses and
expenses;
o adverse developments in the Corporation's loan and investment
portfolios;
o competitive factors in the banking industry, such as the trend
towards consolidation in the Corporation's market;
o changes in the banking legislation or the regulatory requirements of
federal and state agencies applicable to bank holding companies and
banks like the Corporation's affiliate banks;
o acquisitions of other businesses by the Corporation and integration
of such acquired businesses;
o changes in market, economic, operational, liquidity, credit and
interest rate risks associated with the Corporation's business; and
o the continued availability of earnings and excess capital sufficient
for the lawful and prudent declaration and payment of cash
dividends.
Because of these and other uncertainties, the Corporation's actual future
results may be materially different from the results indicated by these
forward-looking statements. In addition, the Corporation's past results of
operations do not necessarily indicate its future results.
3
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES
Generally accepted accounting principles require management to apply significant
judgment to certain accounting, reporting and disclosure matters. Management
must use assumptions and estimates to apply those principles where actual
measurement is not possible or practical. For a complete discussion of the
Corporation's significant accounting policies, see the notes to the consolidated
financial statements and discussion throughout this Annual Report. Below is a
discussion of the Corporation's critical accounting policies. These policies are
critical because they are highly dependent upon subjective or complex judgments,
assumptions and estimates. Changes in such estimates may have a significant
impact on the Corporation's financial statements. Management has reviewed the
application of these policies with the Corporation's Audit Committee.
Allowance for Loan Losses. The allowance for loan losses represents management's
estimate of probable losses inherent in the Corporation's loan portfolio. In
determining the appropriate amount of the allowance for loan losses, management
makes numerous assumptions, estimates and assessments.
The Corporation's strategy for credit risk management includes conservative
credit policies and underwriting criteria for all loans, as well as an overall
credit limit for each customer significantly below legal lending limits. The
strategy also emphasizes diversification on a geographic, industry and customer
level, regular credit quality reviews and management reviews of large credit
exposures and loans experiencing deterioration of credit quality.
The Corporation's allowance consists of three components: probable losses
estimated from individual reviews of specific loans, probable losses estimated
from historical loss rates, and probable losses resulting from economic,
environmental, qualitative or other deterioration above and beyond what is
reflected in the first two components of the allowance.
Larger commercial loans that exhibit probable or observed credit weaknesses are
subject to individual review. Where appropriate, reserves are allocated to
individual loans based on management's estimate of the borrower's ability to
repay the loan given the availability of collateral, other sources of cash flow
and legal options available to the Corporation. Included in the review of
individual loans are those that are impaired as provided in SFAS No. 114,
Accounting by Creditors for Impairment of a Loan. Any allowances for impaired
loans are measured based on the present value of expected future cash flows
discounted at the loan's effective interest rate or fair value of the underlying
collateral. The Corporation evaluates the collectibility of both principal and
interest when assessing the need for a loss accrual. Historical loss rates are
applied to other commercial loans not subject to specific reserve allocations.
Homogenous loans, such as consumer installment and residential mortgage loans
are not individually risk graded. Reserves are established for each pool of
loans using loss rates based on a three year average net charge-off history by
loan category.
Historical loss allocations for commercial and consumer loans may be adjusted
for significant factors that, in management's judgment, reflect the impact of
any current conditions on loss recognition. Factors which management considers
in the analysis include the effects of the national and local economies, trends
in loan growth and charge-off rates, changes in mix, concentrations of loans in
specific industries,
4
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES continued
asset quality trends (delinquencies, charge-offs and nonaccrual loans), risk
management and loan administration, changes in the internal lending policies and
credit standards, examination results from bank regulatory agencies and the
Corporation's internal loan review.
An unallocated reserve, primarily based on the factors noted above, is
maintained to recognize the imprecision in estimating and measuring loss when
evaluating reserves for individual loans or pools of loans. Allowances on
individual loans and historical loss allocations are reviewed quarterly and
adjusted as necessary based on changing borrower and/or collateral conditions.
The Corporation's primary market areas for lending are north-central and
east-central Indiana and Columbus, Ohio. When evaluating the adequacy of
allowance, consideration is given to this regional geographic concentration and
the closely associated effect changing economic conditions have on the
Corporation's customers.
The Corporation has not substantively changed any aspect of its overall approach
in the determination of the allowance for loan losses. There have been no
material changes in assumptions or estimation techniques as compared to prior
periods that impacted the determination of the current period allowance.
Valuation of Securities. The Corporation's available-for-sale security portfolio
is reported at fair value. The fair value of a security is determined based on
quoted market prices. If quoted market prices are not available, fair value is
determined based on quoted prices of similar instruments. Available-for-sale and
held-to-maturity securities are reviewed quarterly for possible
other-than-temporary impairment. The review includes an analysis of the facts
and circumstances of each individual investment such as the length of time the
fair value has been below cost, the expectation for that security's performance,
the credit worthiness of the issuer and the Corporation's ability to hold the
security to maturity. A decline in value that is considered to be other-than
temporary is recorded as a loss within other operating income in the
consolidated statements of income.
Pension. The Corporation provides pension benefits to its employees. In
accordance with applicable accounting rules, the Corporation does not
consolidate the assets and liabilities associated with the pension plan.
Instead, the Corporation recognizes a prepaid asset for contributions the
Corporation has made to the pension plan in excess of pension expense. The
measurement of the prepaid asset and the annual pension expense involves
actuarial and economic assumptions.
The assumptions used in pension accounting relate to the expected rate of return
on plan assets, the rate of increase in salaries, the interest-crediting rate,
the discount rate, and other assumptions. See Note 16 "Employee Benefit Plans"
in the Annual Report for the specific assumptions used by the Corporation.
The annual pension expense for the Corporation is currently most sensitive to
the discount rate. Each 25 basis point reduction in the 2007 discount rate of
5.5 percent would increase the Corporation's 2007 pension expense by
approximately $95,000. In addition, each 25 basis point reduction in the 2007
expected rate of return of 7.75 percent would increase the Corporation's 2007
pension expense by approximately $101,000.
5
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES continued
Goodwill and Intangibles. For purchase acquisitions, the Corporation is required
to record the assets acquired, including identified intangible assets, and the
liabilities assumed at their fair value, which in many instances involves
estimates based on third party valuations, such as appraisals, or internal
valuations based on discounted cash flow analyses or other valuation techniques
that may include estimates of attrition, inflation, asset growth rates or other
relevant factors. In addition, the determination of the useful lives for which
an intangible asset will be amortized is subjective.
Goodwill and indefinite-lived assets recorded must be reviewed for impairment on
an annual basis, as well as on an interim basis if events or changes indicate
that the asset might be impaired. An impairment loss must be recognized for any
excess of carrying value over fair value of the goodwill or the indefinite-lived
intangible with subsequent reversal of the impairment loss being prohibited. The
tests for impairment fair values are based on internal valuations using
management's assumptions of future growth rates, future attrition, discount
rates, multiples of earnings or other relevant factors. The resulting estimated
fair values could have a significant impact on the carrying values of goodwill
or intangibles and could result in impairment losses being recorded in future
periods.
BUSINESS SUMMARY
The Corporation is a diversified financial holding company headquartered in
Muncie, Indiana. Since its organization in 1982, the Corporation has grown to
include eight affiliate banks with over 65 locations in 17 Indiana and 3 Ohio
counties. In addition to its branch network, the Corporation's delivery channels
include ATMs, check cards, interactive voice response systems and internet
technology.
The Corporation's business activities are currently limited to one significant
business segment, which is community banking. The Corporation's financial
service affiliates include eight nationally chartered banks: First Merchants
Bank, N.A., The Madison Community Bank, N.A., United Communities National Bank,
First National Bank, Decatur Bank and Trust Company, N.A., Frances Slocum Bank &
Trust Company, N.A., Lafayette Bank and Trust Company, N.A. and Commerce
National Bank. The banks provide commercial and retail banking services. In
addition, the Corporation's trust company, multi-line insurance company and
title company provide trust asset management services, retail and commercial
insurance agency services and title services, respectively.
Management believes that its vision, mission, culture statement and core values
produce profitable growth for stockholders. Management believes it is important
to maintain a well controlled environment as we continue to grow our businesses.
Credit policies are maintained and continue to produce sound asset quality.
Interest rate and market risks inherent in our asset and liability balances are
managed within prudent ranges, while ensuring adequate liquidity and funding.
6
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
As of December 31, 2006 total assets equaled $3,554,870,000, an increase of
$317,791,000 from December 31, 2005. Of this amount, loans increased
$235,677,000, investments increased $30,951,000, intangibles, including
goodwill, decreased $195,000 and cash value of life insurance increased by
$20,634,000. Details of these changes are discussed within the "EARNING ASSETS"
section of Management's Discussion and Analysis of Financial Condition and
Results of Operations.
As of December 31, 2005 total assets equaled $3,237,079,000, an increase of
$45,411,000 from December 31, 2004. Of this amount, loans increased $30,919,000,
investments increased $12,731,000, intangibles, including goodwill, decreased
$2,451,000 and cash value of life insurance increased by $1,518,000. Details of
these changes are discussed within the "EARNING ASSETS" section of Management's
Discussion and Analysis of Financial Condition and Results of Operations.
Net income for 2006 totaled $30,198,000, a decrease of $41,000 or .1 percent
from 2005. Diluted earnings per share totaled $1.64, a .6 percent increase from
$1.63 reported in 2005. The increase was primarily attributed to increases in
earning assets. This volume increase was offset by a decrease in net interest
margin of 26 basis points. These factors and others are discussed within the
respective sections of Management's Discussion and Analysis of Financial
condition and Results of Operations.
Net income for 2005 totaled $30,239,000, an increase of $828,000 or 2.8 percent
from 2004. Diluted earnings per share totaled $1.63, a 3.2 percent increase from
$1.58 reported for 2004. The increase was primarily attributable to an improved
net interest margin of 9 basis points as compared to 2004. However, the
improvement to net interest margin and its impact to net income was partially
mitigated by a $1,630,000 pension curtailment loss recorded during the year.
These factors and others are discussed within the respective sections of
Management's Discussion and Analysis of Financial Condition and Results of
Operations.
Return on equity totaled 9.45 percent in 2006, 9.58 percent in 2005, and 9.49
percent in 2004. Return on assets totaled .90 percent in 2006 and .95 percent in
2005 and 2004. Multiple factors impacting the reported financial results are
discussed within the respective sections of Management's Discussion and Analysis
of Financial Condition and Results of Operations.
CAPITAL
The Corporation's regulatory capital continues to exceed regulatory "well
capitalized" standards. Tier I regulatory capital consists primarily of total
stockholders' equity and subordinated debentures issued to business trusts
categorized as qualifying borrowings, less non-qualifying intangible assets and
unrealized net securities gains or losses. The Corporation's Tier I capital to
average assets ratio was 7.37 percent and 7.70 percent at December 31, 2006 and
2005, respectively.
7
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CAPITAL continued
In addition, at December 31, 2006, the Corporation had a Tier I risk-based
capital ratio of 9.18 percent and total risk-based capital ratio of 11.09
percent. Regulatory capital guidelines require a Tier I risk-based capital ratio
of 4.0 percent and a total risk-based capital ratio of 8.0 percent.
The Corporation's GAAP capital ratio, defined as total stockholders' equity to
total assets, equaled 9.21 percent as of December 31, 2006, down from 9.68
percent in 2005. When the Corporation acquires other companies for stock, GAAP
capital increases by the entire amount of the purchase price.
The Corporation's tangible capital ratio, defined as total stockholders' equity
less intangibles net of tax to total assets less intangibles net of tax, equaled
5.67 percent as of December 31, 2006 down from 5.82 percent in 2005.
Management believes that all of the above capital ratios are meaningful
measurements for evaluating the safety and soundness of the Corporation.
Additionally, management believes the following table is also meaningful when
considering performance measures of the Corporation. The table details and
reconciles tangible earnings per share, return on tangible capital and tangible
assets to traditional GAAP measures.
December 31,
(Dollars in Thousands) 2006 2005
==============================================================================
Average Goodwill ........................... $ 121,831 $ 120,867
Average Core Deposit Intangible (CDI) ...... 16,103 19,087
Average Deferred Tax on CDI ................ (4,994) (7,141)
----------- -----------
Intangible Adjustment ..................... $ 132,940 $ 132,813
=========== ===========
Average Stockholders' Equity (GAAP Capital) $ 319,519 $ 315,907
Intangible Adjustment ...................... (132,940) (132,813)
----------- -----------
Average Tangible Capital .................. $ 186,579 $ 183,094
=========== ===========
Average Assets ............................. $ 3,371,386 $ 3,195,784
Intangible Adjustment ...................... (132,940) (132,813)
----------- -----------
Average Tangible Assets ................... $ 3,328,446 $ 3,062,971
=========== ===========
Net Income ................................. $ 30,198 $ 30,239
CDI Amortization, net of tax ............... 1,920 1,952
----------- -----------
Tangible Net Income ....................... $ 32,118 $ 32,191
=========== ===========
Diluted Earnings per Share ................. $ 1.64 $ 1.63
Diluted Tangible Earnings per Share ........ $ 1.75 $ 1.73
Return on Average GAAP Capital ............. 9.45% 9.58%
Return on Average Tangible Capital ......... 17.21% 17.58%
Return on Average Assets ................... 0.90% 0.95%
Return on Average Tangible Assets .......... 0.99% 1.05%
ASSET QUALITY/PROVISION FOR LOAN LOSSES
The Corporation's primary business focus is small business and middle market
commercial and residential real estate, auto and small consumer lending, which
results in portfolio diversification. Management ensures that appropriate
methods to understand and underwrite risk are utilized. Commercial loans are
individually underwritten and judgmentally risk rated. They are periodically
monitored and prompt
8
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ASSET QUALITY/PROVISION FOR LOAN LOSSES continued
corrective actions are taken on deteriorating loans. Retail loans are typically
underwritten with statistical decision-making tools and are managed throughout
their life cycle on a portfolio basis.
The allowance for loan losses is maintained through the provision for loan
losses, which is a charge against earnings. The amount provided for loan losses
and the determination of the adequacy of the allowance are based on a continuous
review of the loan portfolio, including an internally administered loan "watch"
list and an independent loan review. The evaluation takes into consideration
identified credit problems, as well as the possibility of losses inherent in the
loan portfolio that are not specifically identified. (See Critical Accounting
Policies)
At December 31, 2006, non-performing loans totaled $20,880,000, an increase of
$6,575,000, as noted in the following table. Loans 90 days past due other than
non-accrual and restructured loans decreased by $1,321,000. The amount of
non-accrual loans totaled $17,926,000 at December 31, 2006. Non-performing loans
will increase or decrease going forward due to portfolio growth, routine problem
loan recognition and resolution through collections, sales or charge-offs. The
performance of any loan can be affected by external factors, such as economic
conditions, or factors particular to a borrower, such as actions of a borrower's
management.
At December 31, 2006, impaired loans totaled $60,320,000, an increase of
$7,940,000 from year end 2005. At December 31, 2006, a specific allowance for
losses was not deemed necessary for impaired loans totaling $43,029,000, but a
specific allowance of $4,130,000 was recorded for the remaining balance of
impaired loans of $17,291,000 and is included in the Corporation's allowance for
loan losses. The average balance of impaired loans for 2006 was $66,139,000. The
increase of total impaired loans is primarily due to the increase of performing,
substandard classified loans, which comprise a portion of the Corporation's
total impaired loans. A loan is deemed impaired when, based on current
information or events, it is probable that all amounts due of principal and
interest according to the contractual terms of the loan agreement will not be
collected. For the Corporation, all performing, substandard classified loans are
included in the impaired loan total.
At December 31, 2006, the allowance for loan losses was $26,540,000, an increase
of $1,352,000 from year end 2005. As a percent of loans, the allowance was .99
percent at December 31, 2006 and 1.02 percent at December 31, 2005. Management
believes that the allowance for loan losses is adequate to cover losses inherent
in the loan portfolio at December 31, 2006. The process for determining the
adequacy of the allowance for loan losses is critical to our financial results.
It requires management to make difficult, subjective and complex judgments, as a
result of the need to make estimates about the effect of matters that are
uncertain. Therefore, the allowance for loan losses, considering current factors
at the time, including economic conditions and ongoing internal and external
examination processes, will increase or decrease as deemed necessary to ensure
the allowance for loan losses remains adequate. In addition, the allowance as a
percentage of charge-offs and nonperforming loans will change at different
points in time based on credit performance, loan mix and collateral values.
The provision for loan losses in 2006 was $6,258,000, or 24 basis points, a
decrease of $2,096,000 from $8,354,000, or 34 basis points, in 2005, reflecting
the decline of 4 basis points in net charge offs during the year.
9
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ASSET QUALITY/PROVISION FOR LOAN LOSSES continued
The provision for loan losses in 2005 was $8,354,000, an increase of $2,649,000
from $5,705,000 in 2004. The Corporation's provision for loan losses increased
primarily due to an increase in the five-year rolling historical loan charge-off
ratio utilized within the Corporation's allowance for loan losses calculation.
The following table summarizes the non-accrual, contractually past due 90 days
or more other than non-accruing and restructured loans for the Corporation.
(Dollars in Thousands) December 31,
2006 2005
================================================================================
Non-accrual loans .......................... $17,926 $10,030
Loans contractually
past due 90 days or more
other than non-accruing .................. 2,870 3,965
Restructured loans ......................... 84 310
------- -------
Total .................................... $20,880 $14,305
======= =======
The table below represents loan loss experience for the years indicated.
(Dollars in Thousands) 2006 2005 2004
==============================================================================================
Allowance for loan losses:
Balance at January 1 ................................... $25,188 $22,548 $25,493
------- ------- -------
Chargeoffs ............................................. 6,510 7,744 10,901
Recoveries ............................................. 1,604 2,030 2,251
------- ------- -------
Net chargeoffs ......................................... 4,906 5,714 8,650
Provision for loan losses .............................. 6,258 8,354 5,705
------- ------- -------
Balance at December 31 ................................. $26,540 $25,188 $22,548
======= ======= =======
Ratio of net chargeoffs during the period to
average loans outstanding during the period ........... .19% .23% .37%
LIQUIDITY
Liquidity management is the process by which the Corporation ensures that
adequate liquid funds are available for the Corporation and its subsidiaries.
These funds are necessary in order for the Corporation and its subsidiaries to
meet financial commitments on a timely basis. These commitments include
withdrawals by depositors, funding credit obligations to borrowers, paying
dividends to shareholders, paying operating expenses, funding capital
expenditures, and maintaining deposit reserve requirements. Liquidity is
monitored and closely managed by the asset/liability committees at each
subsidiary and by the Corporation's asset/liability committee.
The liquidity of the Corporation is dependent upon the receipt of dividends from
its bank subsidiaries, which are subject to certain regulatory limitations as
explained in Note 14 to the consolidated financial statements, and access to
other funding sources. Liquidity of the Corporation's bank subsidiaries is
derived primarily from core deposit growth, principal payments received on
loans, the sale and maturity of investment securities, net cash provided by
operating activities, and access to other funding sources.
The most stable source, of liability-funded liquidity for both the long-term and
short-term, is deposit growth and retention in the core deposit base. In
addition, the Corporation utilizes advances from the Federal Home Loan Bank
("FHLB") and a revolving line of credit with LaSalle Bank, N.A. ("LaSalle") as
funding sources. At
10
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
LIQUIDITY continued
December 31, 2006, total borrowings from the FHLB were $242,408,000, and the
outstanding balance of the LaSalle revolving line of credit totaled $10,500,000.
The Corporation's bank subsidiaries have pledged certain mortgage loans and
certain investments to the FHLB. The total available remaining borrowing
capacities from FHLB and LaSalle at December 31, 2006, were $93,607,000 and
$9,500,000, respectively.
The principal source of asset-funded liquidity is investment securities
classified as available-for-sale, the market values of which totaled
$455,933,000 at December 31, 2006. Securities classified as held-to-maturity
that are maturing within a short period of time can also be a source of
liquidity. Securities classified as held-to-maturity and that are maturing in
one year or less totaled $125,000 at December 31, 2006. In addition, other types
of assets-such as cash and due from banks, federal funds sold and securities
purchased under agreements to resell, and loans and interest-bearing deposits
with other banks maturing within one year-are sources of liquidity.
In the normal course of business, the Corporation is a party to a number of
other off-balance sheet activities that contain credit, market and operational
risk that are not reflected in whole or in part in the Corporation's
consolidated financial statements. Such activities include: traditional
off-balance sheet credit-related financial instruments, commitments under
operating leases and long-term debt.
The Corporation provides customers with off-balance sheet credit support through
loan commitments and standby letters of credit. Summarized credit-related
financial instruments at December 31, 2006 are as follows:
At December 31,
(Dollars in Thousands) 2006
================================================================================
Amounts of commitments:
Loan commitments to extend credit .......................... $681,462
Standby letters of credit .................................. 23,286
--------
$704,748
========
Since many of the commitments are expected to expire unused or be only partially
used, the total amount of unused commitments in the preceding table does not
necessarily represent future cash requirements.
In addition to owned banking facilities, the Corporation has entered into a
number of long-term leasing arrangements to support the ongoing activities of
the Corporation. The required payments under such commitments and other
borrowing arrangements at December 31, 2006 are as follows:
after
(Dollars in Thousands) 2007 2008 2009 2010 2011 2011 Total
=============================================================================================================================
Operating leases $ 1,983 $ 1,571 $ 1,255 $ 1,113 $ 936 $ 752 $ 7,610
Federal funds purchased 56,150 56,150
Securities sold under
repurchase agreements 42,750 42,750
Federal Home Loan Bank advances 59,495 32,121 23,365 35,132 18,953 73,342 242,408
Subordinated debentures,
revolving credit lines and
term loans 10,500 88,956 99,456
-------- ------- ------- ------- ------- -------- --------
Total $170,878 $33,692 $24,620 $36,245 $19,889 $163,050 $448,374
======== ======= ======= ======= ======= ======== ========
11
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
LIQUIDITY continued
The Corporation has various purchase obligations for new facilities or
improvements to existing facilities. At December 31, 2006, the Corporation's
purchase obligations outstanding totaled $3,376,000.
INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK
Asset/Liability Management has been an important factor in the Corporation's
ability to record consistent earnings growth through periods of interest rate
volatility and product deregulation. Management and the Board of Directors
monitor the Corporation's liquidity and interest sensitivity positions at
regular meetings to review how changes in interest rates may affect earnings.
Decisions regarding investment and the pricing of loan and deposit products are
made after analysis of reports designed to measure liquidity, rate sensitivity,
the Corporation's exposure to changes in net interest income given various rate
scenarios and the economic and competitive environments.
It is the objective of the Corporation to monitor and manage risk exposure to
net interest income caused by changes in interest rates. It is the goal of the
Corporation's Asset/Liability function to provide optimum and stable net
interest income. To accomplish this, management uses two asset liability tools.
GAP/Interest Rate Sensitivity Reports and Net Interest Income Simulation
Modeling are both constructed, presented and monitored quarterly.
Management believes that the Corporation's liquidity and interest sensitivity
position at December 31, 2006, remained adequate to meet the Corporation's
primary goal of achieving optimum interest margins while avoiding undue interest
rate risk. The following table presents the Corporation's interest rate
sensitivity analysis as of December 31, 2006.
(Dollars in Thousands) At December 31, 2006
---------------------------------------------------------------------------------------------------------------------------------
1-180 DAYS 181-365 DAYS 1-5 YEARS BEYOND 5 YEARS TOTAL
=================================================================================================================================
Rate-Sensitive Assets:
Interest-bearing deposits .......................... $ 11,284 $ 11,284
Investment securities .............................. 43,360 $ 32,304 $ 308,330 $ 81,223 465,217
Loans .............................................. 1,280,654 372,506 937,464 107,390 2,698,014
Federal Reserve and Federal Home Loan Bank stock ... 23,691 23,691
----------- --------- ---------- -------- ---------
Total rate-sensitive assets ...................... 1,335,298 404,810 1,269,485 188,613 3,198,206
----------- --------- ---------- -------- ---------
Rate-Sensitive Liabilities:
Federal funds purchased ............................ 56,150 56,150
Interest-bearing deposits .......................... 1,670,452 392,587 315,393 10,048 2,388,480
Securities sold under repurchase agreements ........ 42,750 42,750
Federal Home Loan Bank advances .................... 37,000 22,495 109,423 73,490 242,408
Subordinated debentures, revolving credit
lines and term loans .............................. 10,500 88,956 99,456
----------- --------- ---------- -------- ---------
Total rate-sensitive liabilities ................. 1,816,852 415,082 424,816 172,494 2,829,244
----------- --------- ---------- -------- ---------
Interest rate sensitivity gap by period .............. $ (481,554) $ (10,272) $ 844,669 $ 16,119
Cumulative rate sensitivity gap ...................... (481,554) (491,826) 352,843 368,962
Cumulative rate sensitivity gap ratio
at December 31, 2006 ............................... 73.5% 78.0% 113.3% 113.0%
at December 31, 2005 ............................... 71.7% 81.5% 111.9% 113.7%
The Corporation had a cumulative negative gap of $491,826,000 in the one-year
horizon at December 31, 2006, just over 13.8 percent of total assets.
The Corporation places its greatest credence in net interest income simulation
modeling. The above GAP/Interest Rate Sensitivity Report is believed by the
Corporation's management to have two major shortfalls. The GAP/Interest Rate
Sensitivity Report fails to precisely gauge how often an interest rate sensitive
12
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK continued
product reprices, nor is it able to measure the magnitude of potential future
rate movements.
Net interest income simulation modeling, or earnings-at-risk, measures the
sensitivity of net interest income to various interest rate movements. The
Corporation's asset liability process monitors simulated net interest income
under three separate interest rate scenarios; base, rising and falling.
Estimated net interest income for each scenario is calculated over a 12-month
horizon. The immediate and parallel changes to the base case scenario used in
the model are presented below. The interest rate scenarios are used for
analytical purposes and do not necessarily represent management's view of future
market movements. Rather, these are intended to provide a measure of the degree
of volatility interest rate movements may introduce into the earnings of the
Corporation.
The base scenario is highly dependent on numerous assumptions embedded in the
model, including assumptions related to future interest rates. While the base
sensitivity analysis incorporates management's best estimate of interest rate
and balance sheet dynamics under various market rate movements, the actual
behavior and resulting earnings impact will likely differ from that projected.
For mortgage-related assets, the base simulation model captures the expected
prepayment behavior under changing interest rate environments. Assumptions and
methodologies regarding the interest rate or balance behavior of indeterminate
maturity products, e.g., savings, money market, NOW and demand deposits reflect
management's best estimate of expected future behavior.
The comparative rising and falling scenarios for the period ended December 31,
2006 assume further interest rate changes in addition to the base simulation
discussed above. These changes are immediate and parallel changes to the base
case scenario. In addition, total rate movements (beginning point minus ending
point) to each of the various driver rates utilized by management in the base
simulation for the period ended December 31, 2007 are as follows:
Driver Rates RISING FALLING
=================================================================
Prime 200 Basis Points (200) Basis Points
Federal Funds 200 (200)
One-Year CMT 200 (200)
Two-Year CMT 200 (200)
CD's 200 (191)
FHLB Advances 200 (200)
Results for the base, rising and falling interest rate scenarios are listed
below based upon the Corporation's rate sensitive assets and liabilities at
November 30, 2006. The net interest income shown represents cumulative net
interest income over a 12-month time horizon. Balance sheet assumptions used for
the base scenario are the same for the rising and falling simulations.
BASE RISING FALLING
================================================================================
Net Interest Income (Dollars in Thousands) $109,090 $108,036 $108,429
Variance from base $ (1,054) $ (631)
Percent of change from base (.96)% (.58)%
The comparative rising and falling scenarios for the period ending December 31,
2006 assume further interest rate changes in addition to the base simulation
discussed
13
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK continued
above. These changes are immediate and parallel changes to the base case
scenario. In addition, total rate movements (beginning point minus ending point)
to each of the various driver rates utilized by management in the base
simulation for the period ended December 31, 2006 are as follows:
Driver Rates RISING FALLING
=============================================================
Prime 200 Basis Points (200) Basis Points
Federal Funds 200 (200)
One-Year CMT 200 (200)
Two-Year CMT 200 (200)
Three-Year CMT 200 (200)
Five-Year CMT 200 (200)
CD's 200 (89)
FHLB Advances 200 (200)
Results for the base, rising and falling interest rate scenarios are listed
below. The net interest income shown represents cumulative net interest income
over a 12-month time horizon. Balance sheet assumptions used for the base
scenario are the same for the rising and falling simulations.
BASE RISING FALLING
================================================================================
Net Interest Income (Dollars in Thousands) $111,989 $114,930 $109,220
Variance from base $ 2,941 $ (2,769)
Percent of change from base 2.63% (2.47)%
EARNING ASSETS
The following table presents the earning asset mix as of December 31, 2006, and
December 31, 2005. Earnings assets increased by $269,655,000. Loans increased by
$235,677,000 and investment securities increased by $30,951,000 during 2006. The
largest loan segments that increased were in commercial and farmland real estate
of $126,564,000 and commercial and industrial loans of $76,203,000.
Earning Assets
(Dollars in Thousands) December 31,
==========================================================================================
2006 2005
---------- ----------
Interest-bearing time deposits .......................... $ 11,284 $ 8,748
Investment securities available for sale ................ 455,933 422,627
Investment securities held to maturity .................. 9,284 11,639
Mortgage loans held for sale ............................ 5,413 4,910
Loans ................................................... 2,692,601 2,457,427
Federal Reserve and Federal Home Loan Bank stock ........ 23,691 23,200
---------- ----------
Total ................................................. $3,198,206 $2,928,551
========== ==========
14
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
DEPOSITS AND BORROWINGS
The table below reflects the level of deposits and borrowed funds (federal funds
purchased; repurchase agreements; Federal Home Loan Bank advances; subordinated
debentures, revolving credit lines and term loans) based on year-end levels at
December 31, 2006 and 2005.
(Dollars in Thousands) December 31,
2006 2005
---------- ----------
Deposits ......................................... $2,750,538 $2,382,576
Federal funds purchased .......................... 56,150 50,000
Securities sold under repurchase agreements ...... 42,750 106,415
Federal Home Loan Bank advances .................. 242,408 247,865
Subordinated debentures, revolving credit lines
and term loans ................................. 99,456 103,956
---------- ----------
$3,191,302 $2,890,812
========== ==========
The Corporation has continued to leverage its capital position with Federal Home
Loan Bank advances, as well as repurchase agreements which are pledged against
acquired investment securities as collateral for the borrowings. The interest
rate risk is included as part of the Corporation's interest simulation discussed
in Management's Discussion and Analysis of Financial Condition and Results of
Operations under the headings "LIQUIDITY" and "INTEREST SENSITIVITY AND
DISCLOSURES ABOUT MARKET RISK".
NET INTEREST INCOME
Net interest income is the primary source of the Corporation's earnings. It is a
function of net interest margin and the level of average earning assets. The
following table presents the Corporation's asset yields, interest expense, and
net interest income as a percent of average earning assets for the three-year
period ending in 2006.
In 2006, asset yields increased 66 basis points (FTE) and interest cost
increased 92 basis points, resulting in a 26 basis point (FTE) decrease in net
interest margin as compared to 2005. The increase in interest income and
interest expense was primarily a result of four 25 basis point overnight federal
funds rate increases by the Federal Open Market Committee during this period.
During the period, interest rate compression produced a negative rate variance
of $8,021,000, while growth in earning assets produced a positive volume
variance of $6,987,000, resulting in a decline of $1,034,000 in net interest
income.
In 2005, asset yields increased 54 basis points (FTE) and interest cost
increased 45 basis points, resulting in a 9 basis point (FTE) increase in net
interest income as compared to 2004. The improvement in margin was primarily a
result of eight 25 basis point overnight federal funds rate increases by the
Federal Open Market Committee during this period. As a result, the Corporation's
prime lending rates increased accordingly, while offsetting deposit rate
increases were less significant.
15
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
NET INTEREST INCOME continued
(Dollars in Thousands) December 31,
2006 2005 2004
---- ---- ----
Net Interest Income ................................. $ 110,095 $ 111,129 $ 105,389
FTE Adjustment ...................................... $ 3,981 $ 3,778 $ 3,597
Net Interest Income
On a Fully Taxable Equivalent Basis ................ $ 114,076 $ 114,907 $ 108,986
Average Earning Assets .............................. $3,072,898 $2,891,121 $2,806,776
Interest Income (FTE) as a Percent
of Average Earning Assets .......................... 6.92% 6.26% 5.72%
Interest Expense as a Percent
of Average Earning Assets .......................... 3.21% 2.29% 1.84%
Net Interest Income (FTE) as a Percent
of Average Earning Assets .......................... 3.71% 3.97% 3.88%
Average earning assets include the average balance of securities classified as
available for sale, computed based on the average of the historical amortized
cost balances without the effects of the fair value adjustment. In addition,
annualized amounts are computed utilizing a 30/360 day basis.
OTHER INCOME
The Corporation offers a wide range of fee-based services. Fee schedules are
regularly reviewed by a pricing committee to ensure that the products and
services offered by the Corporation are priced to be competitive and profitable.
Other income in 2006 amounted to $34,613,000, a .3 percent decrease from 2005.
The change in other income from 2006 to 2005 was minor and primarily
attributable to fluctuations within the following other income items:
1. Fees on debit cards and ATMs increased by approximately
$297,000 as compared to the same period in 2005. This was
primarily a result of increase card usage by customers.
2. Earnings on cash surrender value of life insurance increased
approximately $619,000 compared to the same period in 2005 due
to a purchase of $18,000,000 of new life insurance policies in
2006.
3. Net gains and fees on sales of mortgage loans decreased by
$731,000 from the same period in 2005 due to stabilizing
mortgage interest rates resulting in reduced mortgage
originations.
4. A cash payment was received in 2005 of approximately $232,000,
related to our membership in a credit card network that was
merged with another card network. No such payment was received
during 2006.
Other income in 2005 amounted to $34,717,000, a .5 percent increase from 2004.
The change in other income from 2005 to 2004 was minor and primarily
attributable to fluctuations within the following other income items:
1. Insurance commissions increased by $733,000, due to the receipt of
increased profit sharing payments from insurance underwriters, as
compared to the same period in 2004.
16
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OTHER INCOME continued
2. Fees on debit cards and ATMs increased by approximately $899,000 as
compared to the same period in 2004. This was primarily a result of
increased card usage by customers.
3. Net gains and fees on sales of mortgage loans decreased by $727,000
from the same period in 2004, as stabilizing mortgage interest rates
caused reduced volumes of mortgage refinancing.
4. In 2005, sales of available for sale securities resulted in a net
loss of $2,000; however, in 2004, sales of available for sale
securities resulted in net gains totaling $1,188,000.
OTHER EXPENSES
Other expenses represent non-interest operating expenses of the Corporation.
Other expenses amounted to $96,057,000 in 2006, an increase of 2.2 percent from
the prior year. Salaries and benefit expense grew $2,100,000 or 3.9 percent due
to staff additions and normal salary increases. Approximately $833,000 of the
increase is due to share-based compensation expense recorded in 2006.
Other expenses amounted to $93,957,000 in 2005, an increase of 2.5 percent from
the prior year, or $2,315,000. A pension accounting loss, totaling approximately
$1,630,000, was recorded during the first quarter of 2005 and accounts for most
of the increase. The loss resulted from the curtailment of the accumulation of
defined benefits in the Corporation's defined benefit plan.
INCOME TAXES
Income tax expense totaled $12,195,000 for 2006, which is a decrease of
$1,101,000 from 2005. The effective tax rates for the periods ending December
31, 2006, 2005 and 2004 were 28.8 percent, 30.5 percent and 31.0 percent,
respectively. The effective tax rate has remained lower than the federal
statutory income tax rate of 34 percent, primarily due to the Corporation's
tax-exempt investment income on securities and loans, income tax credits
generated from investments in affordable housing projects, income generated by
subsidiaries domiciled in a state with no state or local income tax, increases
in tax exempt earnings from bank-owned life insurance contracts and reduced
state taxes, resulting from the effect of state income apportionment.
INFLATION
Changing prices of goods, services and capital affect the financial position of
every business enterprise. The level of market interest rates and the price of
funds loaned or borrowed fluctuate due to changes in the rate of inflation and
various other factors, including government monetary policy.
Fluctuating interest rates affect the Corporation's net interest income, loan
volume and other operating expenses, such as employee salaries and benefits,
reflecting the
17
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INFLATION continued
effects of escalating prices, as well as increased levels of operations and
other factors. As the inflation rate increases, the purchasing power of the
dollar decreases. Those holding fixed-rate monetary assets incur a loss, while
those holding fixed-rate monetary liabilities enjoy a gain. The nature of a
financial holding company's operations is such that there will generally be an
excess of monetary assets over monetary liabilities, and, thus, a financial
holding company will tend to suffer from an increase in the rate of inflation
and benefit from a decrease.
OTHER
The Securities and Exchange Commission maintains a Web site that contains
reports, proxy and information statements and other information regarding
registrants that file electronically with the commission, including the
Corporation, and that address is (http://www.sec.gov).
18
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
PERFORMANCE GRAPH
The following graph compares the cumulative 5-year total return to shareholders
on First Merchants Corporation's common stock relative to the cumulative total
returns of the Russell 2000 index and the Russell 2000 Financial Services index.
The graph assumes that the value of the investment in the Corporation's common
stock and in each of the indexes (including reinvestment of dividends) was $100
on 12/31/2001 and tracks it through 12/31/2006.
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among First Merchants Corporation, The Russell 2000 Index
And The Russell 2000 Financial Services Index
[LINE GRAPH OMITTED]
* $100 invested on 12/31/01 in stock or index-including reinvestment of
dividends. Fiscal year ending December 31.
--------------------------------------------------------------------------------------------------------
12/01 12/02 12/03 12/04 12/05 12/06
--------------------------------------------------------------------------------------------------------
First Merchants Corporation 100.00 103.36 126.01 144.97 137.95 149.63
Russell 2000 100.00 79.52 117.09 138.55 144.86 171.47
Russell 2000 Financial Services 100.00 102.11 142.42 172.97 176.99 211.93
The stock price performance included in this graph is not necessarily indicative
of future stock price performance.
19
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Audit Committee, Board of Directors and Stockholders
First Merchants Corporation
Muncie, Indiana
We have audited the accompanying consolidated balance sheets of First Merchants
Corporation as of December 31, 2006 and 2005, and the related consolidated
statements of income, comprehensive income, stockholders' equity and cash flows
for each of the three years in the period ended December 31, 2006. These
financial statements are the responsibility of the Corporation's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of First Merchants
Corporation as of December 31, 2006 and 2005, and the results of its operations
and its cash flows for each of the three years in the period ended December 31,
2006, in conformity with accounting principles generally accepted in the United
States of America.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of First Merchants
Corporation's internal control over financial reporting as of December 31, 2006
based on criteria established in Internal Control-Integrated Framework issued by
the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and
our report dated February 6, 2007 expressed unqualified opinions on management's
assessment and on the effectiveness of the Corporation's internal control over
financial reporting.
BKD, LLP
Indianapolis, Indiana
February 6, 2007
20
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Balance Sheets
(in thousands, except share data) December 31,
==================================================================================================================
2006 2005
Assets
Cash and due from banks .................................................... $ 89,957 $ 70,417
Interest-bearing time deposits ............................................. 11,284 8,748
Investment securities
Available for sale ........................................................ 455,933 422,627
Held to maturity (fair value of $11,510 and $5,520) ....................... 9,284 11,639
----------- -----------
Total investment securities .............................................. 465,217 434,266
Mortgage loans held for sale ............................................... 5,413 4,910
Loans, net of allowance for loan losses of $26,540 and $25,188 ............. 2,666,061 2,432,239
Premises and equipment ..................................................... 42,393 39,417
Federal Reserve and Federal Home Loan Bank stock ........................... 23,691 23,200
Interest receivable ........................................................ 24,345 19,690
Core deposit intangibles ................................................... 15,470 17,567
Goodwill ................................................................... 123,168 121,266
Cash value of life insurance ............................................... 64,213 43,579
Other assets ............................................................... 23,658 21,780
----------- -----------
Total assets ............................................................. $ 3,554,870 $ 3,237,079
=========== ===========
Liabilities
Deposits
Noninterest-bearing ....................................................... $ 362,058 $ 314,335
Interest-bearing .......................................................... 2,388,480 2,068,241
----------- -----------
Total deposits ........................................................... 2,750,538 2,382,576
Borrowings ................................................................. 440,764 508,236
Interest payable ........................................................... 9,326 5,874
Other liabilities .......................................................... 26,917 26,997
----------- -----------
Total liabilities ........................................................ 3,227,545 2,923,683
Commitments and Contingent Liabilities
Stockholders' equity
Preferred stock, no-par value
Authorized and unissued -- 500,000 shares
Common stock, $.125 stated value
Authorized -- 50,000,000 shares
Issued and outstanding - 18,439,843 and 18,416,714 shares ................. 2,305 2,302
Additional paid-in capital ................................................. 146,460 145,682
Retained earnings .......................................................... 187,965 174,717
Accumulated other comprehensive loss ....................................... (9,405) (9,305)
----------- -----------
Total stockholders' equity ............................................... 327,325 313,396
----------- -----------
Total liabilities and stockholders' equity ............................... $ 3,554,870 $ 3,237,079
=========== ===========
See notes to consolidated financial statements.
21
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Statements of Income
(in thousands, except share data) Year Ended December 31,
================================================================================================================================
2006 2005 2004
Interest income
Loans receivable
Taxable ............................................................ $ 186,768 $ 158,436 $139,953
Tax exempt ......................................................... 828 643 581
Investment securities
Taxable ............................................................ 12,316 9,612 8,371
Tax exempt ......................................................... 6,565 6,374 6,098
Federal funds sold .................................................. 373 264 165
Deposits with financial institutions ................................ 500 695 555
Federal Reserve and Federal Home Loan Bank stock .................... 1,256 1,185 1,251
--------- --------- --------
Total interest income ............................................. 208,606 177,209 156,974
--------- --------- --------
Interest expense
Deposits ............................................................ 74,314 46,121 33,844
Federal funds purchased ............................................. 1,842 623
Securities sold under repurchase agreements ......................... 3,228 1,612 517
Federal Home Loan Bank advances ..................................... 10,734 9,777 9,777
Subordinated debentures, revolving
credit lines and term loans ........................................ 8,124 7,432 6,784
Other borrowings .................................................... 269 515 663
--------- --------- --------
Total interest expense ............................................ 98,511 66,080 51,585
--------- --------- --------
Net interest income ................................................... 110,095 111,129 105,389
Provision for loan losses ........................................... 6,258 8,354 5,705
--------- --------- --------
Net interest income after provision for loan losses ................... 103,837 102,775 99,684
--------- --------- --------
Other income
Fiduciary activities ................................................ 7,625 7,481 7,632
Service charges on deposit accounts ................................. 11,262 11,298 11,638
Other customer fees ................................................. 5,517 5,094 4,083
Net realized gains (losses) on
sales of available-for-sale securities ............................. (4) (2) 1,188
Commission income ................................................... 4,302 3,821 3,088
Earnings on cash surrender value
of life insurance .................................................. 2,286 1,667 1,798
Net gains and fees on sales of loans ................................ 2,171 2,902 3,629
Other income ........................................................ 1,454 2,456 1,498
--------- --------- --------
Total other income ................................................ 34,613 34,717 34,554
--------- --------- --------
Other expenses
Salaries and employee benefits ...................................... 56,125 54,059 52,479
Net occupancy expenses .............................................. 5,886 5,796 5,308
Equipment expenses .................................................. 7,947 7,562 7,665
Marketing expenses .................................................. 1,932 2,012 1,709
Outside data processing fees ........................................ 3,449 4,010 4,920
Printing and office supplies ........................................ 1,496 1,369 1,580
Core deposit amortization ........................................... 3,066 3,102 3,375
Other expenses ...................................................... 16,156 16,047 14,606
--------- --------- --------
Total other expenses .............................................. 96,057 93,957 91,642
--------- --------- --------
Income before income tax .............................................. 42,393 43,535 42,596
Income tax expense .................................................. 12,195 13,296 13,185
--------- --------- --------
Net income ............................................................ $ 30,198 $ 30,239 $ 29,411
========= ========= ========
Net income per share:
Basic ............................................................... $ 1.64 $ 1.64 $ 1.59
Diluted ............................................................. 1.64 1.63 1.58
See notes to consolidated financial statements.
22
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Statements of Comprehensive Income
Year Ended December 31,
(in thousands) 2006 2005 2004
==============================================================================================================================
Net income ....................................................................... $ 30,198 $ 30,239 $ 29,411
-------- -------- --------
Other comprehensive income (loss), net of tax:
Unrealized losses on securities available for sale:
Unrealized holding losses arising during the period,
net of income tax benefit (expense) of $(1,242), $3,562 and $1,199 ............ 2,087 (6,615) (1,799)
Less: Reclassification adjustment for gains (losses) included in net income,
net of income tax (expenses) benefit of $2, $1 and $(475) .................... (2) (1) 713
Unrealized gains (losses) on cash flow hedge assets:
Unrealized gain (loss) arising during the period,
net of income tax benefit of $83, $0 and $0 ................................... (125)
Unrealized loss on pension minimum funding liability:
Unrealized loss arising during the period,
net of income tax benefit of $0, $1,767 and $150 .............................. (2,651) 227
-------- -------- --------
1,964 (9,265) (2,285)
-------- -------- --------
COMPREHENSIVE INCOME $ 32,162 $ 20,974 $ 27,126
======== ======== ========
Consolidated Statements of Stockholders' Equity
COMMON STOCK ACCUMULATED OTHER
------------------------- ADDITIONAL RETAINED COMPREHENSIVE
SHARES AMOUNT PAID-IN CAPITAL EARNINGS INCOME (LOSS) TOTAL
----------- -------- --------------- --------- ------------- --------
Balances, December 31, 2003 ................. 18,512,834 $ 2,314 $ 150,310 $ 149,096 $ 2,245 $303,965
Net income for 2004 ........................ 29,411 29,411
Cash dividends ($.92 per share) ............ (17,048) (17,048)
Other comprehensive income (loss),
net of tax ............................... (2,285) (2,285)
Stock issued under employee benefit plans .. 45,267 6 897 903
Stock issued under dividend reinvestment
and stock purchase plan .................. 50,799 6 1,272 1,278
Stock options exercised .................... 90,338 11 1,393 1,404
Stock redeemed ............................. (193,789) (24) (4,702) (4,726)
Issuance of stock related to acquisition ... 68,548 9 1,692 1,701
----------- -------- --------- --------- ------- --------
Balances, December 31, 2004 ................. 18,573,997 2,322 150,862 161,459 (40) 314,603
Net income for 2005 ........................ 30,239 30,239
Cash dividends ($.92 per share) ............ (16,981) (16,981)
Other comprehensive income (loss),
net of tax ............................... (9,265) (9,265)
Stock issued under employee benefit plans .. 43,238 6 908 914
Stock issued under dividend reinvestment
and stock purchase plan .................. 35,565 4 929 933
Stock options exercised .................... 121,750 15 2,159 2,174
Stock redeemed ............................. (374,598) (47) (9,611) (9,658)
Issuance of stock related to acquisition ... 16,762 2 435 437
----------- -------- --------- --------- ------- --------
Balances, December 31, 2005 ................. 18,416,714 2,302 145,682 174,717 (9,305) 313,396
Net income for 2006 ........................ 30,198 30,198
Cash dividends ($.92 per share) ............ (16,950) (16,950)
Other comprehensive income (loss),
net of tax ............................... 1,964 1,964
Adjustment to initially apply FASB statement
No. 158, net of tax ...................... (2,064) (2,064)
Share-based compensation ................... 972 972
Stock issued under employee benefit plans .. 41,391 5 852 857
Stock issued under dividend reinvestment
and stock purchase plan .................. 48,788 6 1,184 1,190
Stock options exercised .................... 90,138 11 1,598 1,609
Stock redeemed ............................. (234,495) (29) (5,661) (5,690)
Issuance of stock related to acquisition ... 77,307 10 1,833 1,843
----------- -------- --------- --------- ------- --------
Balances, December 31, 2006 ................. 18,439,843 $ 2,305 $ 146,460 $ 187,965 $(9,405) $327,325
=========== ======== ========= ========= ======= ========
See notes to consolidated financial statements.
23
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Statements of Cash Flows
===================================================================================================================================
Year Ended December 31,
(in thousands, except share data) 2006 2005 2004
===================================================================================================================================
Operating activities:
Net income .............................................................. $ 30,198 $ 30,239 $ 29,411
Adjustments to reconcile net income to
net cash provided by operating activities:
Provision for loan losses .............................................. 6,258 8,354 5,705
Depreciation and amortization .......................................... 5,382 5,070 5,064
Share-based compensation ............................................... 833
Tax benefits from stock options exercised .............................. (139)
Mortgage loans originated for sale ..................................... (123,256) (86,122) (83,313)
Proceeds from sales of mortgage loans .................................. 122,753 84,579 82,989
Net change in
Interest receivable .................................................. (4,655) (2,372) (478)
Interest payable ..................................................... 3,452 1,463 (269)
Other adjustments ...................................................... (4,549) 5,283 842
--------- --------- ---------
Net cash provided by operating activities ............................ 36,277 46,494 39,951
--------- --------- ---------
Investing activities:
Net change in interest-bearing deposits ................................. (2,536) 595 (1,202)
Purchases of
Securities available for sale .......................................... (100,355) (97,861) (214,393)
Proceeds from maturities of
Securities available for sale .......................................... 64,778 69,236 116,294
Securities held to maturity ............................................ 6,526
Proceeds from sales of
Securities available for sale .......................................... 575 4,718 32,336
Purchase of Federal Reserve and Federal Home Loan Bank stock ............ (491) (342) (7,356)
Purchase of bank owned life insurance ................................... (18,000)
Net change in loans ..................................................... (240,080) (35,090) (83,198)
Net cash paid in acquisition ............................................ (59) (213) (201)
Other adjustments ....................................................... (8,358) (6,233) (6,106)
--------- --------- ---------
Net cash used by investing activities ................................ (298,000) (65,190) (163,826)
--------- --------- ---------
Cash flows from financing activities:
Net change in
Demand and savings deposits ............................................ 133,591 (80,986) 89,008
Certificates of deposit and other time deposits ........................ 234,372 55,412 (42,959)
Receipt of borrowings ................................................... 182,454 191,002 181,211
Repayment of borrowings ................................................. (249,927) (123,657) (124,763)
Cash dividends .......................................................... (16,899) (16,981) (17,048)
Cash dividends on restricted stock awards ............................... (52)
Stock issued under employee benefit plans ............................... 857 914 903
Stock issued under dividend reinvestment
and stock purchase plan ................................................ 1,190 933 1,278
Stock options exercised ................................................. 1,228 2,174 1,404
Tax benefits from stock options exercised ............................... 139
Stock redeemed .......................................................... (5,690) (9,658) (4,726)
--------- --------- ---------
Net cash provided by financing activities ............................ 281,263 19,153 84,308
--------- --------- ---------
Net change in cash and cash equivalents ................................... 19,540 457 (39,567)
Cash and cash equivalents, beginning of year .............................. 70,417 69,960 109,527
--------- --------- ---------
Cash and cash equivalents, end of year .................................... $ 89,957 $ 70,417 $ 69,960
========= ========= =========
Additional cash flows information:
Interest paid ........................................................... $ 95,059 $ 64,617 $ 51,854
Income tax paid ......................................................... 14,385 16,775 10,501
See notes to consolidated financial statements.
24
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 1
NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies of First Merchants Corporation
("Corporation"), and its wholly owned subsidiaries, First Merchants Bank, N.A.
("First Merchants"), The Madison Community Bank, N.A. ("Madison"), United
Communities National Bank ("United Communities"), First National Bank ("First
National"), Decatur Bank and Trust Company, N.A. ("Decatur"), Frances Slocum
Bank & Trust Company, N.A. ("Frances Slocum"), Lafayette Bank and Trust Company,
N.A. ("Lafayette"), and Commerce National Bank ("Commerce National"),
(collectively the "Banks"), First Merchants Trust Company, National Association
("FMTC"), First Merchants Insurance Services, Inc. ("FMIS"), First Merchants
Reinsurance Company ("FMRC")and Indiana Title Insurance Company ("ITIC"),
conform to generally accepted accounting principles and reporting practices
followed by the banking industry. The Corporation approved on January 23, 2007,
the combination of five of its bank charters into one. Subject to the approval
of the Office of the Comptroller of the Currency (OCC), Frances Slocum, Decatur,
First National and United Communities will combine with First Merchants. The
anticipated effective date of the combinations is April 2, 2007. The Corporation
also approved, subject to OCC approval, the combination of the Hamilton County,
Indiana, offices of First Merchants Bank and Madison Community Bank under the
new name of First Merchants Bank of Central Indiana, National Association. As a
result of these combinations, the Corporation will hold four bank charters:
First Merchants, First Merchants Bank of Central Indiana, Lafayette and Commerce
National. The more significant of the policies are described below.
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
The Corporation is a financial holding company whose principal activity is the
ownership and management of the Banks and operates in a single significant
business segment. The Banks operate under national bank charters and provide
full banking services. As national banks, the Banks are subject to the
regulation of the Office of the Comptroller of the Currency and the Federal
Deposit Insurance Corporation.
The Banks generate commercial, mortgage, and consumer loans and receive deposits
from customers located primarily in north-central and east-central Indiana and
Butler, Franklin and Hamilton counties in Ohio. The Banks' loans are generally
secured by specific items of collateral, including real property, consumer
assets and business assets.
CONSOLIDATION
The consolidated financial statements include the accounts of the Corporation
and all its subsidiaries, after elimination of all material intercompany
transactions.
INVESTMENT SECURITIES-Debt securities are classified as held to maturity when
the Corporation has the positive intent and ability to hold the securities to
maturity. Securities held to maturity are carried at amortized cost. Debt
securities not classified as held to maturity are classified as available for
sale. Securities
25
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 1
NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES continued
available for sale are carried at fair value with unrealized gains and losses
reported separately in accumulated other comprehensive income, net of tax.
Amortization of premiums and accretion of discounts are recorded as interest
income from securities. Realized gains and losses are recorded as net security
gains (losses). Gains and losses on sales of securities are determined on the
specific-identification method.
Available-for-sale and held-to-maturity securities are reviewed quarterly for
possible other-than-temporary impairment. The review includes an analysis of the
facts and circumstances of each individual investment such as the length of time
the fair value has been below cost, the expectation for that security's
performance, the credit worthiness of the issuer and the Corporation's ability
to hold the security to maturity. A decline in value that is considered to be
other-than temporary is recorded as a loss within other operating income in the
consolidated statements of income.
LOANS HELD FOR SALE are carried at the lower of aggregate cost or market. Market
is determined using the aggregate method. Net unrealized losses, if any, are
recognized through a valuation allowance by charges to income based on the
difference between estimated sales proceeds and aggregate cost.
LOANS held in the Corporation's portfolio are carried at the principal amount
outstanding. Certain nonaccrual and substantially delinquent loans may be
considered to be impaired. A loan is impaired when, based on current information
or events, it is probable that the Banks will be unable to collect all amounts
due (principal and interest) according to the contractual terms of the loan
agreement. In applying the provisions of Statement of Financial Accounting
Standards ("SFAS") No. 114, the Corporation considers its investment in
one-to-four family residential loans and consumer installment loans to be
homogeneous and therefore excluded from separate identification for evaluation
of impairment. Interest income is accrued on the principal balances of loans,
except for installment loans with add-on interest, for which a method that
approximates the level yield method is used. The accrual of interest on impaired
loans is discontinued when, in management's opinion, the borrower may be unable
to meet payments as they become due. When interest accrual is discontinued, all
unpaid accrued interest is reversed when considered uncollectable. Interest
income is subsequently recognized only to the extent cash payments are received.
Certain loan fees and direct costs are being deferred and amortized as an
adjustment of yield on the loans.
ALLOWANCE FOR LOAN LOSSES is maintained to absorb losses inherent in the loan
portfolio and is based on ongoing, quarterly assessments of the probable losses
inherent in the loan portfolio. The allowance is increased by the provision for
loan losses, which is charged against current operating results. Loan losses are
charged against the allowance when management believes the uncollectibility of a
loan balance is confirmed. Subsequent recoveries, if any, are credited to the
allowance. The Corporation's methodology for assessing the appropriateness of
the allowance consists of three key elements - the determination of the
appropriate reserves for specifically identified loans, historical losses, and
economic, environmental or qualitative factors.
26
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 1
NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES continued
Larger commercial loans that exhibit probable or observed credit weaknesses are
subject to individual review. Where appropriate, reserves are allocated to
individual loans based on management's estimate of the borrower's ability to
repay the loan given the availability of collateral, other sources of cash flow
and legal options available to the Corporation. Included in the review of
individual loans are those that are impaired as provided in SFAS No. 114. Any
allowances for impaired loans are measured based on the present value of
expected future cash flows discounted at the loan's effective interest rate or
fair value of the underlying collateral. The Corporation evaluates the
collectibility of both principal and interest when assessing the need for a loss
accrual. Historical loss rates are applied to other commercial loans not subject
to specific reserve allocations.
Homogenous loans, such as consumer installment and residential mortgage loans
are not individually risk graded. Reserves are established for each pool of
loans using loss rates based on a three year average net charge-off history by
loan category.
Historical loss allocations for commercial and consumer loans may be adjusted
for significant factors that, in management's judgment, reflect the impact of
any current conditions on loss recognition. Factors which management considers
in the analysis include the effects of the national and local economies, trends
in loan growth and charge-off rates, changes in mix, concentration of loans in
specific industries, asset quality trends (delinquencies, charge-offs and
nonaccrual loans), risk management and loan administration, changes in the
internal lending policies and credit standards, examination results from bank
regulatory agencies and the Corporation's internal loan review.
An unallocated reserve, primarily based on the factors noted above, is
maintained to recognize the imprecision in estimating and measuring loss when
evaluating reserves for individual loans or pools of loans. Allowances on
individual loans and historical loss allocations are reviewed quarterly and
adjusted as necessary based on changing borrower and/or collateral conditions.
PREMISES AND EQUIPMENT are carried at cost net of accumulated depreciation.
Depreciation is computed using the straight-line and declining balance methods
based on the estimated useful lives of the assets. Maintenance and repairs are
expensed as incurred, while major additions and improvements are capitalized.
Gains and losses on dispositions are included in current operations.
FEDERAL RESERVE AND FEDERAL HOME LOAN BANK STOCK are required investments for
institutions that are members of the Federal Reserve Bank ("FRB") and Federal
Home Loan Bank ("FHLB") systems. The required investment in the common stock is
based on a predetermined formula.
INTANGIBLE ASSETS that are subject to amortization, including core deposit
intangibles, are being amortized on both the straight-line and accelerated basis
over 3 to 20 years. Intangible assets are periodically evaluated as to the
recoverability of their carrying value.
27
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 1
NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES continued
GOODWILL is maintained by applying the provisions of SFAS No. 142. Goodwill is
reviewed for impairment annually in accordance with this statement with any loss
recognized through the income statement, at that time.
INCOME TAX in the consolidated statements of income includes deferred income tax
provisions or benefits for all significant temporary differences in recognizing
income and expenses for financial reporting and income tax purposes. The
Corporation files consolidated income tax returns with its subsidiaries.
STOCK OPTION AND RESTRICTED STOCK AWARD PLANS are maintained by the Corporation
and are described more fully in Note 16. Prior to 2006, the Corporation
accounted for these plans under the recognition and measurement principles of
APB Opinion No. 25. Accounting for Stock Issued to Employees, and related
Interpretations. Accordingly, in 2005 and 2004 no stock-based employee
compensation cost is reflected in net income, as all awards granted under these
plans had an exercise price equal to the market value of the underlying common
stock at the grant date.
Effective January 1, 2006 the Corporation adopted the fair value recognition
provisions of Statement of Financial Accounting Standards (SFAS) No. 123R,
Share-Based Payment. The Corporation selected the modified prospective
application. Accordingly, after January 1, 2006, the Corporation began expensing
the fair value of stock awards granted, modified, repurchased or cancelled.
The following table illustrates the effect on net income and earnings per share
if the Corporation had applied the fair value provisions of SFAS No. 123,
Accounting for Stock-Based Compensation, to stock-based compensation in 2005 and
2004.
Year Ended December 31
2005 2004
--------------------
Net income, as reported .......................... $30,239 $ 29,411
Add: Total stock-based employee compensation
cost included in reported net income, net
of income taxes
Less: Total stock-based employee compensation
cost determined under the fair value based
method, net of income taxes .................... (2,159) (1,083)
------- --------
Pro forma net income ............................. $28,080 $ 28,328
======= ========
Earnings per share:
Basic - as reported ............................ $ 1.64 $ 1.59
Basic - pro forma .............................. $ 1.52 $ 1.53
Diluted - as reported .......................... $ 1.63 $ 1.58
Diluted - pro forma ............................ $ 1.51 $ 1.52
EARNINGS PER SHARE have been computed based upon the weighted average common and
common equivalent shares outstanding during each year.
NOTE 2
BUSINESS COMBINATIONS
Effective October 13, 2006, the Corporation acquired Armstrong Insurance, Inc.
of Parker City, an Indiana corporation, which has merged into FMIS, a
wholly-owned subsidiary of the Corporation. The Corporation issued 77,307 shares
of it's common
28
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 2
BUSINESS COMBINATIONS continued
stock at a cost of $23.845 per share to complete the transaction. The
acquisition was deemed to be an immaterial acquisition.
Effective September 1, 2005, the Corporation acquired Trustcorp Financial
Services of Greenville, Inc., an Ohio corporation, which was merged into FMIS, a
wholly-owned subsidiary of the Corporation. The Corporation issued 16,762 shares
of its common stock at a cost of $26.10 per share to complete the transaction.
The acquisition was deemed to be an immaterial acquisition.
Effective October 15, 2004, the Corporation acquired Mangas Agencies, Inc.,
which was merged into FMIS, a wholly-owned subsidiary of the Corporation. The
Corporation issued 68,548 shares of its common stock at a cost of $24.80 per
share to complete the transaction. The acquisition was deemed to be an
immaterial acquisition.
NOTE 3
RESTRICTION ON CASH AND DUE FROM BANKS
The Banks are required to maintain reserve funds in cash and/or on deposit with
the Federal Reserve Bank. The reserve required at December 31, 2006, was
$12,950,000.
29
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 4
INVESTMENT SECURITIES
------------------------------------------------------------------------------------------------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
====================================================================================================================================
Available for sale at December 31, 2006
U.S. Treasury ................................................ $ 1,502 $ 1 $ 1,503
U.S. Government-sponsored agency securities .................. 87,193 69 $ 1,284 85,978
State and municipal .......................................... 168,262 2,251 892 169,621
Mortgage-backed securities ................................... 195,228 600 3,983 191,845
Other asset-backed securities
Marketable equity securities ................................. 7,296 310 6,986
-------- -------- -------- --------
Total available for sale .................................... 459,481 2,921 6,469 455,933
-------- -------- -------- --------
Held to maturity at December 31, 2006
State and municipal .......................................... 9,266 432 200 9,498
Mortgage-backed securities ................................... 18 18
-------- -------- -------- --------
Total held to maturity ...................................... 9,284 432 200 9,516
-------- -------- -------- --------
Total investment securities ................................. $468,765 $ 3,353 $ 6,669 $465,449
======== ======== ======== ========
Available for sale at December 31, 2005
U.S. Treasury ................................................ $ 1,586 $ 1 $ 1,585
U.S. Government-sponsored agency securities .................. 83,026 $ 1 1,836 81,191
State and municipal .......................................... 167,095 2,159 1,131 168,123
Mortgage-backed securities ................................... 168,019 139 5,656 162,502
Other asset-backed securities ................................ 1 1
Marketable equity securities ................................. 9,660 435 9,225
-------- -------- -------- --------
Total available for sale .................................... 429,387 2,299 9,059 422,627
-------- -------- -------- --------
Held to maturity at December 31, 2005
State and municipal .......................................... 11,609 283 412 11,480
Mortgage-backed securities ................................... 30 30
-------- -------- -------- --------
Total held to maturity ...................................... 11,639 283 412 11,510
-------- -------- -------- --------
Total investment securities ................................. $441,026 $ 2,582 $ 9,471 $434,137
======== ======== ======== ========
Certain investments in debt securities are reported in the financial statements
at an amount less than their historical cost. The historical cost of these
investments totaled $306,650,000 and $337,959,000 at December 31, 2006 and 2005,
respectively. Total fair value of these investments was $299,984,000 and
$328,488,000, which is approximately 64.5 and 75.7 percent of the Corporation's
available-for-sale and held-to-maturity investment portfolio at December 31,
2006 and 2005, respectively. These declines primarily resulted from recent
increases in market interest rates.
Based on evaluation of available evidence, including recent changes in market
interest rates, credit rating information and information obtained from
regulatory filings, management believes the declines in fair value for these
securities are temporary. Should the impairment of any of these securities
become other than temporary, the cost basis of the investment will be reduced
and the resulting loss recognized in net income in the period the
other-than-temporary impairment is identified.
30
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 4
INVESTMENT SECURITIES continued
The following tables show the Corporation's gross unrealized losses and fair
value, aggregated by investment category and length of time that individual
securities have been in a continuous unrealized loss position at December 31,
2006 and 2005:
Less than 12 12 Months or Total
Months Longer
----------------------------------------------------------------------
GROSS GROSS GROSS
FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED
VALUE LOSSES VALUE LOSSES VALUE LOSSES
----------------------------------------------------------------------
Temporarily impaired investment
securities at December 31, 2006:
U.S. Government-sponsored agency securities ............. $ 1,576 $ (3) $ 71,702 $ (1,281) $ 73,278 $ (1,284)
State and municipal ..................................... 9,608 (35) 81,841 (1,057) 91,449 (1,092)
Mortgage-backed securities .............................. 7,459 (20) 126,555 (3,963) 134,014 (3,983)
Other asset-backed securities ........................... 28 (6) 28 (6)
Marketable equity securities ............................ 1,215 (304) 1,215 (304)
-------- -------- -------- -------- -------- --------
Total temporarily impaired investment securities ...... $ 19,858 $ (362) $280,126 $ (6,307) $299,984 $ (6,669)
======== ======== ======== ======== ======== ========
Less than 12 12 Months or Total
Months Longer
----------------------------------------------------------------------
GROSS GROSS GROSS
FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED
VALUE LOSSES VALUE LOSSES VALUE LOSSES
----------------------------------------------------------------------
Temporarily impaired investment
securities at December 31, 2005:
U.S. Treasury ........................................... $ 1,487 $ (1) $ 1,487 $ (1)
U.S. Government-sponsored agency securities ............. 31,692 (581) $ 45,466 $ (1,255) 77,158 (1,836)
State and municipal ..................................... 90,905 (1,501) 2,124 (42) 93,029 (1,543)
Mortgage-backed securities .............................. 59,595 (1,511) 96,120 (4,141) 155,715 (5,652)
Marketable equity securities ............................ 27 (8) 1,072 (431) 1,099 (439)
-------- -------- -------- -------- -------- --------
Total temporarily impaired investment securities ...... $183,706 $ (3,602) $144,782 $ (5,869) $328,488 $ (9,471)
======== ======== ======== ======== ======== ========
The amortized cost and fair value of securities available for sale and held to
maturity at December 31, 2006, by contractual maturity, are shown below.
Expected maturities will differ from contractual maturities because issuers may
have the right to call or prepay obligations with or without call or prepayment
penalties.
-----------------------------------------------------------------------------------------------------------------------------------
AVAILABLE FOR SALE HELD TO MATURITY
AMORTIZED COST FAIR VALUE AMORTIZED COST FAIR VALUE
===================================================================================================================================
Maturity distribution at December 31, 2006:
Due in one year or less ................................... $ 33,750 $ 33,452 $ 125 $ 125
Due after one through five years .......................... 164,485 163,038 830 842
Due after five through ten years .......................... 50,226 51,615 880 879
Due after ten years ....................................... 8,496 8,997 7,431 7,652
-------- -------- -------- --------
256,957 257,102 9,266 9,498
Mortgage-backed securities ................................ 195,228 191,845
Other asset-backed securities ............................. 18 18
Marketable equity securities .............................. 7,296 6,986
-------- -------- -------- --------
Totals ................................................... $459,481 $455,933 $ 9,284 $ 9,516
======== ======== ======== ========
Securities with a carrying value of approximately $143,652,000 and $190,079,000
were pledged at December 31, 2006 and 2005 to secure certain deposits and
securities sold under repurchase agreements, and for other purposes as permitted
or required by law.
Proceeds from sales of securities available for sale during 2006, 2005 and 2004
were $575,000, $4,718,000 and $32,336,000. Gross gains of $0, $28,000 and
$1,502,000
31
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 4
INVESTMENT SECURITIES continued
in 2006, 2005 and 2004, and gross losses of $4,000, $30,000 and $314,000 in
2006, 2005 and 2004 were realized on those sales.
NOTE 5
LOANS AND ALLOWANCE
2006 2005
==========================================================================================================
Loans at December 31:
Commercial and industrial loans ........................................ $ 537,305 $ 461,102
Agricultural production financing and other loans to farmers ........... 100,098 95,130
Real estate loans:
Construction ........................................................ 169,491 174,783
Commercial and farmland ............................................. 861,429 734,865
Residential ......................................................... 749,921 751,217
Individuals' loans for household and other personal expenditures ....... 223,504 200,139
Tax-exempt loans ....................................................... 14,423 8,263
Lease financing receivables, net of unearned income .................... 8,010 8,713
Other loans ............................................................ 28,420 23,215
----------- -----------
2,692,601 2,457,427
Allowance for loan losses ............................................. (26,540) (25,188)
----------- -----------
Total loans ......................................................... $ 2,666,061 $ 2,432,239
=========== ===========
2006 2005 2004
===============================================================================
Allowance for loan losses:
Balance, January 1 .............. $ 25,188 $ 22,548 $ 25,493
Provision for losses ............ 6,258 8,354 5,705
Recoveries on loans ............. 1,604 2,030 2,251
Loans charged off ............... (6,510) (7,744) (10,901)
-------- -------- --------
Balance, December 31 ............ $ 26,540 $ 25,188 $ 22,548
======== ======== ========
Information on nonaccruing, contractually past due 90 days or more other than
nonaccruing and restructured loans is summarized below:
2006 2005 2004
===============================================================================
At December 31:
Non-accrual loans .......................... $17,926 $10,030 $15,355
Loans contractually past due 90 days
or more other than nonaccruing ............ 2,870 3,965 1,907
Restructured loans ......................... 84 310 2,019
------- ------- -------
Total non-performing loans .............. $20,880 $14,305 $19,281
======= ======= =======
Nonaccruing loans are loans which are reclassified to a nonaccruing status when
in management's judgment the collateral value and financial condition of the
borrower do not justify accruing interest. Interest previously recorded, but not
deemed collectible, is reversed and charged against current income. Interest
income on these loans is then recognized when collected.
Restructured loans are loans for which the contractual interest rate has been
reduced or other concessions are granted to the borrower, because of a
deterioration in the financial condition of the borrower resulting in the
inability of the borrower to meet the original contractual terms of the loans.
32
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 5
LOANS AND ALLOWANCE continued
Information on impaired loans is summarized below: 2006 2005 2004
============================================================================================================
As of, and for the year ending December 31:
Impaired loans with an allowance .................................. $17,291 $ 7,540 $ 7,728
Impaired loans for which the discounted
cash flows or collateral value exceeds the
carrying value of the loan ...................................... 43,029 44,840 41,683
------- ------- -------
Total impaired loans ......................................... $60,320 $52,380 $49,411
======= ======= =======
Total impaired loans as a percent
of total loans .................................................. 2.24% 2.13% 2.03%
Allowance for impaired loans (included in the
Corporation's allowance for loan losses) ........................ $ 4,130 $ 2,824 $ 1,673
Average balance of impaired loans ................................. 66,139 44,790 59,568
Interest income recognized on impaired loans ...................... 5,143 3,511 3,457
Cash basis interest included above ................................ 1,364 650 796
NOTE 6
PREMISES AND EQUIPMENT
2006 2005
===============================================================================
Cost at December 31:
Land ........................................... $ 7,767 $ 8,653
Buildings and leasehold improvements ........... 37,791 43,001
Equipment ...................................... 46,895 40,155
-------- --------
Total cost ................................... 92,453 91,809
Accumulated depreciation and amortization ...... (50,060) (52,392)
-------- --------
Net .......................................... $ 42,393 $ 39,417
======== ========
The Corporation is committed under various noncancelable lease contracts for
certain subsidiary office facilities and equipment. Total lease expense for
2006, 2005 and 2004 was $2,651,000, $2,391,000 and $2,151,000, respectively. The
future minimum rental commitments required under the operating leases in effect
at December 31, 2006, expiring at various dates through the year 2016 are as
follows for the years ending December 31:
=========================================================
2007 .......................................... $1,983
2008 .......................................... 1,571
2009 .......................................... 1,255
2010 .......................................... 1,113
2011 .......................................... 936
After 2011 .................................... 752
------
Total future minimum obligations .............. $7,610
======
33
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 7
GOODWILL
The changes in the carrying amount of goodwill at December 31 are noted below.
No impairment loss was recorded in 2006 and 2005.
2006 2005
===============================================================================
Balance, January 1 ................................. $ 121,266 $ 120,615
Goodwill acquired .................................. 1,902 651
--------- ---------
Balance, December 31 ............................... $ 123,168 $ 121,266
========= =========
NOTE 8
CORE DEPOSIT INTANGIBLES
The carrying basis and accumulated amortization of recognized core deposit
intangibles at December 31 were:
2006 2005
===============================================================================
Gross carrying amount .............................. $ 32,025 $ 31,073
Accumulated amortization ........................... (16,555) (13,506)
--------- ---------
Core deposit intangibles ......................... $ 15,470 $ 17,567
========= =========
Amortization expense for the years ended December 31, 2006, 2005 and 2004, was
$3,066,000, $3,102,000 and $3,375,000, respectively. Estimated amortization
expense for each of the following five years is:
2007 ................................ $ 3,159
2008 ................................ 3,146
2009 ................................ 3,143
2010 ................................ 3,035
2011 ................................ 2,069
After 2011 .......................... 918
-------
$15,470
=======
NOTE 9
DEPOSITS
2006 2005
================================================================================
Deposits at December 31:
Demand deposits .............................. $ 883,294 $ 690,923
Savings deposits ............................. 507,431 566,212
Certificates and other time deposits
of $100,000 or more ......................... 431,068 276,679
Other certificates and time deposits ......... 928,745 848,762
---------- ----------
Total deposits ............................. $2,750,538 $2,382,576
========== ==========
34
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 9
DEPOSITS continued
=======================================================
Certificates and other time deposits maturing
in years ending December 31:
2007 .................................. $1,031,864
2008 .................................. 186,070
2009 .................................. 70,251
2010 .................................. 34,084
2011 .................................. 27,497
After 2011 ............................ 10,047
----------
$1,359,813
==========
Time deposits obtained through brokers was $256,632,000 and $194,713,000 at
December 31, 2006 and 2005, respectively.
NOTE 10
BORROWINGS
2006 2005
================================================================================
Borrowings at December 31:
Federal funds purchased .......................... $ 56,150 $ 50,000
Securities sold under repurchase agreements ...... 42,750 106,415
Federal Home Loan Bank advances .................. 242,408 247,865
Subordinated debentures, revolving credit
lines and term loans ............................ 99,456 103,956
-------- --------
Total borrowings ............................... $440,764 $508,236
======== ========
Securities sold under repurchase agreements consist of obligations of the Banks
to other parties. The obligations are secured by U.S. Treasury, U.S.
Government-sponsored agency security obligations and corporate asset-backed
securities. The maximum amount of outstanding agreements at any month-end during
2006 and 2005 totaled $98,765,000 and $106,415,000, and the average of such
agreements totaled $73,818,000 and $77,897,000 during 2006 and 2005.
Maturities of securities sold under repurchase agreements; Federal Home Loan
Bank advances; and subordinated debentures, revolving credit lines and term
loans as of December 31, 2006, are as follows:
SUBORDINATED DEBENTURES
SECURITIES SOLD UNDER FEDERAL HOME LOAN REVOLVING CREDIT LINES
REPURCHASE AGREEMENTS BANK ADVANCES AND TERM LOANS
------------------------------------------------------------------------------------------------------------
AMOUNT AMOUNT AMOUNT
============================================================================================================
Maturities in years ending December 31:
2007 ......................... $ 42,750 $ 59,495 $ 10,500
2008 ......................... 32,121
2009 ......................... 23,365
2010 ......................... 35,132
2011 ......................... 18,953
After 2011 ................... 73,342 88,956
-------- -------- --------
Total .................... $ 42,750 $242,408 $ 99,456
======== ======== ========
35
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 10
BORROWINGS continued
The terms of a security agreement with the FHLB require the Corporation to
pledge, as collateral for advances, qualifying first mortgage loans and all
otherwise unpledged investment securities in an amount equal to at least 145
percent of these advances. Advances, with interest rates from 2.80 to 6.84
percent, are subject to restrictions or penalties in the event of prepayment.
The total available remaining borrowing capacity from the FHLB at December 31,
2006, was $93,607,000.
Subordinated Debentures, Revolving Credit Lines and Term Loans. Three borrowings
were outstanding on December 31, 2006, for $99,456,000.
o First Merchants Capital Trust I. The subordinated debenture, entered
into on April 12, 2002, for $54,832,000 will mature on June 20,
2032. The Corporation may redeem the debenture no earlier than June
30, 2007, subject to the prior approval of the Federal Reserve, as
required by law or regulation. Interest is fixed at 8.75 percent and
payable on March 31, June 30, September 30 and December 31 of each
year.
o CNBC Statutory Trust I. As part of the March 1, 2003, acquisition of
CNBC Bancorp, the Corporation assumed $4,124,000 of a junior
subordinated debenture entered into on February 22, 2001. The
subordinated debenture of $4,124,000 will mature on February 22,
2031. Interest is fixed at 10.20 percent and payable on February 22
and August 22 of each year. The Corporation may redeem the
debenture, in whole or in part, at its option commencing February
22, 2011, at a redemption price of 105.10 percent of the outstanding
principal amount and, thereafter, at a premium which declines
annually. On or after February 22, 2021, the securities may be
redeemed at face value with prior approval of the Board of Governors
of the Federal Reserve System.
o LaSalle Bank, N.A. A Loan and Subordinated Debenture Loan Agreement
("LaSalle Agreement") was entered into with LaSalle Bank, N.A. on
March 25, 2003 and later amended as of March 7, 2006. The LaSalle
Agreement includes three credit facilities:
o The Term Loan of $5,000,000 matures on March 7, 2012.
Interest is calculated at a floating rate equal to the
lender's prime rate or LIBOR plus 1.00 percent. The Term
Loan is secured by 100 percent of the common stock of
First Merchants. The Agreement contains several
restrictive covenants, including the maintenance of
various capital adequacy levels, asset quality and
profitability ratios, and certain restrictions on
dividends and other indebtedness.
o The Revolving Loan had a balance of $10,500,000 at
December 31, 2006. Interest is payable quarterly based
on LIBOR plus 1 percent. Principal and interest are due
on or before March 6,2007. The total principal amount
outstanding at any one time may not exceed $20,000,000.
The Revolving Loan is secured by 100 percent of the
common stock of First Merchants. The Agreement contains
several restrictive covenants, including the maintenance
of various capital adequacy levels,
36
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 10
BORROWINGS continued
asset quality and profitability ratios, and certain
restrictions on dividends and other indebtedness.
o The Subordinated Debenture of $25,000,000 matures on
March 7, 2012. Interest is calculated at a floating rate
equal to, at the Corporation's option, either the
lender's prime rate or LIBOR plus 1.50 percent. The
Subordinated Debenture is treated as Tier 2 Capital for
regulatory capital purposes.
NOTE 11
LOAN SERVICING
Mortgage loans serviced for others are not included in the accompanying
consolidated balance sheets. The loans are serviced primarily for the Federal
Home Loan Mortgage Corporation, and the unpaid balances totaled $98,538,000,
$107,730,000 and $113,344,000 at December 31, 2006, 2005 and 2004. The amount of
capitalized servicing assets is considered immaterial.
NOTE 12
INCOME TAX
2006 2005 2004
=========================================================================================================================
Income tax expense for the year ended December 31:
Currently payable:
Federal ................................................................ $ 13,192 $ 14,814 $ 11,934
State .................................................................. 1,415 2,231 1,772
Deferred:
Federal ................................................................ (1,785) (3,248) (615)
State .................................................................. (627) (501) 94
-------- -------- --------
Total income tax expense .............................................. $ 12,195 $ 13,296 $ 13,185
======== ======== ========
Reconciliation of federal statutory to actual tax expense:
Federal statutory income tax at 34% .................................... $ 14,413 $ 14,802 $ 14,483
Tax-exempt interest .................................................... (2,151) (2,141) (2,098)
Graduated tax rates .................................................... 338 345 335
Effect of state income taxes ........................................... 482 1,132 1,178
Earnings on life insurance ............................................. (577) (439) (472)
Tax credits ............................................................ (391) (395) (274)
Other .................................................................. 81 (8) 33
-------- -------- --------
Actual tax expense .................................................... $ 12,195 $ 13,296 $ 13,185
======== ======== ========
Tax expense (benefit) applicable to security gains and losses for the years
ended December 31, 2006, 2005 and 2004, was $(2,000), $(1,000) and $475,000,
respectively.
37
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 12
INCOME TAX continued
A cumulative net deferred tax asset is included in the consolidated balance
sheets. The components of the net asset are as follows:
2006 2005
================================================================================================
Deferred tax asset at December 31:
Assets:
Differences in accounting for loan losses .................... $10,641 $10,609
Deferred compensation ........................................ 3,078 2,768
Difference in accounting for pensions
and other employee benefits ................................. 5,442 2,707
State income tax ............................................. 187 311
Net unrealized loss on securities available for sale ......... 1,241 2,365
Other ........................................................ 399 255
------- -------
Total assets ............................................... 20,988 19,015
------- -------
Liabilities:
Differences in depreciation methods .......................... 3,114 3,450
Differences in accounting for loans and securities ........... 4,974 6,505
Differences in accounting for loan fees ...................... 534 613
Other ........................................................ 2,381 2,575
------- -------
Total liabilities .......................................... 11,003 13,143
------- -------
Net deferred tax asset ..................................... $ 9,985 $ 5,872
======= =======
NOTE 13
COMMITMENTS AND CONTINGENT LIABILITIES
In the normal course of business there are outstanding commitments and
contingent liabilities, such as commitments to extend credit and standby letters
of credit, which are not included in the accompanying financial statements. The
Corporation's exposure to credit loss in the event of nonperformance by the
other party to the financial instruments for commitments to extend credit and
standby letters of credit is represented by the contractual or notional amount
of those instruments. The Banks use the same credit policies in making such
commitments as they do for instruments that are included in the consolidated
balance sheets.
Financial instruments whose contract amount represents credit risk as of
December 31, were as follows:
2006 2005
-------- --------
Commitments
to extend credit $681,462 $574,384
Standby letters
of credit 23,286 30,410
Commitments to extend credit are agreements to lend to a customer, as long as
there is no violation of any condition established in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. Since many of the commitments are expected to expire
without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements. The Banks evaluate each customer's credit
worthiness on a case-by-case basis. The amount of collateral obtained, if deemed
necessary by the Banks upon extension of credit, is based on management's credit
evaluation. Collateral held varies, but may
38
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 13
COMMITMENTS AND CONTINGENT LIABILITIES continued
include accounts receivable, inventory, property and equipment, and
income-producing commercial properties.
Standby letters of credit are conditional commitments issued by the Banks to
guarantee the performance of a customer to a third party.
The Corporation and subsidiaries are also subject to claims and lawsuits, which
arise primarily in the ordinary course of business. It is the opinion of
management that the disposition or ultimate resolution of such claims and
lawsuits will not have a material adverse effect on the consolidated financial
position of the Corporation.
NOTE 14
STOCKHOLDERS' EQUITY
National banking laws restrict the maximum amount of dividends that a bank may
pay in any calendar year. National banks are limited to the bank's retained net
income (as defined) for the current year plus those for the previous two years.
At December 31, 2006, Frances Slocum had no retained net profits available for
2007 dividends to the Corporation. The amount at December 31, 2006, available
for 2007 dividends from First Merchants, Madison, United Communities, First
National, Decatur, Lafayette, Commerce National and FMTC to the Corporation
totaled $3,512,000, $6,005,000, $3,895,000, $363,000, $432,000, $1,755,000,
$7,804,000 and $463,000, respectively.
Total stockholders' equity for all subsidiaries at December 31, 2006, was
$436,205,000, of which $402,056,000 was restricted from dividend distribution to
the Corporation.
The Corporation has a Dividend Reinvestment and Stock Purchase Plan, enabling
stockholders to elect to have their cash dividends on all shares held
automatically reinvested in additional shares of the Corporation's common stock.
In addition, stockholders may elect to make optional cash payments up to an
aggregate of $2,500 per quarter for the purchase of additional shares of common
stock. The stock is credited to participant accounts at fair market value.
Dividends are reinvested on a quarterly basis.
39
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 15
REGULATORY CAPITAL
The Corporation and Banks are subject to various regulatory capital requirements
administered by the federal banking agencies and are assigned to a capital
category. The assigned capital category is largely determined by three ratios
that are calculated according to the regulations: total risk adjusted capital,
Tier 1 capital, and Tier 1 leverage ratios. The ratios are intended to measure
capital relative to assets and credit risk associated with those assets and
off-balance sheet exposures of the entity. The capital category assigned to an
entity can also be affected by qualitative judgments made by regulatory agencies
about the risk inherent in the entity's activities that are not part of the
calculated ratios.
There are five capital categories defined in the regulations, ranging from well
capitalized to critically undercapitalized. Classification of a bank in any of
the undercapitalized categories can result in actions by regulators that could
have a material effect on a bank's operations.
At December 31, 2006, the management of the Corporation believes that it meets
all capital adequacy requirements to which it is subject. The most recent
notifications from the regulatory agencies categorized the Corporation and Banks
as well capitalized under the regulatory framework for prompt corrective action.
To be categorized as well capitalized, the Banks must maintain a minimum total
capital to risk-weighted assets, Tier I capital to risk-weighted assets and Tier
I capital to average assets of 10 percent, 6 percent and 5 percent,
respectively. There have been no conditions or events since that notification
that management believes have changed this categorization.
40
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 15
REGULATORY CAPITAL continued
Actual and required capital amounts and ratios are listed below.
2006 2005
------------------------------------------------------------------------------------------------------------------------------------
REQUIRED FOR REQUIRED FOR
ACTUAL ADEQUATE CAPITAL (1) ACTUAL ADEQUATE CAPITAL (1)
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
====================================================================================================================================
December 31
Total Capital (1)(2)(to risk-weighted assets)
Consolidated .......................... $299,353 11.09% $215,906 8.00% $285,823 11.72% $195,449 8.00%
First Merchants ....................... 77,072 10.46 58,965 8.00 69,691 11.93 46,747 8.00
First United .......................... 7,988 11.09 5,761 8.00
Madison ............................... 28,541 11.06 20,637 8.00 27,386 11.82 18,542 8.00
United Communities .................... 27,723 11.21 19,790 8.00 26,057 11.66 17,872 8.00
First National ........................ 10,881 11.13 7,820 8.00 10,243 11.29 7,260 8.00
Decatur ............................... 12,200 11.06 8,828 8.00 11,597 11.75 7,895 8.00
Frances Slocum ........................ 20,016 11.87 13,488 8.00 18,907 13.52 11,188 8.00
Lafayette ............................. 79,106 11.60 54,539 8.00 74,089 11.49 51,568 8.00
Commerce National ..................... 46,997 11.28 33,320 8.00 42,025 11.11 30,539 8.00
Tier I Capital (1)(2)(to risk-weighted assets)
Consolidated .......................... $247,813 9.18% $107,953 4.00% $235,635 9.66% $ 97,725 4.00%
First Merchants ....................... 69,957 9.45 29,482 4.00 63,550 10.88 23,374 4.00
First United .......................... 7,237 10.05 2,880 4.00
Madison ............................... 26,036 10.09 10,318 4.00 25,115 10.84 9,271 4.00
United Communities .................... 25,201 10.19 9,895 4.00 23,711 10.61 8,936 4.00
First National ........................ 10,126 10.36 3,910 4.00 9,489 10.46 3,630 4.00
Decatur ............................... 11,261 10.20 4,414 4.00 10,808 10.95 3,948 4.00
Frances Slocum ........................ 17,918 10.63 6,744 4.00 17,152 12.27 5,594 4.00
Lafayette ............................. 72,646 10.66 27,269 4.00 67,795 10.52 25,784 4.00
Commerce National ..................... 43,149 10.36 16,660 4.00 32,350 8.55 15,270 4.00
Tier I Capital (1)(2)(to average assets)
Consolidated .......................... $247,813 7.37% $134,443 4.00% $235,635 7.70% $122,396 4.00%
First Merchants ....................... 69,657 7.33 38,005 4.00 63,550 8.28 30,701 4.00
First United .......................... 7,237 7.83 3,696 4.00
Madison ............................... 26,036 8.63 12,068 4.00 25,115 9.38 10,716 4.00
United Communities .................... 25,201 7.91 12,747 4.00 23,711 7.93 11,953 4.00
First National ........................ 10,126 8.04 5,040 4.00 9,489 8.20 4,630 4.00
Decatur ............................... 11,261 7.31 6,162 4.00 10,808 8.47 5,104 4.00
Frances Slocum ........................ 17,918 9.08 7,895 4.00 17,152 9.96 6,886 4.00
Lafayette ............................. 72,646 7.99 36,385 4.00 67,795 7.86 34,484 4.00
Commerce National ..................... 43,149 8.99 19,203 4.00 32,350 7.41 17,641 4.00
(1) As defined by regulatory agencies
(2) Effective January 1, 2006, First United Bank, N.A. ("FUB") was merged into
First Merchants Bank, N.A.
NOTE 16
SHARE-BASED COMPENSATION
Stock options and restricted stock awards ("RSAs") have been issued to
directors, officers and other management employees under the Corporation's 1994
Stock Option Plan and The 1999 Long-term Equity Incentive Plan. The stock
options, which have a ten-year life, become 100 percent vested ranging from
three months to two years and are fully exercisable when vested. Option exercise
prices equal the Corporation's common stock closing price on NASDAQ on the date
of grant. RSAs provide for the issuance of shares of the Corporation's common
stock at no cost to the holder and generally vest after three years. The RSAs
only vest if the employee is actively employed by the Corporation on the vesting
date and, therefore, any unvested shares are forfeited.
41
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 16
SHARE-BASED COMPENSATION continued
The Corporation's 2004 Employee Stock Purchase Plan ("ESPP") provides eligible
employees of the Corporation and its subsidiaries an opportunity to purchase
shares of common stock of the Corporation through annual offerings financed by
payroll deductions. The price of the stock to be paid by the employees may not
be less than 85 percent of the lesser of the fair market value of the
Corporation's common stock at the beginning or at the end of the offering
period. Common stock purchases are made annually and are paid through advance
payroll deductions of up to 20 percent of eligible compensation.
SFAS 123(R) required the Corporation to begin recording compensation expense in
2006 related to unvested share-based awards outstanding as of December 31, 2005,
by recognizing the un-amortized grant date fair value of these awards over the
remaining service periods of those awards, with no change in historical reported
fair values and earnings. Awards granted after December 31, 2005 are valued at
fair value in accordance with provisions of SFAS 123(R) and are recognized on a
straight-line basis over the service periods of each award. To complete the
exercise of vested stock options, RSA's and ESPP options, the Corporation
generally issues new shares from its authorized but un-issued share pool.
Share-based compensation for the year ended December 31, 2006 totaled $833,000,
and has been recognized as a component of salaries and benefits expense in the
accompanying Consolidated Condensed Statements of Income.
Prior to 2006, the Corporation accounted for share-based compensation in
accordance with APB 25 using the intrinsic value method, which did not require
that compensation expense be recognized for the Corporation's stock and ESPP
options; however, under APB 25, the Corporation was required to record
compensation expense over the vesting period for the value of RSAs granted, if
any.
The Corporation provided pro forma disclosure amounts in accordance with SFAS
No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure"
(SFAS No. 148), as if the fair value method defined by SFAS No. 123 had been
applied to its share-based compensation. The Corporation's net income and net
income per share for the period ended December 31, 2005 and 2004 would have been
reduced if compensation expense related to stock and ESPP options had been
recorded in the financial statements, based on fair value at the grant dates.
The estimated fair value of the stock options granted during 2006, 2005 and 2004
was calculated using a Black Scholes options pricing model. The following
summarizes the assumptions used in the Black Scholes model:
2006 Assumptions:
2006 2005 2004
---- ---- ----
Risk-free interest rate 4.59% 4.05% 4.57%
Expected price volatility 29.84% 30.20% 30.89%
Dividend yield 3.54% 3.56% 3.64%
Forfeiture rate 4.00% 4.00% 4.00%
Weighted-average expected life, until exercise 5.75 years 8.50 years 8.50 years
The Black Scholes model incorporates assumptions to value share-based awards.
The risk-free rate of interest, for periods equal to the expected life of the
option, is based on a zero-coupon U.S. government instrument over a similar
contractual term of
42
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 16
SHARE-BASED COMPENSATION continued
the equity instrument. Expected price volatility is based on historical
volatility of the Corporation's common stock. In addition, the Corporation
generally uses historical information to determine the dividend yield and
weighted-average expected life of the options, until exercise. Separate groups
of employees that have similar historical exercise behavior with regard to
option exercise timing and forfeiture rates are considered separately for
valuation and attribution purposes.
Share-based compensation expense recognized in the Consolidated Condensed
Statements of Income is based on awards ultimately expected to vest and is
reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods,
if actual forfeitures differ from those estimates. Pre-vesting forfeitures were
estimated to be approximately 4 percent for the year ended December 31, 2006,
based on historical experience. In the Corporation's pro forma disclosures
required under SFAS 123(R) for the periods prior to fiscal 2006, the Corporation
accounted for forfeitures as they occurred.
As a result of adopting SFAS 123(R), net income of the Corporation for the year
ended December 31, 2006 was $656,000 lower (net of $177,000 in tax benefits),
than if it had continued to account for share-based compensation under APB 25.
The impact on both basic and diluted earnings per share for the year ended
December 31, 2006 was $.04 per share.
The following table summarizes the components of the Corporation's share-based
compensation awards recorded as expense:
Components of the share-based compensation:
Year Ended
December 31, 2006
-----------------
Stock and ESPP Options:
Pre-tax compensation expense ............................ $ 449
Income tax benefit ...................................... (42)
----------
Stock and ESPP options expense, net of income ............ $ 407
==========
Restricted Stock Awards:
Pre-tax compensation expense ............................ $ 384
Income tax benefit ...................................... (135)
----------
Restricted stock awards expense, net of tax .............. $ 249
==========
Total share-based compensation:
Pre-tax compensation expense ............................ $ 833
Income tax benefit ...................................... (177)
----------
Total share-based compenstion expense, net of tax ........ $ 656
==========
As of December 31, 2006, unrecognized compensation expense related to stock
options, RSAs and ESPP options totaling $227,000, $908,000 and $99,000,
respectively, is expected to be recognized over weighted-average periods of
1.08, 2.10 and .5 years, respectively.
43
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 16
SHARE-BASED COMPENSATION continued
Stock option activity under the Corporation's stock option plans as of December
31, 2006 and changes during the year ended December 31, 2006 were as follows:
Weighted-
Average
Weighted- Remaining
Number Average Contractual Aggregate
of Exercise Term Intrinsic
Shares Price (in Years) Value
--------- ---------- ----------- ----------
Outstanding at January 1, 2006 ...................................... 1,104,787 $ 23.28
Granted ............................................................. 72,256 25.03
Exercised ........................................................... (89,938) 17.62
Cancelled ........................................................... (19,858) 23.99
----------
Outstanding at December 31, 2006 .................................... 1,067,247 $ 23.87 5.87 $3,539,295
==========
Vested and Expected to Vest at December 31, 2006. ................... 1,064,100 $ 23.87 0.07 $3,533,113
Exercisable at December 31, 2006 .................................... 984,991 $ 23.77 5.60 $3,370,588
The weighted-average grant date fair value was $6.22, $6.93 and $6.98 for stock
options granted during the year ended December 31, 2006, 2005 and 2004,
respectively.
The aggregate intrinsic value in the table above represents the total pre-tax
intrinsic value (the difference between the Corporation's closing stock price on
the last trading day of 2006 and the exercise price, multiplied by the number of
in-the-money options) that would have been received by the option holders had
all option holders exercised their stock options on the last trading day of
2006. The amount of aggregate intrinsic value will change based on the fair
market value of the Corporation's common stock.
The aggregate intrinsic value of stock options exercised during the years ended
December 31, 2006, 2005 and 2004 were $665,000, $903,000 and $964,000,
respectively. Exercise of options during these same periods resulted in cash
receipts of $1,228,000, $1,347,000 and $863,000, respectively. The Corporation
recognized a tax benefit of approximately $177,000 for the year ended December
31, 2006, related to the exercise of employee stock options and has been
recorded as an increase to additional paid-in capital.
The following table summarizes information on unvested restricted stock awards
outstanding as of December 31, 2006:
Number of Grant-Date
Shares Fair Value
---------- ----------
Unvested RSAs at January 1, 2006 .......... 2,000 26.44
Granted ................................... 55,900 25.13
Forfeited ................................. 2,700 25.14
Vested .................................... 200 25.14
-------
Unvested RSAs at December 31, 2006 ........ 55,000 27.83
=======
The grant date fair value of ESPP options was estimated at the beginning of the
July 1, 2006 offering period and approximates $198,000. The ESPP options vested
during the twelve-month period ending June 30, 2007. At December 31, 2006, total
unrecognized compensation expense related to unvested ESPP options was $99,000,
which is expected to be recognized over a six month period ending June 30, 2007.
44
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 17
PENSION AND OTHER POST RETIREMENT BENEFIT PLANS
The Corporation's defined-benefit pension plans cover substantially all of the
Corporation's employees. On December 31, 2006 the Corporation adopted the
recognition provision of SFAS No. 158 Employers' Accounting for Defined Benefit,
Pension and other Post-Retirement Plans. The benefits are based primarily on
years of service and employees' pay near retirement. Contributions are intended
to provide not only for benefits attributed to service-to-date, but also for
those expected to be earned in the future.
The table below sets forth the plans' funded status and amounts recognized in
the consolidated balance sheet at December 31, using measurement dates of
September 30, 2006 and 2005.
December 31
2006 2005
=======================================================================================================
Change in benefit obligation
Benefit obligation at beginning of year ......................... $ 50,776 $ 50,358
Service cost .................................................... 524 578
Interest cost ................................................... 2,733 2,633
Actuarial gain (loss) ........................................... 1,575 (677)
Benefits paid ................................................... (2,382) (2,116)
-------- --------
Benefit obligation at end of year ............................... 53,226 50,776
-------- --------
Change in plan assets
Fair value of plan assets at beginning of year .................. 39,913 39,027
Actual return on plan assets .................................... 3,243 2,978
Employer contributions .......................................... 817 24
Benefits paid ................................................... (2,382) (2,116)
-------- --------
End of year ..................................................... 41,591 39,913
-------- --------
Funded status at end of year ....................................... $ 11,635 $ 10,863
======== ========
Assets and Liabilities recognized in the Balance Sheets:
Deferred tax assets ............................................. $ 4,654 $ 3,317
Liabilities ..................................................... $(11,635) $ (8,732)
Amounts recognized in accumulated other comprehensive income not yet
recognized as components of net periodic benefit cost consist of:
Net loss (gain) ................................................. $ 6,701 $ 6,017
Prior service cost (credit) ..................................... 34 36
-------- --------
$ 6,735 $ 6,053
======== ========
In January 2005, the Board of Directors of the Corporation approved the
curtailment of the accumulation of defined benefits for future services provided
by certain participants in the First Merchants Corporation Retirement Pension
Plan (the "Plan"). Employees of the Corporation and certain of its subsidiaries
who are participants in the Plan were notified that, on and after March 1, 2005,
no additional pension benefits will be earned by employees who have not both
attained the age of fifty-five (55) and accrued at least ten (10) years of
"Vesting Service". As a result of this action, the Corporation incurred a
$1,630,000 pension curtailment loss to record previously unrecognized prior
service costs in accordance with SFAS No. 88, "Employers' Accounting for
Settlements and Curtailments of Defined Benefit Plans and for Termination
Benefits." This loss was recognized and recorded by the Corporation in 2005.
45
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 17
PENSION AND OTHER POST RETIREMENT BENEFIT PLANS continued
The accumulated benefit obligation for all defined benefit plans was $51,732,000
and $48,646,000 at December 31, 2006 and 2005, respectively.
Information for pension plans with an accumulated benefit obligation in excess
of plan assets:
December 31
2006 2005
====================================================================================================
Projected benefit obligation .................................. $ 53,226 $ 50,776
======== ========
Accumulated benefit obligation ................................ $ 51,732 $ 48,646
======== ========
Fair value of plan assets ..................................... $ 41,591 $ 39,913
======== ========
Components of net periodic pension cost:
December 31
2006 2005
====================================================================================================
Service cost .................................................. $ 524 $ 578
Interest cost ................................................. 2,733 2,632
Expected return on plan assets ................................ (2,913) (3,074)
Amortization of prior service costs ........................... 5 5
Amortization of net (gain) loss ............................... 347 94
Curtailment loss .............................................. 1,630
-------- --------
Net periodic pension cost ..................................... $ 696 $ 1,865
======== ========
The estimated net loss and prior service cost for the defined benefit pension
plans that will be amortized from accumulated other comprehensive income into
net periodic benefit cost over the next fiscal year are $416,000 and $5,000,
respectively.
Significant assumptions include:
December 31
2006 2005
=====================================================================================================
Weighted-agerage assumptions used to determine benefit obligation:
Discount rate ................................................. 5.50% 5.50%
Rate of compensation increase ................................. 3.50% 4.00%
Weighted-average assumptions used to determine benefit cost:
Discount rate ................................................. 5.50% 5.50%
Expected return on plan assets ................................ 7.50% 7.50%
Rate of compensation increase ................................. 4.00% 4.00%
At September 30, 2006 and 2005, the Corporation based its estimate of the
expected long-term rate of return on analysis of the historical returns of the
plans and current market information available. The plans' investment strategies
are to provide for preservation of capital with an emphasis on long-term growth
without undue exposure to risk. The assets of the plans' are invested in
accordance with the plans' Investment Policy Statement, subject to strict
compliance with ERISA and any other applicable statutes.
The plans' risk management practices include quarterly evaluations of investment
managers, including reviews of compliance with investment manager guidelines and
restrictions; ability to exceed performance objectives; adherence to the
investment philosophy and style; and ability to exceed the performance of other
investment managers. The evaluations are reviewed by management with appropriate
follow-up and
46
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 17
PENSION AND OTHER POST RETIREMENT BENEFIT PLANS continued
actions taken, as deemed necessary. The Investment Policy Statement generally
allows investments in cash and cash equivalents, real estate, fixed income debt
securities and equity securities, and specifically prohibits investments in
derivatives, options, futures, private placements, short selling, non-marketable
securities and purchases of non-investment grade bonds.
At December 31, 2006, the maturities of the plans' debt securities ranged from 1
day to 10.4 years, with a weighted average maturity of 3.0 years. At December
31, 2005, the maturities of the plans' debt securities ranged from 135 days to
12.4 years, with a weighted average maturity of 3.1 years.
The following benefit payments, which reflect expected future service, as
appropriate, are expected to be paid as of December 31, 2006. The Corporation
plans to contribute $117,000 to the plans in 2007.
2007 ................................ $ 2,275
2008 ................................ 2,342
2009 ................................ 2,467
2010 ................................ 2,647
2011 ................................ 2,796
2012 and after ....................... 16,458
Plan assets are re-balanced quarterly. At December 31, 2006 and 2006, plan
assets by category are as follows:
December 31
2006 2005
=============================================================================
Equity securities .............................. 66% 66%
Debt securities ................................ 32% 31%
Other .......................................... 2% 3%
------ ------
100% 100%
====== ======
The following table reflects the adjustments recorded in accordance with the
adoption of the recognition and disclosure requirement of SFAS No. 158:
Before After
Application of Application of
Statement 158 Adjustments Statement 158
============================================================================================================
Other assets ............................... 22,281 1,377 23,658
Total assets ............................... 3,553,493 1,377 3,554,870
Other liabilities .......................... 23,486 3,431 26,917
Total liabilities .......................... 3,224,114 3,431 3,227,545
Accumulated other comprehensive loss ....... (7,341) (2,064) (9,405)
Total stockholders' equity ................. 329,389 (2,064) 327,325
The First Merchants Corporation Retirement and Income Savings Plan (the "Savings
Plan"), a Section 401(k) qualified defined contribution plan, was amended on
March 1, 2005 to provide enhanced retirement benefits, including employer and
matching contributions, for eligible employees of the Corporation and its
subsidiaries. The Corporation matches employees' contributions primarily at the
rate of 50 percent for the first 6 percent of base salary contributed by
participants. Beginning in 2005, employees who have completed 1,000 hours of
service and are an active employee on the last day of the year receive an
additional retirement contribution after year-end. The amount of a participant's
retirement contribution varies from 2 to 7 percent of salary based upon years of
service. Full vesting occurs after 5 years of service. The
47
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 17
PENSION AND OTHER POST RETIREMENT BENEFIT PLANS continued
Corporations' expense for the Savings Plan was $2,026,000 for 2006, $2,052,000
for 2005 and $660,000 for 2004.
The Corporation maintains supplemental executive retirement and other
nonqualified retirement plans for the benefit of certain directors and officers.
Under the plans, the Corporation agrees to pay retirement benefits that are
actuarially determined based upon plan participants' compensation amounts and
years of service. Accrued benefits payable totaled $3,525,000 and $3,307,000 at
December 31, 2006 and 2005. Benefit plan expense was $535,000, $571,000 and
$615,000 for 2006, 2005 and 2004.
The Corporation maintains post-retirement benefit plans that provide health
insurance benefits to retirees. The plans allow retirees to be carried under the
Corporation's health insurance plan, generally from ages 55 to 65. The retirees
pay most of the premiums due for their coverage, with amounts paid by retirees
ranging from 70 to 100 percent of the premiums payable. The accrued benefits
payable under the plans totaled $1,089,000 and $1,084,000 at December 31, 2006
and 2005. Post-retirement plan expense totaled $127,000, $120,000 and $202,000
for the years ending December 31, 2006, 2005 and 2004.
NOTE 18
NET INCOME PER SHARE
====================================================================================================================================
Year Ended December 31, 2006 2005 2004
------------------------------------------------------------------------------------------------------------------------------------
WEIGHTED-AVERAGE PER SHARE WEIGHTED-AVERAGE PER SHARE WEIGHTED-AVERAGE PER SHARE
INCOME SHARES AMOUNT INCOME SHARES AMOUNT INCOME SHARES AMOUNT
====================================================================================================================================
Basic net income per share:
Net income available to
common stockholders ............... $30,198 18,383,074 $1.64 $30,239 18,484,832 $1.64 $29,411 18,540,451 $1.59
===== ===== =====
Effect of dilutive stock options .... 83,679 110,863 126,826
------- ---------- ------- ---------- ------- ----------
Diluted net income per share:
Net income available to
common stockholders
and assumed conversions ........... $30,198 18,466,753 $1.64 $30,239 18,595,695 $1.63 $29,411 18,667,277 $1.58
======= ========== ===== ======= ========== ===== ======= ========== =====
Options to purchase 590,736, 214,840 and 320,661 shares of common stock with
weighted average exercise prices of $26.21, $26.81 and $24.66 at December 31,
2006, 2005 and 2004 were excluded from the computation of diluted net income per
share because the options exercise price was greater than the average market
price of the common stock.
NOTE 19
FAIR VALUES OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of
each class of financial instrument:
CASH AND CASH EQUIVALENTS The fair value of cash and cash equivalents
approximates carrying value.
48
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 19
FAIR VALUES OF FINANCIAL INSTRUMENTS continued
INTEREST-BEARING TIME DEPOSITS The fair value of interest-bearing time deposits
approximates carrying value.
INVESTMENT SECURITIES Fair values are based on quoted market prices.
MORTGAGE LOANS HELD FOR SALE The fair value of mortgages held for sale
approximates carrying values.
LOANS For both short-term loans and variable-rate loans that reprice frequently
and with no significant change in credit risk, fair values are based on carrying
values. The fair value for other loans is estimated using discounted cash flow
analyses, using interest rates currently being offered for loans with similar
terms to borrowers of similar credit quality.
FEDERAL RESERVE AND FEDERAL HOME LOAN BANK STOCK The fair value of FRB and FHLB
stock is based on the price at which it may be resold to the FRB and FHLB.
INTEREST RECEIVABLE/PAYABLE The fair values of interest receivable/payable
approximate carrying values.
DEPOSITS The fair values of noninterest-bearing demand accounts,
interest-bearing demand accounts and savings deposits are equal to the amount
payable on demand at the balance sheet date. The carrying amounts for variable
rate, fixed-term certificates of deposit approximate their fair values at the
balance sheet date. Fair values for fixed-rate certificates of deposit and other
time deposits are estimated using a discounted cash flow calculation that
applies interest rates currently being offered on certificates to a schedule of
aggregated expected monthly maturities on such time deposits.
BORROWINGS The fair value of borrowings is estimated using a discounted cash
flow calculation, based on current rates for similar debt, except for short-term
and adjustable rate borrowing arrangements. At December 31, the fair value for
these instruments approximates carrying value.
OFF-BALANCE SHEET COMMITMENTS
Loan commitments and letters-of-credit generally have short-term, variable-rate
features and contain clauses which limit the Banks' exposure to changes in
customer credit quality. Accordingly, their carrying values, which are
immaterial at the respective balance sheet dates, are reasonable estimates of
fair value.
49
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 19
FAIR VALUES OF FINANCIAL INSTRUMENTS continued
The estimated fair values of the Corporation's financial instruments are as
follows:
2006 2005
------------------------------------------------------------------------------------------------------------------------------------
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
====================================================================================================================================
Assets at December 31:
Cash and cash equivalents ................................ $ 89,957 $ 89,957 $ 70,417 $ 70,417
Interest-bearing time deposits ........................... 11,284 11,284 8,748 8,748
Investment securities available for sale ................. 455,933 455,933 422,627 422,627
Investment securities held to maturity ................... 9,284 9,516 11,639 11,510
Mortgage loans held for sale ............................. 5,413 5,413 4,910 4,910
Loans .................................................... 2,666,061 2,649,916 2,432,239 2,511,784
FRB and FHLB stock ....................................... 23,691 23,691 23,200 23,200
Interest receivable ...................................... 24,345 24,345 19,690 19,690
Liabilities at December 31:
Deposits ................................................. 2,750,538 2,661,866 2,382,576 2,250,494
Borrowings:
Federal funds purchased ................................ 56,150 56,150 50,000 50,000
Securities sold under repurchase agreements ............ 42,750 42,750 106,415 106,415
FHLB advances .......................................... 242,408 242,954 247,865 248,303
Subordinated debentures, revolving credit
lines and term loans .................................. 99,456 112,966 103,956 115,822
Interest payable ......................................... 9,326 9,326 5,874 5,874
NOTE 20
CONDENSED FINANCIAL INFORMATION (parent company only)
Presented below is condensed financial information as to financial position,
results of operations, and cash flows of the Corporation:
CONDENSED BALANCE SHEETS
December 31,
2006 2005
================================================================================
Assets
Cash ............................................. $ 6,122 $ 2,749
Investment securities available for sale ......... 3,500
Investment in subsidiaries ....................... 417,287 404,974
Goodwill ......................................... 448 448
Other assets ..................................... 15,425 12,259
-------- --------
Total assets .................................... $439,282 $423,930
======== ========
Liabilities
Borrowings ....................................... $ 99,456 $103,956
Other liabilities ................................ 12,501 6,578
-------- --------
Total liabilities ............................... 111,957 110,534
Stockholders' equity ............................... 327,325 313,396
-------- --------
Total liabilities and stockholders' equity ...... $439,282 $423,930
======== ========
50
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 20
CONDENSED FINANCIAL INFORMATION (parent company only) continued
CONDENSED STATEMENTS OF INCOME
December 31,
2006 2005 2004
===============================================================================================================================
Income
Dividends from subsidiaries .................................................... $33,919 $30,930 $28,983
Administrative services fees from subsidiaries ................................. 15,104 13,823 13,767
Other income ................................................................... 240 644 375
------- ------- -------
Total income ................................................................. 49,263 45,397 43,125
------- ------- -------
Expenses
Amortization of core deposit intangibles
and fair value adjustments .................................................... 11 11 11
Interest expense ............................................................... 8,124 7,432 6,785
Salaries and employee benefits ................................................. 13,934 12,500 11,240
Net occupancy expenses ......................................................... 1,232 1,294 1,481
Equipment expenses ............................................................. 4,210 3,418 2,918
Telephone expenses ............................................................. 1,108 1,181 1,383
Postage and courier expense .................................................... 1,658 1,528 1,467
Other expenses ................................................................. 2,548 2,394 1,761
------- ------- -------
Total expenses ............................................................... 32,825 29,758 27,046
------- ------- -------
Income before income tax benefit and equity in
undistributed income of subsidiaries ............................................ 16,438 15,639 16,079
Income tax benefit ........................................................... 6,771 5,404 4,557
------- ------- -------
Income before equity in undistributed income of subsidiaries .................... 23,209 21,043 20,636
Equity in undistributed (distributions in excess of)
income of subsidiaries ........................................................ 6,989 9,196 8,775
------- ------- -------
Net Income ...................................................................... $30,198 $30,239 $29,411
======= ======= =======
CONDENSED STATEMENTS OF CASH FLOWS
Year Ended December 31,
=======================================================================================================================
2006 2005 2004
========================================================================================================================
Operating activities:
Net income ..................................................... $ 30,198 $ 30,239 $ 29,411
Adjustments to reconcile net income to net cash
provided by operating activities:
Amortization .................................................. 11 11 11
Share-based compensation ...................................... 41
Distributions in excess of (equity in undistributed)
income of subsidiaries ....................................... (6,989) (9,196) (8,775)
Net change in:
Other assets ................................................. (3,166) (2,220) (535)
Other liabilities ............................................ 5,923 1,680 461
-------- -------- --------
Net cash provided by operating activities .................. 26,018 20,514 20,573
-------- -------- --------
Investing activities - Investment in subsidiaries ................ 840 (2,884) (2,289)
-------- -------- --------
Net cash provided (used) by investing activities ........... 840 (2,884) (2,289)
-------- -------- --------
Financing activities:
Cash dividends ................................................. (16,951) (16,981) (17,048)
Borrowings ..................................................... 3,750 9,833 7,251
Repayment of borrowings ........................................ (8,250) (3,083) (9,594)
Stock issued under employee benefit plans ...................... 857 914 903
Stock issued under dividend reinvestment
and stock purchase plan ....................................... 1,190 933 1,278
Stock options exercised ........................................ 1,228 2,174 1,404
Stock redeemed ................................................. (5,690) (9,658) (4,726)
Other .......................................................... 381
-------- -------- --------
Net cash used by financing activities ...................... (23,485) (15,868) (20,532)
-------- -------- --------
Net change in cash ............................................... 3,373 1,762 (2,248)
Cash, beginning of year .......................................... 2,749 987 3,235
-------- -------- --------
Cash, end of year ................................................ $ 6,122 $ 2,749 $ 987
======== ======== ========
51
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 21
QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The following table sets forth certain quarterly results for the years ended
December 31, 2006 and 2005:
------------------------------------------------------------------------------------------------------------------------------------
AVERAGE SHARES OUTSTANDING NET INCOME PER SHARE
QUARTER INTEREST INTEREST NET INTEREST PROVISION FOR NET -------------------------- --------------------
ENDED INCOME EXPENSE INCOME LOAN LOSSES INCOME BASIC DILUTED BASIC DILUTED
2006:
March ........... $ 48,062 $ 20,473 $ 27,589 $ 1,726 $ 7,509 18,425,047 18,532,136 $ .41 $ .41
June ............ 51,047 23,281 27,766 1,729 7,291 18,385,298 18,463,278 .39 .39
September ....... 54,325 26,701 27,624 1,558 7,739 18,317,558 18,380,631 .42 .42
December ........ 55,172 28,056 27,116 1,245 7,659 18,405,330 18,497,507 .42 .42
---------- ---------- ---------- ---------- ---------- ----- -----
$ 208,606 $ 98,511 $ 110,095 $ 6,258 $ 30,198 18,383,074 18,466,753 $1.64 $1.64
========== ========== ========== ========== ========== ===== =====
2005:
March ........... $ 41,315 $ 14,373 $ 26,942 $ 2,667 $ 6,567 18,559,664 18,696,526 $ .35 $ .35
June ............ 43,513 15,592 27,921 1,948 7,921 18,435,677 18,536,137 .43 .43
September ....... 45,567 17,427 28,140 1,794 8,220 18,478,154 18,590,034 .45 .44
December ........ 46,814 18,688 28,126 1,945 7,531 18,458,990 18,557,622 .41 .41
---------- ---------- ---------- ---------- ---------- ----- -----
$ 177,209 $ 66,080 $ 111,129 $ 8,354 $ 30,239 18,484,832 18,595,695 $1.64 $1.63
========== ========== ========== ========== ========== ===== =====
NOTE 22
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
Statement of Financial Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities (SFAS 133), as amended and interpreted,
establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities. As required by SFAS 133, the Corporation records all
derivatives on the balance sheet at fair value. The accounting for changes in
the fair value of derivatives depends on the intended use of the derivative and
the resulting designation. Derivatives used to hedge the exposure to changes in
the fair value of an asset, liability, or firm commitment attributable to a
particular risk, such as interest rate risk, are considered fair value hedges.
Derivatives used to hedge the exposure to variability in expected future cash
flows, or other types of forecasted transactions, are considered cash flow
hedges.
For derivatives designated as cash flow hedges, the effective portion of changes
in the fair value of the derivative is initially reported in other comprehensive
income (outside of earnings) and subsequently reclassified to earnings when the
hedged transaction affects earnings, and the ineffective portion of changes in
the fair value of the derivative is recognized directly in earnings. The
Corporation assesses the effectiveness of each hedging relationship by comparing
the changes in cash flows of the derivative hedging instrument with the changes
in cash flows of the designated hedged transaction.
The Corporation's objective in using derivatives is to add stability to interest
income and to manage its exposure to interest rate movements or other identified
risks. To accomplish this objective, the Corporation primarily uses interest
rate floors as part of its cash flow hedging strategy. Interest rate floors
designated as cash flow hedges protect the Corporation against movements in
interest rates below the instruments' strike rates, over the life of the
agreements without exchange of
52
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 22
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES continued
the underlying principal amount. During 2006, such derivatives were used to
hedge the variable cash flows associated with existing variable-rate assets.
As of December 31, 2006, no derivatives were designated as fair value hedges or
hedges of net investments in foreign operations. Additionally, the Corporation
does not use derivatives for trading or speculative purposes and currently does
not have any derivatives that are not designated as hedges.
At December 31, 2006, derivatives with a fair value of $428,000 were included in
other assets. The notional amount is $250 million and strike rates range from 6
percent to 7 percent with a termination date of August 1, 2009. The change in
net unrealized losses of $125,000 in 2006 for derivatives designated as cash
flow hedges is separately disclosed in the statement of changes in shareholders'
equity and comprehensive income. No hedge ineffectiveness on cash flow hedges
was recognized during 2006.
Amounts reported in accumulated other comprehensive income related to
derivatives will be reclassified to interest income as interest payments are
received on the Corporation's variable-rate assets. The change in net unrealized
losses on cash flow hedges reflects a reclassification of $38 of net unrealized
losses from accumulated other comprehensive income to interest income during
2006. During 2007, the Corporation estimates that an additional $50,000 will be
reclassified.
NOTE 23
ACCOUNTING MATTERS
In March 2006, the FASB issued Statement of Financial Accounting Standards No.
156 (SFAS No. 156), Accounting for Servicing of Financial Assets, an amendment
of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities, which requires that all separately
recognized servicing assets and servicing liabilities be initially measured at
fair value, if practicable and permits the entities to elect either fair value
measurement with changes in fair value reflected in earnings or the amortization
and impairment requirements of SFAS No. 140 for subsequent measurement. The
subsequent measurement of separately recognized servicing assets and servicing
liabilities at fair value eliminates the necessity for entities that manage the
risks inherent in servicing assets and servicing liabilities with derivatives to
qualify for hedge accounting treatment and eliminates the characterization of
declines in fair value as impairments or direct write-downs. SFAS No. 156 is
effective for the Corporation beginning January 1, 2007. We have evaluated the
requirements of SFAS No. 156 and determined that it will not have a material
effect on our financial condition or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS
No. 157 defines fair value, establishes a framework for measuring fair value in
generally accepted accounting standards, and expands disclosures about fair
value measurements. SFAS No. 157 is effective for financial statements issued
for fiscal years beginning after November 15, 2007, and interim periods within
those fiscal years. We do not
53
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(table dollar amounts in thousands, except share data)
NOTE 23
ACCOUNTING MATTERS continued
expect that the adoption of SFAS No. 157 will have a material impact on our
financial condition or results of operations.
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty
in Income Taxes, an interpretation of SFAS No. 109, Accounting for Income Taxes
(Interpretation No. 48). Interpretation No. 48 clarifies the accounting for
uncertainty in income taxes in financial statements and prescribes a recognition
threshold and measurement attribute for financial statement recognition and
measurement of a tax position taken or expected to be taken. It also provides
guidance on derecognition, classification, interest and penalties, accounting in
interim periods, disclosure and transition. Interpretation No. 48 is effective
for the Corporation beginning January 1, 2007. We have evaluated the
requirements of Interpretation No. 48 and determined that it will not have a
material effect on our financial condition or results of operations.
In September 2006, the SEC Staff issued Staff Accounting Bulletin ("SAB") No.
108, Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements, which addresses how the
effects of prior year uncorrected misstatements should be considered when
quantifying misstatements in current year financial statements. SAB No. 108 will
require registrants to quantify misstatements using both the balance sheet and
income-statement approaches and to evaluate whether either approach results in
quantifying an error that is material in light of relevant quantitative and
qualitative factors. When the effect of initial adoption is determined to be
material, SAB No. 108 allows registrants to record that effect as a cumulative
effect adjustment to beginning retained earnings. The requirements are effective
for the Corporation beginning January 1, 2007. We have evaluated the
requirements of SAB No. 108 and determined that it will not have a material
effect on our financial condition or results of operations.
In September 2006, the Emerging Issues Task Force Issue 06-4 (EITF 06-4),
Accounting for Deferred Compensation and Postretirement Benefit Aspects of
Endorsement Split-Dollar Life Insurance Arrangements, was ratified. EITF 06-4
addresses accounting for separate agreements which split life insurance policy
benefits between an employer and employee. The Issue requires the employer to
recognize a liability for future benefits payable to the employee under these
agreements. The effects of applying EITF 06-4 must be recognized through either
a change in accounting principle through an adjustment to equity or through the
retrospective application to all prior periods. For calendar year companies,
EITF 06-4 is effective beginning January 1, 2008. Early adoption is permitted as
of January 1, 2007. We do not expect the adoption of EITF 06-4 to have a
material effect on our consolidated financial statements.
54
ANNUAL MEETING, STOCK PRICE AND DIVIDEND INFORMATION
The 2007 Annual Meeting of Stockholders
of First Merchants Corporation
will be held...
Tuesday, April 24, 2007 at 3:30 p.m.
Horizon Convention Center
401 South High Street
Muncie, Indiana
STOCK INFORMATION
PRICE PER SHARE
QUARTER HIGH LOW DIVIDENDS DECLARED(1)
============================================================================================================
2006 2005 2006 2005 2006 2005
-------------------- ------------------- ---------------------
First Quarter ................ $29.42 $28.57 $24.37 $25.09 $ .23 $ .23
Second Quarter ............... 26.50 26.06 22.20 23.05 .23 .23
Third Quarter ................ 25.00 27.30 22.51 24.75 .23 .23
Fourth Quarter ............... 27.99 26.89 22.81 23.98 .23 .23
(1) The Liquidity section of Management's Discussion & Analysis of Financial
Condition and Results of Operations and Note 14 to Consolidated Financial
Statements include discussions regarding dividend restrictions from the
bank subsidiaries to the Corporation.
The table above lists per share prices and dividend payments during 2006 and
2005. Prices are as reported by the National Association of Securities Dealers
Automated Quotation - National Market System.
Numbers rounded to nearest cent when applicable.
55
COMMON STOCK LISTING
COMMON STOCK LISTING
First Merchants Corporation common stock is traded over-the-counter on the
NASDAQ National Market System. Quotations are carried in many daily papers. The
NASDAQ symbol is FRME (Cusip #320817-10-9). At the close of business on January
31, 2007, the number of shares outstanding was 18,442,765. There were 5,916
stockholders of record on that date.
General Stockholder Inquiries
Stockholders and interested investors may obtain information about the
Corporation upon written request or by calling:
Mr. Brian Edwards
Shareholder Relations Officer
First Merchants Corporation
P. O. Box 792
Muncie, Indiana 47308-0792
765-741-7278
800-262-4261 Ext. 7278
Stock Transfer Agent and Registrar
American Stock Transfer & Trust Company
59 Maiden Lane, 1st Floor
New York, NY 10038
56
FORM 10-K, FINANCIAL INFORMATION AND CODE OF ETHICS
The Corporation, upon request and without charge, will furnish stockholders,
security analysts and investors a copy of Form 10-K filed with the Securities
and Exchange Commission.
The Securities and Exchange Commission maintains a web site that contains
reports, proxy and information statements and other information regarding
registrants that file electronically with the commission, including the
Corporation; that address is http://www.sec.gov
The Corporation has adopted a Code of Ethics that applies to its Chief Executive
Officer, Chief Operating Officer, Chief Financial Officer, Controller and
Treasurer. It is part of the Corporation's Code of Business Conduct, which
applies to all employees and directors of the Corporation and its affiliates. A
copy of the Code of Ethics may be obtained, free of charge, by writing to First
Merchants Corporation at 200 East Jackson Street, Muncie, IN 47305. In addition,
the Code of Ethics is maintained on the Corporation's web site, which can be
accessed at http://www.firstmerchants.com.
Please contact:
Mr. Mark Hardwick
Executive Vice President
and Chief Financial Officer
First Merchants Corporation
P. O. Box 792
Muncie, Indiana 47308-0792
765-751-1857
1-800-262-4261 Ext. 1857
57
EXHIBIT-21
SUBSIDIARIES OF THE REGISTRANT
EXHIBIT 21--SUBSIDIARIES OF THE REGISTRANT
--------------------------------------------------------------------------------
State of
Name Incorporation
---- -------------
First Merchants Bank, National Association (also doing
business as First Merchants Bank of Hamilton County)......U.S.
The Madison Community Bank, National Association............U.S.
United Communities National Bank............................U.S.
The First National Bank of Portland.........................U.S.
Decatur Bank & Trust Company, National Association..........U.S.
Frances Slocum Bank & Trust Company, National Association...U.S.
Lafayette Bank and Trust Company, National Association......U.S.
Commerce National Bank......................................U.S.
First Merchants Capital Trust I.........................Delaware
First Merchants Insurance Services, Inc..................Indiana
First Merchants Reinsurance Co. Ltd.....................Providencials Turkes and
Caicos, Island
Indiana Title Insurance Company..........................Indiana
Indiana Title Insurance Company, LLC.....................Indiana
FMB Portfolio Management, Inc...........................Delaware
UCNB Portfolio Management, Inc..........................Delaware
Wabash Valley Investments, Inc............................Nevada
Wabash Valley, LLC........................................Nevada
Wabash Valley Holdings, Inc...............................Nevada
Merchants Trust Company, National Association...............U.S.
CNBC Statutory Trust I...............................Connecticut
EXHIBIT-23
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
EXHIBIT 23 - CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
We consent to the incorporation by reference in the registration statement on
Form S-8 (File Nos. 033-54065, 333-116074, 333-50484, 333-80119 and 333-80117)
of First Merchants Corporation (the "Corporation") of our reports dated February
6, 2007 on the consolidated financial statements of the Corporation as of
December 31, 2006 and 2005, and for each of the three years in the period ended
December 31, 2006, and on our audit of internal control over financial reporting
of the Corporation as of December 31, 2006, which reports are included in this
Annual Report on Form 10-K.
/s/ BKD, LLP
Indianapolis, Indiana
March 14, 2007
EXHIBIT-24
LIMITED POWER OF ATTORNEY
EXHIBIT 24--LIMITED POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS that the undersigned directors and officers of
First Merchants Corporation, an Indiana corporation, hereby constitute and
appoint Mark K. Hardwick, the true and lawful agent and attorney-in-fact of the
undersigned with full power and authority in said agent and attorney-in-fact to
sign for the undersigned and in their respective names as directors and officers
of the Corporation the Form 10-K of the Corporation to be filed with the
Securities and Exchange Commission, Washington, D.C., under the Securities
Exchange Act of 1934, as amended, and to sign any amendment to such Form 10-K,
hereby ratifying and confirming all acts taken by such agent and
attorney-in-fact, as herein authorized.
Dated: January 23, 2007
/s/ Michael L. Cox /s/ Richard A. Boehning
-------------------------------------- ------------------------------------
Michael L. Cox President and Richard A. Boehning Director
Chief Executive
Officer (Principal
Executive Officer)
/s/ Mark K. Hardwick /s/ Thomas B. Clark
-------------------------------------- ------------------------------------
Mark K. Hardwick Executive Vice Thomas B. Clark Director
President and Chief
Financial Officer
(Principal Financial
and Accounting
Officer)
/s/ Michael L. Cox
------------------------------------
Michael L. Cox Director
/s/ Roderick English
------------------------------------
Roderick English Director
------------------------------------
Dr. Jo Ann M. Gora Director
/s/ Barry J. Hudson
------------------------------------
Barry J. Hudson Director
/s/ Thomas D. McAuliffe
------------------------------------
Thomas D. McAuliffe Director
/s/ Michael C. Rechin
------------------------------------
Michael C. Rechin Director
/s/ Charles E. Schalliol
------------------------------------
Charles E. Schalliol Director
/s/ Robert M. Smitson
------------------------------------
Robert M. Smitson Director
------------------------------------
Terry L. Walker Director
/s/ Jean L. Wojtowicz
------------------------------------
Jean L. Wojtowicz Director
EXHIBIT-31.1
FIRST MERCHANTS CORPORATION
FORM 10-K
CERTIFICATION PURSUANT TO
SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002
CERTIFICATION
-------------
I, Michael L. Cox, President and Chief Executive Officer of First Merchants
Corporation, certify that:
1. I have reviewed this Annual Report on Form 10-K of First Merchants
Corporation;
2. Based on my knowledge, this report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered
by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal
control over financial reporting (as defined in the Exchange Act Rules
13a-15(f) and 15d-15(f)) for the registrant and have:
(a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known to
us by others within those entities, particularly during the period in
which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused
such internal control over financial reporting to be designed under
our supervision, to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally
accepted accounting principles;
(c) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the
end of the period covered by this report, based on such evaluation;
and
(d) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation of internal control over financial reporting,
to the registrant's auditors and the audit committee of the registrant's
board or directors (or persons performing the equivalent functions):
(a) All significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
(b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
control over financial reporting.
Date: March 16, 2007 /s/Michael L. Cox
----------------------------------------
Michael L. Cox
President and Chief Executive Officer
(Principal Executive Officer)
EXHIBIT-31.2
FIRST MERCHANTS CORPORATION
FORM 10-K
CERTIFICATION PURSUANT TO
SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002
CERTIFICATION
-------------
I, Mark K. Hardwick, Executive Vice President and Chief Financial Officer of
First Merchants Corporation, certify that:
1. I have reviewed this Annual Report on Form 10-K of First Merchants
Corporation;
2. Based on my knowledge, this report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered
by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal
control over financial reporting (as defined in the Exchange Act Rules
13a-15(f) and 15d-15(f)) for the registrant and have:
(a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known to
us by others within those entities, particularly during the period in
which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused
such internal control over financial reporting to be designed under
our supervision, to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally
accepted accounting principles;
(c) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the
end of the period covered by this report, based on such evaluation;
and
(d) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation of internal control over financial reporting,
to the registrant's auditors and the audit committee of the registrant's
board or directors (or persons performing the equivalent functions):
(a) All significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
(b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
control over financial reporting.
Date: March 16, 2007 /s/Mark K. Hardwick
----------------------------------------
Mark K. Hardwick
Executive Vice President and
Chief Financial Officer
(Principal Financial and
Principal Accounting Officer)
EXHIBIT-32
CERTIFICATIONS PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the annual report of First Merchants Corporation (the
"Corporation") on Form 10-K for the period ending December 31, 2006 as filed
with the Securities and Exchange Commission on the date hereof (the "Report"), I
Michael L. Cox, President and Chief Executive Officer of the Corporation, do
hereby certify, in accordance with 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002, that:
(1) The Report fully complies with the requirements of section 13(a) or
15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o (d)); and
(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations of the
Corporation.
Date March 16, 2007 by /s/ Michael L. Cox
------------------------- -------------------------------------
Michael L. Cox
President and Chief Executive Officer
(Principal Executive Officer)
A signed copy of this written statement required by Section 906 has been
provided to First Merchants Corporation and will be retained by First Merchants
Corporation and furnished to the Securities and Exchange Commission or its staff
upon request.
In connection with the annual report of First Merchants Corporation (the
"Corporation") on Form 10-K for the period ending December 31, 2006 as filed
with the Securities and Exchange Commission on the date hereof (the "Report"), I
Mark K. Hardwick, Executive Vice President and Chief Financial Officer of the
Corporation, do hereby certify, in accordance with 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:
(1) The Report fully complies with the requirements of section 13(a) or
15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o (d)); and
(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations of the
Corporation.
Date March 16, 2007 by /s/ Mark K. Hardwick
------------------------- -------------------------------------
Mark K. Hardwick
Executive Vice President and
Chief Financial Officer
(Principal Financial and
Principal Accounting Officer)
A signed copy of this written statement required by Section 906 has been
provided to First Merchants Corporation and will be retained by First Merchants
Corporation and furnished to the Securities and Exchange Commission or its staff
upon request.
EXHIBIT-99.1
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM'S REPORT
FOR FIRST MERCHANTS CORPORATION EMPLOYEE STOCK PURCHASE PLAN
EXHIBIT 99.1--FINANCIAL STATEMENTS AND INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM'S REPORT FOR FIRST MERCHANTS CORPORATION EMPLOYEE STOCK
PURCHASE PLAN
--------------------------------------------------------------------------------
The annual financial statements and independent registered public accounting
firm's report thereon for First Merchants Corporation Employee Stock Purchase
Plan for the year ending December 31, 2006, will be filed as an amendment to the
2006 Annual Report on Form 10-K.