10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended June 30, 2018

 

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 1-15817

 

 

OLD NATIONAL BANCORP

(Exact name of Registrant as specified in its charter)

 

 

 

INDIANA   35-1539838

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

One Main Street

Evansville, Indiana

  47708
(Address of principal executive offices)   (Zip Code)

(800) 731-2265

(Registrant’s telephone number, including area code)

 

 

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 the filing requirements for at least the past 90 days.     Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (s232.405 of this chapter) during the preceding 12 months (or for shorter period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer      Accelerated filer  
Non-accelerated filer   ☐  (Do not check if a smaller reporting company)    Smaller reporting company  
Emerging growth company       

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock. The registrant has one class of common stock (no par value) with 152,351,000 shares outstanding at June 30, 2018.

 

 

 


Table of Contents

OLD NATIONAL BANCORP

FORM 10-Q

TABLE OF CONTENTS

 

         Page  

PART I. FINANCIAL INFORMATION

     4  

Item 1.

 

Financial Statements

     4  
 

Consolidated Balance Sheets

     4  
 

Consolidated Statements of Income (unaudited)

     5  
 

Consolidated Statements of Comprehensive Income (unaudited)

     6  
 

Consolidated Statements of Changes in Shareholders’ Equity (unaudited)

     7  
 

Consolidated Statements of Cash Flows (unaudited)

     8  
 

Notes to Consolidated Financial Statements (unaudited)

     9  
 

Note 1. Basis of Presentation

     9  
 

Note 2. Revenue Recognition

     9  
 

Note 3. Recent Accounting Pronouncements

     11  
 

Note 4. Acquisition and Divestiture Activity

     16  
 

Note 5. Net Income Per Share

     17  
 

Note 6. Investment Securities

     19  
 

Note 7. Loans Held for Sale

     23  
 

Note 8. Loans and Allowance for Loan Losses

     23  
 

Note 9. Other Real Estate Owned

     35  
 

Note 10. Premises and Equipment

     36  
 

Note 11. Goodwill and Other Intangible Assets

     36  
 

Note 12. Loan Servicing Rights

     37  
 

Note 13. Qualified Affordable Housing Projects and Other Tax Credit Investments

     38  
 

Note 14. Securities Sold Under Agreements to Repurchase

     39  
 

Note 15. Federal Home Loan Bank Advances

     40  
 

Note 16. Other Borrowings

     41  
 

Note 17. Accumulated Other Comprehensive Income (Loss)

     44  
 

Note 18. Employee Benefit Plans

     46  
 

Note 19. Share-Based Compensation

     47  
 

Note 20. Income Taxes

     48  
 

Note 21. Derivative Financial Instruments

     50  
 

Note 22. Commitments and Contingencies

     54  
 

Note 23. Financial Guarantees

     54  
 

Note 24. Segment Information

     55  
 

Note 25. Fair Value

     55  

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     64  
 

Financial Highlights

     65  
 

Non-GAAP Financial Measures

     66  
 

Executive Summary

     67  
 

Results of Operations

     68  
 

Financial Condition

     77  
 

Risk Management

     80  
 

Off-Balance Sheet Arrangements

     90  
 

Contractual Obligations

     90  
 

Critical Accounting Policies and Estimates

     91  
 

Forward-Looking Statements

     93  

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

     94  

Item 4.

 

Controls and Procedures

     94  

PART II. OTHER INFORMATION

     95  

Item 1A.

 

Risk Factors

     95  

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

     95  

Item 5.

 

Other Information

     95  

Item 6.

 

Exhibits

     96  

SIGNATURE

     97  

 

2


Table of Contents

GLOSSARY OF ABBREVIATIONS AND ACRONYMS

As used in this report, references to “Old National,” “we,” “our,” “us,” and similar terms refer to the consolidated entity consisting of Old National Bancorp and its wholly-owned affiliates. Old National Bancorp refers solely to the parent holding company, and Old National Bank refers to Old National’s bank subsidiary.

The acronyms and abbreviations identified below are used in the Notes to Consolidated Financial Statements (Unaudited) as well as in the Management’s Discussion and Analysis of Financial Condition and Results of Operations. You may find it helpful to refer to this page as you read this report.

Anchor (MN): Anchor Bancorp, Inc.

Anchor Bank (MN): Anchor Bank, N.A.

Anchor (WI): Anchor BanCorp Wisconsin Inc.

AnchorBank (WI): AnchorBank, fsb

AOCI: accumulated other comprehensive income (loss)

AQR: asset quality rating

ASC: Accounting Standards Codification

ASU: Accounting Standards Update

ATM: automated teller machine

Common Stock: Old National Bancorp common stock, without par value

CReED: Indiana Community Revitalization Enhancement District Tax Credit

DTI: debt-to-income

Dodd-Frank Act: Dodd-Frank Wall Street Reform and Consumer Protection Act

EITF: Emerging Issues Task Force

FASB: Financial Accounting Standards Board

FDIC: Federal Deposit Insurance Corporation

FHLB: Federal Home Loan Bank

FHTC: Federal Historic Tax Credit

FICO: Fair Isaac Corporation

GAAP: generally accepted accounting principles in the United States

Klein: Klein Financial, Inc.

LGD: loss given default

LIBOR: London Interbank Offered Rate

LIHTC: Low Income Housing Tax Credit

LTV: loan-to-value

N/A: not applicable

N/M: not meaningful

NASDAQ: The NASDAQ Stock Market LLC

NOW: negotiable order of withdrawal

OTTI: other-than-temporary impairment

PCI: purchased credit impaired

PD: probability of default

Renewable Energy: investment tax credits for solar projects

SAB: Staff Accounting Bulletin

SEC: Securities and Exchange Commission

TBA: to be announced

TDR: troubled debt restructuring

 

3


Table of Contents

OLD NATIONAL BANCORP    

CONSOLIDATED BALANCE SHEETS    

 

(dollars and shares in thousands, except per share data)

   June 30,
2018
    December 31,
2017
    June 30,
2017
 
     (unaudited)           (unaudited)  

Assets

      

Cash and due from banks

   $ 219,626     $ 222,753     $ 230,809  

Money market and other interest-earning investments

     54,248       67,679       31,932  
  

 

 

   

 

 

   

 

 

 

Total cash and cash equivalents

     273,874       290,432       262,741  

Trading securities, at fair value

     5,596       5,584       5,235  

Investment securities - available-for-sale, at fair value:

      

U.S. Treasury

     5,257       5,551       5,634  

U.S. government-sponsored entities and agencies

     568,231       664,286       580,624  

Mortgage-backed securities

     1,448,526       1,667,682       1,462,111  

States and political subdivisions

     797,533       530,193       431,874  

Other securities

     362,118       328,495       334,095  
  

 

 

   

 

 

   

 

 

 

Total investment securities - available-for-sale

     3,181,665       3,196,207       2,814,338  

Investment securities - held-to-maturity, at amortized cost (fair value $524,597; $727,703; and $749,363, respectively)

     525,718       684,063       695,139  

Federal Home Loan Bank/Federal Reserve Bank stock, at cost

     136,206       119,686       109,715  

Loans held for sale, at fair value

     26,198       17,930       27,425  

Loans:

      

Commercial

     2,962,895       2,717,269       2,001,621  

Commercial real estate

     4,451,772       4,354,552       3,259,998  

Residential real estate

     2,153,973       2,167,053       2,099,374  

Consumer credit, net of unearned income

     1,726,989       1,879,247       1,871,047  
  

 

 

   

 

 

   

 

 

 

Total loans

     11,295,629       11,118,121       9,232,040  

Allowance for loan losses

     (53,660     (50,381     (50,986
  

 

 

   

 

 

   

 

 

 

Net loans

     11,241,969       11,067,740       9,181,054  
  

 

 

   

 

 

   

 

 

 

Premises and equipment, net

     449,304       458,074       413,933  

Accrued interest receivable

     81,290       87,102       79,830  

Goodwill

     828,804       828,051       655,018  

Other intangible assets

     45,417       53,096       31,876  

Company-owned life insurance

     405,492       403,753       354,875  

Net deferred tax assets

     90,187       110,857       146,780  

Loan servicing rights

     24,303       24,661       25,023  

Assets held for sale

     10,222       7,180       11,725  

Other real estate owned and repossessed personal property

     3,729       8,810       11,071  

Other assets

     153,016       155,066       131,503  
  

 

 

   

 

 

   

 

 

 

Total assets

   $ 17,482,990     $ 17,518,292     $ 14,957,281  
  

 

 

   

 

 

   

 

 

 

Liabilities

      

Deposits:

      

Noninterest-bearing demand

   $ 3,600,793     $ 3,680,807     $ 3,011,156  

Interest-bearing:

      

Checking and NOW

     3,054,302       3,115,822       2,639,813  

Savings

     3,026,110       3,035,622       2,924,689  

Money market

     1,090,621       1,139,077       672,391  

Time

     1,824,550       1,634,436       1,435,665  
  

 

 

   

 

 

   

 

 

 

Total deposits

     12,596,376       12,605,764       10,683,714  

Federal funds purchased and interbank borrowings

     175,044       335,033       227,029  

Securities sold under agreements to repurchase

     347,511       384,810       298,094  

Federal Home Loan Bank advances

     1,757,308       1,609,579       1,515,628  

Other borrowings

     250,241       248,782       219,167  

Accrued expenses and other liabilities

     156,295       179,927       127,055  
  

 

 

   

 

 

   

 

 

 

Total liabilities

     15,282,775       15,363,895       13,070,687  
  

 

 

   

 

 

   

 

 

 

Shareholders’ Equity

      

Preferred stock, 2,000 shares authorized, no shares issued or outstanding

     —         —         —    

Common stock, $1.00 per share stated value, 300,000 shares authorized, 152,351; 152,040; and 135,516 shares issued and outstanding, respectively

     152,351       152,040       135,516  

Capital surplus

     1,642,790       1,639,499       1,352,411  

Retained earnings

     471,777       413,130       429,787  

Accumulated other comprehensive income (loss), net of tax

     (66,703     (50,272     (31,120
  

 

 

   

 

 

   

 

 

 

Total shareholders’ equity

     2,200,215       2,154,397       1,886,594  
  

 

 

   

 

 

   

 

 

 

Total liabilities and shareholders’ equity

   $ 17,482,990     $ 17,518,292     $ 14,957,281  
  

 

 

   

 

 

   

 

 

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

4


Table of Contents

OLD NATIONAL BANCORP

CONSOLIDATED STATEMENTS OF INCOME (unaudited)

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 

(dollars and shares in thousands, except per share data)

   2018      2017      2018      2017  

Interest Income

           

Loans including fees:

           

Taxable

   $ 124,610      $ 92,189      $ 242,999      $ 184,390  

Nontaxable

     3,984        3,236        7,858        6,415  

Investment securities:

           

Taxable

     18,367        15,501        37,171        31,186  

Nontaxable

     6,658        7,228        13,207        14,600  

Money market and other interest-earning investments

     117        55        207        86  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total interest income

     153,736        118,209        301,442        236,677  
  

 

 

    

 

 

    

 

 

    

 

 

 

Interest Expense

           

Deposits

     9,139        4,724        16,394        9,107  

Federal funds purchased and interbank borrowings

     647        422        1,664        778  

Securities sold under agreements to repurchase

     434        334        793        590  

Federal Home Loan Bank advances

     8,824        6,017        16,604        11,329  

Other borrowings

     2,729        2,379        5,452        4,739  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total interest expense

     21,773        13,876        40,907        26,543  
  

 

 

    

 

 

    

 

 

    

 

 

 

Net interest income

     131,963        104,333        260,535        210,134  

Provision for loan losses

     2,446        1,355        2,826        1,702  
  

 

 

    

 

 

    

 

 

    

 

 

 

Net interest income after provision for loan losses

     129,517        102,978        257,709        208,432  
  

 

 

    

 

 

    

 

 

    

 

 

 

Noninterest Income

           

Wealth management fees

     9,746        9,679        18,772        18,678  

Service charges on deposit accounts

     10,765        10,040        21,524        19,883  

Debit card and ATM fees

     5,080        4,436        9,945        8,672  

Mortgage banking revenue

     5,189        5,186        9,381        9,412  

Investment product fees

     5,066        5,004        10,097        9,993  

Capital markets income

     896        2,747        1,394        3,778  

Company-owned life insurance

     2,430        2,117        5,035        4,266  

Net securities gains (losses)

     1,494        3,075        2,282        4,575  

Recognition of deferred gain on sale leaseback transactions

     394        538        789        1,075  

Other income

     8,229        6,449        11,975        11,859  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total noninterest income

     49,289        49,271        91,194        92,191  
  

 

 

    

 

 

    

 

 

    

 

 

 

Noninterest Expense

           

Salaries and employee benefits

     66,592        57,606        130,771        114,170  

Occupancy

     12,873        10,539        26,153        22,673  

Equipment

     3,728        3,350        7,293        6,577  

Marketing

     3,962        3,673        7,659        6,723  

Data processing

     9,724        8,226        18,124        15,834  

Communication

     2,772        2,288        5,836        4,702  

Professional fees

     2,923        4,077        5,653        6,728  

Loan expenses

     1,843        1,693        3,587        3,324  

Supplies

     903        594        1,625        1,173  

FDIC assessment

     3,161        2,130        5,806        4,617  

Other real estate owned expense

     196        1,009        545        2,124  

Amortization of intangibles

     3,416        2,781        7,025        5,801  

Amortization of tax credit investments

     11,858        —          12,574        —    

Other expense

     6,509        4,845        14,966        10,256  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total noninterest expense

     130,460        102,811        247,617        204,702  
  

 

 

    

 

 

    

 

 

    

 

 

 

Income before income taxes

     48,346        49,438        101,286        95,921  

Income tax expense

     4,345        10,584        9,302        21,075  
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income

   $ 44,001      $ 38,854      $ 91,984      $ 74,846  
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income per common share - basic

   $ 0.29      $ 0.28      $ 0.61      $ 0.55  

Net income per common share - diluted

     0.29        0.28        0.60        0.55  
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average number of common shares outstanding - basic

     151,878        135,085        151,800        134,999  

Weighted average number of common shares outstanding - diluted

     152,568        135,697        152,483        135,641  
  

 

 

    

 

 

    

 

 

    

 

 

 

Dividends per common share

   $ 0.13      $ 0.13      $ 0.26      $ 0.26  

The accompanying notes to consolidated financial statements are an integral part of these statements.    

 

5


Table of Contents

OLD NATIONAL BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 

(dollars in thousands)

   2018     2017     2018     2017  

Net income

   $ 44,001     $ 38,854     $ 91,984     $ 74,846  

Other comprehensive income (loss):

        

Change in securities available-for-sale:

        

Unrealized holding gains (losses) for the period

     (7,327     30,627       (33,121     46,407  

Reclassification for securities transferred to held-to-maturity

     —         —         14,007       —    

Reclassification adjustment for securities gains realized in income

     (1,494     (3,075     (2,282     (4,575

Income tax effect

     2,070       (10,017     5,180       (15,277
  

 

 

   

 

 

   

 

 

   

 

 

 

Unrealized gains (losses) on available-for-sale securities

     (6,751     17,535       (16,216     26,555  

Change in securities held-to-maturity:

        

Adjustment for securities transferred to available-for-sale

     —         —         19,412       —    

Adjustment for securities transferred from available-for-sale

     —         —         (14,007     —    

Amortization of unrealized losses on securities transferred from available-for-sale

     521       453       1,112       902  

Income tax effect

     (119     (155     (1,145     (309
  

 

 

   

 

 

   

 

 

   

 

 

 

Changes from securities held-to-maturity

     402       298       5,372       593  

Cash flow hedges:

        

Net unrealized derivative gains (losses) on cash flow hedges

     1,516       (2,387     6,079       (1,807

Reclassification adjustment for losses realized in net income

     10       1,734       779       3,533  

Income tax effect

     (375     248       (1,683     (656
  

 

 

   

 

 

   

 

 

   

 

 

 

Changes from cash flow hedges

     1,151       (405     5,175       1,070  

Defined benefit pension plans:

        

Amortization of net loss recognized in income

     27       27       54       54  

Income tax effect

     (6     (10     (13     (20
  

 

 

   

 

 

   

 

 

   

 

 

 

Changes from defined benefit pension plans

     21       17       41       34  
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss), net of tax

     (5,177     17,445       (5,628     28,252  
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income

   $ 38,824     $ 56,299     $ 86,356     $ 103,098  
  

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

6


Table of Contents

OLD NATIONAL BANCORP

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (unaudited)

 

(dollars in thousands)

   Common
Stock
    Capital
Surplus
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income (Loss)
    Total
Shareholders’
Equity
 

Balance at December 31, 2016

   $ 135,159     $ 1,348,338     $ 390,292     $ (59,372   $ 1,814,417  

Net income

     —         —         74,846       —         74,846  

Other comprehensive income (loss)

     —         —         —         28,252       28,252  

Dividends - common stock ($0.26 per share)

     —         —         (35,219     —         (35,219

Common stock issued

     11       177       —         —         188  

Common stock repurchased

     (104     (1,748     —         —         (1,852

Share-based compensation expense

     —         3,184       —         —         3,184  

Stock activity under incentive compensation plans

     450       2,460       (132     —         2,778  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at June 30, 2017

   $ 135,516     $ 1,352,411     $ 429,787     $ (31,120   $ 1,886,594  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2017

   $ 152,040     $ 1,639,499     $ 413,130     $ (50,272   $ 2,154,397  

Cumulative effect of change in accounting principles (Note 3)

     —         —         (4,127     (52     (4,179

Reclassification of certain tax effects related to the Tax Cuts and Jobs Act of 2017 (Note 3)

     —         —         10,751       (10,751     —    

Net income

     —         —         91,984       —         91,984  

Other comprehensive income (loss)

     —         —         —         (5,628     (5,628

Dividends - common stock ($0.26 per share)

     —         —         (39,588     —         (39,588

Common stock issued

     14       208       —         —         222  

Common stock repurchased

     (100     (1,649     —         —         (1,749

Share-based compensation expense

     —         3,606       —         —         3,606  

Stock activity under incentive compensation plans

     397       1,126       (373     —         1,150  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at June 30, 2018

   $ 152,351     $ 1,642,790     $ 471,777     $ (66,703   $ 2,200,215  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes to consolidated financial statements are an integral part of these statements.    

 

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OLD NATIONAL BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

 

    

Six Months Ended

June 30,

 

(dollars in thousands)

   2018     2017  

Cash Flows From Operating Activities

    

Net income

   $ 91,984     $ 74,846  
  

 

 

   

 

 

 

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

    

Depreciation

     11,772       10,406  

Amortization of other intangible assets

     7,025       5,801  

Amortization of tax credit investments

     12,574       —    

Net premium amortization on investment securities

     7,538       7,529  

Accretion income related to acquired loans

     (22,312     (22,157

Share-based compensation expense

     3,606       3,184  

Excess tax (benefit) expense on share-based compensation

     432       160  

Provision for loan losses

     2,826       1,702  

Net securities (gains) losses

     (2,282     (4,575

Recognition of deferred gain on sale leaseback transactions

     (789     (1,075

Net (gains) losses on sales of loans and other assets

     1,078       (5,398

Increase in cash surrender value of company-owned life insurance

     (5,035     (4,266

Residential real estate loans originated for sale

     (240,201     (179,025

Proceeds from sales of residential real estate loans

     234,736       246,549  

(Increase) decrease in interest receivable

     2,316       1,551  

(Increase) decrease in other real estate owned

     5,081       7,475  

(Increase) decrease in other assets

     16,127       3,707  

Increase (decrease) in accrued expenses and other liabilities

     (21,669     (20,504
  

 

 

   

 

 

 

Total adjustments

     12,823       51,064  
  

 

 

   

 

 

 

Net cash flows provided by (used in) operating activities

     104,807       125,910  
  

 

 

   

 

 

 

Cash Flows From Investing Activities

    

Purchases of investment securities available-for-sale

     (235,161     (414,742

Purchases of Federal Home Loan Bank/Federal Reserve Bank stock

     (16,520     (8,008

Proceeds from maturities, prepayments, and calls of investment securities available-for-sale

     220,753       252,486  

Proceeds from sales of investment securities available-for-sale

     131,321       186,277  

Proceeds from maturities, prepayments, and calls of investment securities held-to-maturity

     35,750       48,204  

Proceeds from sales of Federal Home Loan Bank/Federal Reserve Bank stock

     —         9  

Proceeds from sales of trading securities

     128       127  

Proceeds from sale of student loan portfolio

     70,674       —    

Net principal collected from (loans made to) loan customers

     (219,685     (199,895

Proceeds from settlements on company-owned life insurance

     3,296       2,347  

Proceeds from sales of premises and equipment and other assets

     4,708       10,120  

Purchases of premises and equipment and other assets

     (17,005     (9,461
  

 

 

   

 

 

 

Net cash flows provided by (used in) investing activities

     (21,741     (132,536
  

 

 

   

 

 

 

Cash Flows From Financing Activities

    

Net increase (decrease) in:

    

Deposits

     (9,527     (59,539

Federal funds purchased and interbank borrowings

     (159,989     14,026  

Securities sold under agreements to repurchase

     (37,299     (68,958

Other borrowings

     1,159       (97

Payments for maturities of Federal Home Loan Bank advances

     (898,801     (892,298

Proceeds from Federal Home Loan Bank advances

     1,045,000       1,055,000  

Cash dividends paid on common stock

     (39,588     (35,219

Common stock repurchased

     (1,749     (1,852

Proceeds from exercise of stock options

     948       2,597  

Common stock issued

     222       188  
  

 

 

   

 

 

 

Net cash flows provided by (used in) financing activities

     (99,624     13,848  
  

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     (16,558     7,222  

Cash and cash equivalents at beginning of period

     290,432       255,519  
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 273,874     $ 262,741  
  

 

 

   

 

 

 

Supplemental cash flow information:

    

Total interest paid

   $ 40,426     $ 26,534  

Total taxes paid (net of refunds)

   $ (819   $ 3,000  

Securities transferred from held-to-maturity to available-for-sale

   $ 447,026     $ —    

Securities transferred from available-for-sale to held-to-maturity

   $ 323,990     $ —    

The accompanying notes to consolidated financial statements are an integral part of these statements.    

 

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OLD NATIONAL BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

NOTE 1 – BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements include the accounts of Old National Bancorp and its wholly-owned affiliates (hereinafter collectively referred to as “Old National”) and have been prepared in conformity with accounting principles generally accepted in the United States of America and prevailing practices within the banking industry. Such principles require management to make estimates and assumptions that affect the reported amounts of assets, liabilities, and the disclosures of contingent assets and liabilities at the date of the financial statements and amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. In the opinion of management, the consolidated financial statements contain all the normal and recurring adjustments necessary for a fair statement of the financial position of Old National as of June 30, 2018 and 2017, and December 31, 2017, and the results of its operations for the three and six months ended June 30, 2018 and 2017. Interim results do not necessarily represent annual results. These financial statements should be read in conjunction with Old National’s Annual Report for the year ended December 31, 2017.

All significant intercompany transactions and balances have been eliminated. Certain prior year amounts have been reclassified to conform to the 2018 presentation. Such reclassifications had no effect on net income or shareholders’ equity and were insignificant amounts.

NOTE 2 – REVENUE RECOGNITION

In May 2014, the FASB issued an update (ASU No. 2014-09, Revenue from Contracts with Customers) creating FASB Topic 606, Revenue from Contracts with Customers. The guidance in this update affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (for example, insurance contracts or lease contracts). The scope of this update explicitly excludes net interest income, as well as other revenues from transactions involving financial instruments, such as loans and securities. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance provides steps to follow to achieve the core principle. An entity should disclose sufficient information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The amendments in this update became effective for annual periods and interim periods within those annual periods beginning after December 15, 2017 and did not have a material impact on the consolidated financial statements. Old National finalized the in-depth assessment and identified the revenue line items within the scope of this new guidance. For Old National, the revenue streams that are affected by this update are presented within noninterest income.

In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net). The amendments relate to when another party, along with the entity, is involved in providing a good or service to a customer. Topic 606 requires an entity to determine whether the nature of its promise is to provide that good or service to the customer (that is, the entity is a principal) or to arrange for the good or service to be provided to the customer by the other party (that is, the entity is an agent). This determination is based upon whether the entity controls the good or the service before it is transferred to the customer. Topic 606 includes indicators to assist in this evaluation. The amendments in this update affect the guidance in ASU No. 2014-09 above. The effective date is the same as the effective date of ASU No. 2014-09.

In April 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing. The amendments clarify the following two aspects of Topic 606: identifying performance obligations, and the licensing implementation guidance. Before an entity can identify its performance obligations in a contract with a customer, the entity first identifies the promised goods or services in the contract. The amendments in this update are expected to reduce the cost and complexity of applying the guidance on identifying promised goods or services. To identify performance obligations in a contract, an entity evaluates whether promised goods and services are distinct. Topic 606 includes two criteria for assessing whether promises to transfer goods or services are distinct. One of those criteria is that the promises are separately

 

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identifiable. This update will improve the guidance on assessing that criterion. Topic 606 also includes implementation guidance on determining whether as entity’s promise to grant a license provides a customer with either a right to use the entity’s intellectual property, which is satisfied at a point in time, or a right to access the entity’s intellectual property, which is satisfied over time. The amendments in this update are intended to improve the operability and understandability of the licensing implementation guidance. The amendments in this update affect the guidance in ASU No. 2014-09 above. The effective date is the same as the effective date of ASU No. 2014-09.

In May 2016, the FASB issued ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients. The amendments do not change the core revenue recognition principle in Topic 606. The amendments provide clarifying guidance in certain narrow areas and add some practical expedients.

In December 2016, the FASB issued ASU No. 2016-20, Revenue from Contracts with Customers (Topic 606): Technical Corrections and Improvements. The FASB decided to issue a separate update for technical corrections and improvements to Topic 606 and other Topics amended by ASU No. 2014-09 to increase awareness of the proposals and to expedite improvements to ASU No. 2014-09. The amendment affects narrow aspects of the guidance issued in ASU No. 2014-09.

On January 1, 2018, Old National adopted ASU 2014-09, Revenue from Contracts with Customers and all subsequent amendments to the ASU (collectively, “Topic 606”) utilizing the modified retrospective application. A significant majority of Old National’s revenues are not subject to the new guidance. Services within the scope of Topic 606 include wealth management fees, service charges on deposit accounts, debit card and ATM fees, and investment product fees. Old National enters into various contracts with customers to provide these traditional banking services on a routine basis. Old National’s performance obligations are generally service-related and provided on a daily, monthly, or quarterly basis. The performance obligations are generally satisfied as services are rendered and the fees are collected at such time, or shortly thereafter. It is not typical for contracts to require significant judgment to determine the transaction price. The implementation of this update did not have a material impact on the measurement, timing, or recognition of revenue. Accordingly, no cumulative effect adjustment to opening retained earnings was deemed necessary. Results for reporting periods beginning after adoption are presented under Topic 606. As allowed under the update, results for prior periods continue to be reported under the accounting standards in effect for those periods.

Wealth management fees: Old National earns wealth management fees based upon asset custody and investment management services provided to individual and institutional customers. Most of these customers receive monthly or quarterly billings for services rendered based upon the market value of assets in custody. Fees that are transaction based are recognized at the point in time that the transaction is executed.

Service charges on deposit accounts: Old National earns fees from deposit customers for transaction-based, account maintenance, and overdraft services. Transaction-based fees and overdraft fees are recognized at a point in time, since the customer generally has a right to cancel the depository arrangement at any time. The arrangement is considered a day-to-day contract with ongoing renewals and optional purchases, so the duration of the contract does not extend beyond the services already performed. Account maintenance fees, which relate primarily to monthly maintenance, are earned over the course of a month, representing the period over which Old National satisfies its performance obligation.

Debit card and ATM fees: Debit card and ATM fees include ATM usage fees and debit card interchange income. As with the transaction-based fees on deposit accounts, the ATM fees are recognized at the point in time that Old National fulfills the customer’s request. Old National earns interchange fees from cardholder transactions processed through card association networks. Interchange rates are generally set by the card associations based upon purchase volumes and other factors. Interchange fees represent a percentage of the underlying transaction value and are recognized daily, concurrently with the transaction processing services provided to the cardholder.

Investment product fees: Investment product fees are the commissions and fees received from a registered broker/dealer and investment adviser that provide those services to Old National customers. Old National acts as an agent in arranging the relationship between the customer and the third-party service provider. These fees are recognized monthly from the third-party broker based upon services already performed, net of the processing fees charged to Old National by the broker.

 

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The consolidated statements of income include all categories of noninterest income. The following table reflects only the categories of noninterest income that are within the scope of Topic 606:

 

    

Three Months Ended

June 30,

    

Six Months Ended

June 30,

 

(dollars in thousands)

   2018      2017      2018      2017  

Wealth management fees

   $ 9,746      $ 9,679      $ 18,772      $ 18,678  

Service charges on deposit accounts

     10,765        10,040        21,524        19,883  

Debit card and ATM fees

     5,080        4,436        9,945        8,672  

Investment product fees

     5,066        5,004        10,097        9,993  

Other income:

           

Merchant processing fees

     778        633        1,419        1,230  

Gain (loss) on other real estate owned

     586        (41      721        617  

Safe deposit box fees

     224        207        628        514  

Insurance premiums and commissions

     78        160        182        267  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 32,323      $ 30,118      $ 63,288      $ 59,854  
  

 

 

    

 

 

    

 

 

    

 

 

 

The adoption of Topic 606 did not have a material impact on our consolidated financial position, results of operations, equity, or cash flows as of the adoption date or for the three or six months ended June 30, 2018.

NOTE 3 – RECENT ACCOUNTING PRONOUNCEMENTS

FASB ASC 825 – In January 2016, the FASB issued an update (ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities). The amendments in this update impact public business entities as follows: (1) require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; (2) simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; and when a qualitative assessment indicates that impairment exists, an entity is required to measure the investment at fair value; (3) eliminate the requirement to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; (4) require entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (5) require an entity to present separately in other comprehensive income the portion of the total change in fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; (6) require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements; and (7) clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. The amendments in this update became effective for annual periods and interim periods within those annual periods beginning after December 15, 2017 and did not have a material impact on the consolidated financial statements.

FASB ASC 842 – In February 2016, the FASB issued its new lease accounting guidance in ASU No. 2016-02, Leases (Topic 842). Under the new guidance, lessees will be required to recognize the following for all leases, with the exception of short-term leases, at the commencement date: (1) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. The amendments in this update become effective for annual periods and interim periods within those annual periods beginning after December 15, 2018. Old National has formed a cross functional team to plan and execute the adoption of this standard. The implementation efforts are ongoing, including the review of our leases and related accounting policies, review of contracts for embedded leases, and the implementation of a new lease software solution. Based on leases outstanding at June 30, 2018, Old

 

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National does not expect the new standard to have a material impact on the income statement, but anticipates a $125 million to $140 million increase in assets and liabilities. Decisions to repurchase, modify, or renew leases prior to the implementation date will impact this level of materiality.

In July 2018, the FASB issued an update (ASU No. 2018-10, Codification Improvements to Topic 842, Leases). The FASB decided to issue a separate update for the improvements related to ASU No. 2016-02 to increase stakeholders’ awareness of the amendments and to expedite the improvements. The amendments affect narrow aspects of the guidance issued in ASU No. 2016-02.

FASB ASC 815 – In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. The amendments in the update make certain targeted improvements to simplify the application of the hedge accounting guidance in GAAP. The amendments in this update better align an entity’s risk management activities and financial reporting for hedging relationships through changes to both the designation and measurement guidance for qualifying hedging relationships and the presentation of hedge results. To meet that objective, the amendments expand and refine hedge accounting for both nonfinancial and financial risk components and align the recognition and presentation of the effects of the hedging instrument and the hedged item in the financial statements. This update addresses several limitations that GAAP placed on the risk components, how an entity can designate the hedged item in a fair value hedge of interest rate risk, and how an entity can measure changes in fair value of the hedged item attributable to interest rate risk. In addition to the amendments to the designation and measurement guidance for qualifying hedging relationships, the amendments in this update also align the recognition and presentation of the effects of the hedging instrument and the hedged item in the financial statements to increase the understandability of the results of an entity’s intended hedging strategies. The amendments in this update require an entity to present the earnings effect of the hedging instrument in the same income statement line item in which the earnings effect of the hedged item is reported. Prior to the issuance of this update, GAAP provided special hedge accounting only for the portion of the hedge deemed to be “highly effective” and required an entity to separately reflect the amount by which the hedging instrument did not offset the hedged item, which is referred to as the “ineffective” amount. However, the concept and reporting of hedge ineffectiveness were difficult for financial statement users to understand and, at times, for preparers to explain. The FASB decided on an approach that no longer separately measures and reports hedge ineffectiveness. This update also includes certain targeted improvements to ease the application of current guidance related to the assessment of hedge effectiveness. Prior to the issuance of this update, GAAP contained specific requirements for initial and ongoing quantitative hedge effectiveness testing and strict requirements for specialized effectiveness testing methods that allowed an entity to forgo quantitative hedge effectiveness assessments for qualifying relationships. The amendments in this update become effective for annual periods and interim periods within those annual periods beginning after December 15, 2018. Early adoption is permitted in any interim period. Management elected to early adopt this update effective January 1, 2018 using the modified retrospective method. The impact of the adoption resulted in a reduction to Old National’s opening retained earnings of $3.2 million. In addition, as permitted by the amendments in the update, Old National reclassified $447.0 million in state and political subdivision securities with unrealized holding gains of $26.1 million from the held-to-maturity portfolio to the available-for-sale portfolio.

FASB ASC 718 – In May 2017, the FASB issued ASU No. 2017-09, Compensation – Stock Compensation (Topic 718): Scope of Modification Accounting. The amendments in this update provide guidance about which changes to the terms and conditions of a share-based payment award require an entity to apply modification accounting. An entity should account for the effect of a modification unless all the following are met: (1) the fair value of the modified award is the same as the fair value of the original award immediately before the original award is modified – if the modification does not affect any of the inputs to the valuation technique that the entity uses to value the award, the entity is not required to estimate the value immediately before and after the modification; (2) the vesting conditions of the modified award are the same as the vesting conditions of the original award immediately before the original award is modified; (3) the classification of the modified award as an equity instrument or a liability instrument is the same as the classification of the original award immediately before the original award is modified. The amendments in this update became effective for annual periods and interim periods within those annual periods beginning after December 15, 2017 and did not have a material impact on the consolidated financial statements.

FASB ASC 326 – In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“CECL”). The main objective of this amendment is to provide financial statement users with more decision-useful information about the expected credit losses on

 

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financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. The amendment requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to enhance their credit loss estimates. The amendment requires enhanced disclosures to help investors and other financial statement users better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The amendments in this update become effective for annual periods and interim periods within those annual periods beginning after December 15, 2019. Early adoption will be permitted beginning after December 15, 2018.

As previously disclosed, Old National formed a cross functional committee to oversee the adoption of the ASU at the effective date. A working group was also formed and has developed a project plan focused on understanding the ASU, researching issues, identifying data needs for modeling inputs, technology requirements, modeling considerations, and ensuring overarching governance has been achieved for each objective and milestone. The project plan is targeting data and model validation completion in early 2019, with parallel processing of our existing allowance for loan losses model with the CECL for 2 – 4 quarters prior to implementation, depending on how model completion and validation occurs over the remainder of 2018. Currently, the working group has identified seven distinct loan portfolios for which a model has been or is in the process of being developed. For two of the loan portfolios, the data sets have been identified, populated, and internally validated. Additionally, models have been built, tested, and internally validated. During the remainder of 2018, Old National is focused on the completion of its remaining models, refining assumptions, and continued review and challenge of its models. Concurrent with this, Old National is also focused on researching and resolving interpretive accounting issues in the ASU, contemplating various related accounting policies, developing processes and related controls, and considering various reporting disclosures.

As of the beginning of the first reporting period in which the new standard is effective, Old National expects to recognize a one-time cumulative effect adjustment increasing the allowance for loan losses, since the ASU covers credit losses over the expected life of a loan as well as considering future changes in macroeconomic conditions. The magnitude of any such one-time adjustment or the overall impact of the new guidance on the consolidated financial statements cannot yet be reasonably estimated.

FASB ASC 740 – In October 2016, the FASB issued ASU No. 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory. Current guidance prohibits the recognition of current and deferred income taxes for an intra-entity asset transfer until the asset has been sold to an outside party. This prohibition on recognition is an exception to the principle of comprehensive recognition of current and deferred income taxes in generally accepted accounting principles. The exception has led to diversity in practice and is a source of complexity in financial reporting. FASB decided that an entity should recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. Consequently, the amendments in this update eliminate the exception for an intra-entity transfer of an asset other than inventory. The amendments in this update do not include new disclosure requirements; however, existing disclosure requirements might be applicable when accounting for the current and deferred income taxes for an intra-entity transfer of an asset other than inventory. The amendments in this update became effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods within those annual reporting periods. The amendments in this update were applied on a modified retrospective basis through a cumulative-effect reduction of $1.0 million directly to retained earnings as of the beginning of 2018.

FASB ASC 805 – In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. The amendments in this update provide a more robust framework to use in determining when a set of assets and activities is a business. Because the current definition of a business is interpreted broadly and can be difficult to apply, stakeholders indicated that analyzing transactions is inefficient and costly and that the definition does not permit the use of reasonable judgment. The amendments provide more consistency in applying the guidance, reduce the costs of application, and make the definition of a business more operable. The amendments in this update became effective for annual periods and interim periods within those annual periods beginning after December 15, 2017. Old National has completed its evaluation of adopting the new guidance on the consolidated financial statements and there is no impact to record.

 

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FASB ASC 350 – In January 2017, the FASB issued ASU No. 2017-04, Intangibles: Goodwill and Other: Simplifying the Test for Goodwill Impairment. To simplify the subsequent measurement of goodwill, the amendments eliminate Step 2 from the goodwill impairment test. The annual, or interim, goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In addition, the income tax effects of tax deductible goodwill on the carrying amount of the reporting unit should be considered when measuring the goodwill impairment loss, if applicable. The amendments also eliminate the requirements for any reporting unit with a zero or negative carrying amount to perform Step 2 of the goodwill impairment test. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the qualitative impairment test is necessary. The amendments should be applied on a prospective basis. The nature of and reason for the change in accounting principle should be disclosed upon transition. The amendments in this update should be adopted for annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted on testing dates after January 1, 2017. Old National is currently evaluating the impact of adopting the new guidance on the consolidated financial statements, but it is not expected to have a material impact.

FASB ASC 610 – In February 2017, the FASB issued ASU No. 2017-05, Other Income – Gains and Losses from the Derecognition of Nonfinancial Assets (Topic 610): Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets. Subtopic 610-20 was originally issued as part of ASU No. 2014-09 to provide guidance for recognizing gains and losses from the transfer of nonfinancial assets in contracts with noncustomers. This update was issued to help clarify uncertainties and complexities of ASU 2014-09. The amendments in this update define the term in substance nonfinancial asset, in part, as a financial asset promised to a counterparty in a contract if substantially all of its fair value of the assets (recognized and unrecognized) that are promised to the counterparty in the contract is concentrated in nonfinancial assets. If substantially all of the fair value of the assets that are promised to the counterparty in a contract is concentrated in nonfinancial assets, then all of the financial assets promised to the counterparty are in substance nonfinancial assets. The amendments in this update also clarify that nonfinancial assets within the scope of Subtopic 610-20 may include nonfinancial assets transferred within a legal entity to a counterparty. The amendments in this update require an entity to derecognize a distinct nonfinancial asset or distinct in substance nonfinancial asset in a partial sale transaction when it (1) does not have (or ceases to have) a controlling financial interest in the legal entity that holds the asset in accordance with Topic 810 and (2) transfers control of the asset in accordance with Topic 606. Once an entity transfers control of a distinct nonfinancial asset or distinct in substance nonfinancial asset, it is required to measure any noncontrolling interest it receives (or retains) at fair value. The amendments were effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period and did not have a material impact on the consolidated financial statements.

FASB ASC 715 – In March 2017, the FASB issued ASU No. 2017-07, Compensation – Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. The amendments in this update require that an employer disaggregate the service cost component from the other components of net benefit cost. The amendments also provide explicit guidance on how to present the service cost component and the other components of net benefit cost in the income statement and allow only the service cost component of net benefit cost to be eligible for capitalization. The amendments in this update improve the consistency, transparency, and usefulness of financial information to users that have communicated that the service cost component generally is analyzed differently from the other components of net benefit cost. The amendments in this update became effective for annual periods and interim periods within those annual periods beginning after December 15, 2017 and did not have a material impact on the consolidated financial statements.

FASB ASC 310 – In March 2017, the FASB issued ASU No. 2017-08, Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. This update amends the amortization period for certain purchased callable debt securities held at a premium. FASB is shortening the amortization period for the premium to the earliest call date. Under current GAAP, entities generally amortize the premium as an adjustment of yield over the contractual life of the instrument. Concerns were raised that current GAAP excludes certain callable debt securities from consideration of early repayment of principal even if the holder is certain that the call will be exercised. As a result, upon the exercise of a call on a callable debt security held at a premium, the unamortized premium is recorded as a loss in earnings. There is diversity in practice (1) in the amortization period for premiums of callable debt securities and (2) in how the potential for exercise of a call is factored into current impairment assessments. The amendments in this update become effective for annual periods

 

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and interim periods within those annual periods beginning after December 15, 2018. Old National is currently evaluating the impact of adopting the new guidance on the consolidated financial statements, but it is not expected to have a material impact.

FASB ASC 220 – In February 2018, the FASB issued ASU No. 2018-02, Income Statement – Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. The amendments in this ASU help organizations address certain stranded income tax effects in AOCI resulting from the Tax Cuts and Jobs Act. The ASU provides financial statement preparers with an option to reclassify stranded tax effects within AOCI to retained earnings in each period in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act (or portion thereof) is recorded. The amendments are effective for all organizations for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted. Management has elected to early adopt this update effective January 1, 2018, which resulted in a reclassification that decreased beginning accumulated other comprehensive income and increased beginning retained earnings by $10.8 million.

FASB ASC 825 – In February 2018, the FASB issued an update (ASU No. 2018-03, Technical Corrections and Improvements to Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities). The amendments in this update clarified the guidance in ASU No. 2016-01 specifically for equity securities without a readily determinable fair value and financial liabilities for which the fair value option is elected. The amendments in this update become effective for annual periods beginning after December 15, 2017 and interim periods within those fiscal years beginning after June 15, 2018. Old National is currently evaluating the impact of adopting the new guidance on the consolidated financial statements.

FASB ASC 718 – In June 2018, the FASB issued ASU No. 2018-07, Compensation – Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting. The amendments in this update expand the scope of Topic 718, Compensation—Stock Compensation (which currently only includes share-based payments to employees) to include share-based payments issued to nonemployees for goods or services. Consequently, the accounting for share-based payments to nonemployees and employees will be substantially aligned. The ASU supersedes Subtopic 505-50, Equity—Equity-Based Payments to Non-Employees. The amendments in this update become effective for annual periods beginning after December 15, 2018, including interim periods within that fiscal year and will not have a material impact on the consolidated financial statements.

FASB ASC 958 – In June 2018, the FASB issued ASU No. 2018-08, Not-for-Profit Entities (Topic 958): Clarifying the Scope and the Accounting Guidance for Contributions Received and Contributions Made. The amendments in this update clarify and improve the scope and accounting guidance around contributions of cash and other assets received and made by not-for-profit organizations and business enterprises. The ASU clarifies and improves current guidance about whether a transfer of assets, or the reduction, settlement, or cancellation of liabilities, is a contribution or an exchange transaction. It provides criteria for determining whether the resource provider is receiving commensurate value in return for the resources transferred which, depending on the outcome, determines whether the organization follows contribution guidance or exchange transaction guidance in the revenue recognition and other applicable standards. It also provides a more robust framework for determining whether a contribution is conditional or unconditional, and for distinguishing a donor-imposed condition from a donor-imposed restriction. This is important because such classification affects the timing of contribution revenue and expense recognition. The new ASU does not apply to transfers of assets from governments to businesses. The amendments in this update become effective for a public business entity for transactions in which the entity serves as a resource recipient to annual periods beginning after June 15, 2018, including interim periods within those annual periods. The amendments in this update become effective for a public business entity for a public business for transactions in which the entity serves as a resource provider to annual periods beginning after December 15, 2018, including interim periods within those annual periods. Early adoption is permitted. Old National is currently evaluating the impact of adopting the new guidance on the consolidated financial statements.

In July 2018, the FASB issued an update (ASU No. 2018-09, Codification Improvements). The amendments in this update affect a wide variety of topics in the Codification and are intended to clarify the Codification or correct the unintended application of guidance that is not expected to have a significant effect on current accounting practice. The transition and effective date guidance is based on the facts and circumstances of each amendment. Old National is currently evaluating the impact of adopting the new guidance on the consolidated financial statements, but it is not expected to have a material impact.

 

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NOTE 4 – ACQUISITION AND DIVESTITURE ACTIVITY

Acquisitions

Anchor Bancorp, Inc.

Effective November 1, 2017, Old National completed the acquisition of St. Paul, Minnesota-based Anchor (MN) through a stock and cash merger. Anchor (MN) was a bank holding company with Anchor Bank (MN) as its wholly-owned subsidiary. Founded in 1967 and with 17 total branches, Anchor Bank (MN) was one of the largest community banks headquartered in the Twin Cities, and also served Mankato, Minnesota. Anchor Bank (MN) has no affiliation with the former AnchorBank (WI) in Madison, Wisconsin, which Old National acquired in 2016. Old National believes that it will be able to achieve cost savings by integrating the two companies and combining accounting, data processing, retail and lending support, and other administrative functions, which will enable Old National to achieve economies of scale in these areas.

Pursuant to the merger agreement, each holder of Anchor (MN) common stock received $2.625 in cash and 1.350 shares of Old National Common Stock per share of Anchor (MN) common stock such holder owned. The total fair value of consideration for Anchor (MN) was $332.8 million, consisting of $31.9 million of cash and the issuance of 16.5 million shares of Old National Common Stock valued at $300.8 million. This acquisition was accounted for under the acquisition method of accounting. Accordingly, Old National recognized amounts for identifiable assets acquired and liabilities assumed at their estimated acquisition date fair values. Through June 30, 2018, transaction and integration costs of $17.0 million associated with this acquisition have been expensed and remaining integration costs will be expensed in future periods as incurred.

During the six months ended June 30, 2018, immaterial adjustments were made to the preliminary valuation of the assets acquired and liabilities assumed. These adjustments affected goodwill, definite lived intangible assets, premises and equipment, other assets, and deposits. As of June 30, 2018, Old National finalized its valuation of all assets acquired and liabilities assumed, resulting in no material change to acquisition accounting adjustments. A summary of the fair values of the acquired assets, liabilities assumed, and resulting goodwill follows (in thousands):

 

Cash and cash equivalents

   $ 34,501  

Investment securities

     302,195  

FHLB/Federal Reserve Bank stock

     6,585  

Loans held for sale

     1,407  

Loans

     1,593,991  

Premises and equipment

     33,433  

Accrued interest receivable

     5,872  

Other real estate owned

     1,058  

Company-owned life insurance

     44,490  

Other assets

     30,036  

Deposits

     (1,777,588

Federal funds purchased and interbank borrowings

     (45,600

Securities sold under agreements to repurchase

     (22,965

Other borrowings

     (49,257

Accrued expenses and other liabilities

     (25,784
  

 

 

 

Net tangible assets acquired

     132,374  

Definite-lived intangible assets acquired

     26,606  

Goodwill

     173,785  
  

 

 

 

Total consideration

   $ 332,765  
  

 

 

 

Goodwill related to this acquisition will not be deductible for tax purposes.

The estimated fair value of the core deposit intangible was $26.6 million and is being amortized over an estimated useful life of 10 years.

 

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Acquired loan data for Anchor (MN) can be found in the table below:

 

(in thousands)

   Fair Value
of Acquired Loans
at Acquisition Date
     Gross Contractual
Cash Flows at
Acquisition Date
     Best Estimate at
Acquisition Date of
Contractual Cash
Flows Not Expected
to be Collected
 
        

Acquired receivables subject to ASC 310-30

   $ 10,555      $ 16,898      $ 4,787  

Acquired receivables not subject to ASC 310-30

   $ 1,583,436      $ 1,879,449      $ 87,767  
        

Divestitures

Based on an ongoing assessment of our service and delivery network, Old National consolidated 29 branches during 2017 and 9 branches during the six months ended June 30, 2018. In addition, there is one branch scheduled to be consolidated in the third quarter of this year.

Old National has entered into a branch purchase and assumption agreement for the sale of ten Old National branches in Wisconsin to Marine Credit Union of La Crosse, Wisconsin. Assets associated with this divestiture are included in assets held for sale on the balance sheet. The branch sale includes the assumption of approximately $261 million in deposits and no loans. Subject to regulatory approval and other terms and conditions, the sale is expected to close in the fourth quarter of 2018.

Pending Acquisition

On June 20, 2018, Old National entered into an agreement to acquire Minnesota-based Klein through a 100% stock merger. Klein is a bank holding company with KleinBank as its wholly-owned subsidiary. Founded in 1907 and headquartered in Chaska, Minnesota with 18 full-service branches, KleinBank is the largest family-owned community bank serving the Twin Cities and its western communities. At March 31, 2018, Klein had total assets of $2.0 billion and $1.7 billion of deposit liabilities. Pursuant to the merger agreement, each holder of Klein common stock will receive 7.92 shares of Old National common stock per share of Klein common stock such holder owns. Based on Old National’s June 20, 2018 closing price of $19.05 per share, this represents a total transaction value of approximately $433.8 million. The transaction value is likely to change until closing due to fluctuations in the price of Old National common stock and is also subject to adjustment under certain circumstances as provided in the merger agreement. The transaction remains subject to regulatory approval and the vote of Klein shareholders. The transaction is anticipated to close in the fourth quarter of 2018.

NOTE 5NET INCOME PER SHARE

Basic and diluted net income per share are calculated using the two-class method. Net income is divided by the weighted-average number of common shares outstanding during the period. Adjustments to the weighted average number of common shares outstanding are made only when such adjustments will dilute net income per common share. Net income is then divided by the weighted-average number of common shares and common share equivalents during the period.

 

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The following table reconciles basic and diluted net income per share for the three and six months ended June 30, 2018 and 2017:

 

(dollars and shares in thousands,

except per share data)                

   Three Months Ended
June 30,
     Six Months Ended
June 30,
 
   2018      2017      2018      2017  

Basic Earnings Per Share

           

Net income

   $ 44,001      $ 38,854      $ 91,984      $ 74,846  

Weighted average common shares outstanding

     151,878        135,085        151,800        134,999  

Basic Net Income Per Share

   $ 0.29      $ 0.28      $ 0.61      $ 0.55  
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted Earnings Per Share

           

Net income

   $ 44,001      $ 38,854      $ 91,984      $ 74,846  

Weighted average common shares outstanding

     151,878        135,085        151,800        134,999  

Effect of dilutive securities:

           

Restricted stock

     623        523        610        543  

Stock options (1)

     67        89        73        99  
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average shares outstanding

     152,568        135,697        152,483        135,641  

Diluted Net Income Per Share

   $ 0.29      $ 0.28      $ 0.60      $ 0.55  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Options to purchase 14 thousand shares and 55 thousand shares outstanding at June 30, 2018 and 2017, respectively, were not included in the computation of net income per diluted share for the three and six months ended June 30, 2018 and 2017 because the exercise price of these options was greater than the average market price of the common shares and, therefore, the effect would be antidilutive.

 

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NOTE 6 – INVESTMENT SECURITIES

The following table summarizes the amortized cost and fair value of the available-for-sale and held-to-maturity investment securities portfolio at June 30, 2018 and December 31, 2017 and the corresponding amounts of unrealized gains and losses therein:

 

(dollars in thousands)

   Amortized
Cost
     Unrealized
Gains
     Unrealized
Losses
     Fair
Value
 

June 30, 2018

           

Available-for-Sale

           

U.S. Treasury

   $ 5,312      $ —        $ (55    $ 5,257  

U.S. government-sponsored entities and agencies

     583,644        —          (15,413      568,231  

Mortgage-backed securities - Agency

     1,503,636        501        (55,611      1,448,526  

States and political subdivisions

     793,141        8,406        (4,014      797,533  

Pooled trust preferred securities

     13,887        —          (5,682      8,205  

Other securities

     359,820        345        (6,252      353,913  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total available-for-sale securities

   $ 3,259,440      $ 9,252      $ (87,027    $ 3,181,665  
  

 

 

    

 

 

    

 

 

    

 

 

 

Held-to-Maturity

           

U.S. government-sponsored entities and agencies

   $ 73,570      $ —        $ (2,286    $ 71,284  

Mortgage-backed securities - Agency

     139,594        58        (3,868      135,784  

States and political subdivisions

     312,554        7,209        (2,234      317,529  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total held-to-maturity securities

   $ 525,718      $ 7,267      $ (8,388    $ 524,597  
  

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2017

           

Available-for-Sale

           

U.S. Treasury

   $ 5,473      $ 83      $ (5    $ 5,551  

U.S. government-sponsored entities and agencies

     675,643        3        (11,360      664,286  

Mortgage-backed securities - Agency

     1,704,014        1,600        (37,932      1,667,682  

States and political subdivisions

     529,835        5,085        (4,727      530,193  

Pooled trust preferred securities

     16,605        —          (8,157      8,448  

Other securities

     321,016        1,172        (2,141      320,047  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total available-for-sale securities

   $ 3,252,586      $ 7,943      $ (64,322    $ 3,196,207  
  

 

 

    

 

 

    

 

 

    

 

 

 

Held-to-Maturity

           

Mortgage-backed securities - Agency

   $ 6,903      $ 153      $ —        $ 7,056  

States and political subdivisions

     677,160        43,495        (8      720,647  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total held-to-maturity securities

   $ 684,063      $ 43,648      $ (8    $ 727,703  
  

 

 

    

 

 

    

 

 

    

 

 

 

As previously disclosed in Note 3, upon the early adoption of ASU No. 2017-12 on January 1, 2018, Old National reclassified $447.0 million in state and political subdivision securities from the held-to-maturity portfolio to the available-for-sale portfolio. Separately, on January 1, 2018, U.S. government-sponsored entities and agencies, agency mortgage-backed securities, and state and political subdivision securities with a fair value of $324.0 million were transferred from the available-for-sale portfolio to the held-to-maturity portfolio. The $10.8 million unrealized holding loss, net of tax, at the date of transfer shall continue to be reported as a separate component of shareholders’ equity and will be amortized over the remaining life of the securities as an adjustment to yield. The corresponding discount on these securities will offset this adjustment to yield as it is amortized.

 

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Proceeds from sales or calls of available-for-sale investment securities, the resulting realized gains and realized losses, and other securities gains or losses were as follows for the three and six months ended June 30, 2018 and 2017:

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 

(dollars in thousands)

   2018      2017      2018      2017  

Proceeds from sales of available-for-sale securities

   $ 47,064      $ 152,689      $ 131,321      $ 186,277  

Proceeds from calls of available-for-sale securities

     11,211        60,600        28,647        71,120  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 58,275      $ 213,289      $ 159,968      $ 257,397  
  

 

 

    

 

 

    

 

 

    

 

 

 

Realized gains on sales of available-for-sale securities

   $ 1,251      $ 2,954      $ 3,259      $ 4,283  

Realized gains on calls of available-for-sale securities

     283        —          284        —    

Realized losses on sales of available-for-sale securities

     (48      (13      (1,305      (43

Realized losses on calls of available-for-sale securities

     (4      (7      (53      (8

Other securities gains (losses) (1)

     12        141        97        343  
  

 

 

    

 

 

    

 

 

    

 

 

 

Net securities gains (losses)

   $ 1,494      $ 3,075      $ 2,282      $ 4,575  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Other securities gains (losses) includes net realized and unrealized gains or losses associated with trading securities and mutual funds.

Trading securities, which consist of mutual funds held in trusts associated with deferred compensation plans for former directors and executives, are recorded at fair value and totaled $5.6 million at June 30, 2018 and December 31, 2017.

All the mortgage-backed securities in the investment portfolio are residential mortgage-backed securities. The amortized cost and fair value of the investment securities portfolio are shown by expected maturity. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Weighted average yield is based on amortized cost.

 

     At June 30, 2018  
(dollars in thousands)           Weighted  
     Amortized      Fair      Average  

Maturity

   Cost      Value      Yield  

Available-for-Sale

        

Within one year

   $ 60,410      $ 60,376        2.22

One to five years

     511,930        505,586        2.29  

Five to ten years

     383,847        380,192        3.03  

Beyond ten years

     2,303,253        2,235,511        2.64  
  

 

 

    

 

 

    

 

 

 

Total

   $ 3,259,440      $ 3,181,665        2.62
  

 

 

    

 

 

    

 

 

 

Held-to-Maturity

        

Within one year

   $ 27,128      $ 27,341        3.75

One to five years

     33,736        34,432        4.06  

Five to ten years

     75,966        77,962        4.38  

Beyond ten years

     388,888        384,862        3.59  
  

 

 

    

 

 

    

 

 

 

Total

   $ 525,718      $ 524,597        3.74
  

 

 

    

 

 

    

 

 

 

 

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The following table summarizes the available-for-sale investment securities with unrealized losses at June 30, 2018 and December 31, 2017 by aggregated major security type and length of time in a continuous unrealized loss position:

 

     Less than 12 months     12 months or longer     Total  

(dollars in thousands)

   Fair
Value
     Unrealized
Losses
    Fair
Value
     Unrealized
Losses
    Fair
Value
     Unrealized
Losses
 
               

June 30, 2018

               

Available-for-Sale

               

U.S. Treasury

   $ 5,257      $ (55   $ —        $ —       $ 5,257      $ (55

U.S. government-sponsored entities and agencies

     178,133        (3,476     390,097        (11,937     568,230        (15,413

Mortgage-backed securities - Agency

     728,486        (20,942     657,333        (34,669     1,385,819        (55,611

States and political subdivisions

     278,063        (3,761     8,239        (253     286,302        (4,014

Pooled trust preferred securities

     —          —         8,205        (5,682     8,205        (5,682

Other securities

     186,479        (3,599     110,953        (2,653     297,432        (6,252
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total available-for-sale

   $ 1,376,418      $ (31,833   $ 1,174,827      $ (55,194   $ 2,551,245      $ (87,027
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

December 31, 2017

               

Available-for-Sale

               

U.S. Treasury

   $ 1,480      $ (5   $ —        $ —       $ 1,480      $ (5

U.S. government-sponsored entities and agencies

     201,773        (1,333     408,493        (10,027     610,266        (11,360

Mortgage-backed securities - Agency

     789,804        (8,692     774,825        (29,240     1,564,629        (37,932

States and political subdivisions

     196,024        (1,899     90,637        (2,828     286,661        (4,727

Pooled trust preferred securities

     —          —         8,448        (8,157     8,448        (8,157

Other securities

     61,260        (429     125,517        (1,712     186,777        (2,141
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total available-for-sale

   $ 1,250,341      $ (12,358   $ 1,407,920      $ (51,964   $ 2,658,261      $ (64,322
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

The following table summarizes the held-to-maturity investment securities with unrecognized losses at June 30, 2018 and December 31, 2017 by aggregated major security type and length of time in a continuous unrecognized loss position:

 

     Less than 12 months     12 months or longer     Total  

(dollars in thousands)

   Fair
Value
     Unrecognized
Losses
    Fair
Value
     Unrecognized
Losses
    Fair
Value
     Unrecognized
Losses
 
               

June 30, 2018

               

Held-to-Maturity

               

U.S. government-sponsored entities and agencies

   $ —        $ —       $ 71,284      $ (5,716   $ 71,284      $ (5,716

Mortgage-backed securities - Agency

     35,489        (992     99,239        (9,029     134,728        (10,021

States and political subdivisions

     36,231        (1,466     70,130        (3,692     106,361        (5,158
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total held-to-maturity

   $ 71,720      $ (2,458   $ 240,653      $ (18,437   $ 312,373      $ (20,895
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

December 31, 2017

               

Held-to-Maturity

               

States and political subdivisions

   $ 2,309      $ (8   $ —        $ —       $ 2,309      $ (8
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total held-to-maturity

   $ 2,309      $ (8   $ —        $ —       $ 2,309      $ (8
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

The unrecognized losses on held-to-maturity investment securities presented in the table above include unrecognized losses on securities that were transferred from available-for-sale to held-to-maturity totaling $12.5 million at June 30, 2018. There were no unrecognized losses on securities that were transferred from available-for-sale to held-to-maturity at December 31, 2017.

 

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Management evaluates securities for OTTI at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Investment securities classified as available-for-sale or held-to-maturity are generally evaluated for OTTI under FASB ASC 320, Investments – Debt and Equity Securities. In determining OTTI under FASB ASC 320, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. Otherwise, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors shall be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings shall become the new amortized cost basis of the investment.

There was no OTTI recorded during the six months ended June 30, 2018 or 2017.

At June 30, 2018, Old National’s securities portfolio consisted of 1,628 securities, 844 of which were in an unrealized loss position. The unrealized losses attributable to our U.S. Treasury, U.S. government-sponsored entities and agencies, agency mortgage-backed securities, states and political subdivisions, and other securities are the result of fluctuations in interest rates. Our pooled trust preferred securities are discussed below. At June 30, 2018, we had no intent to sell any securities that were in an unrealized loss position nor is it expected that we would be required to sell any securities.

Pooled Trust Preferred Securities

At June 30, 2018, our securities portfolio contained two pooled trust preferred securities with a fair value of $8.2 million and unrealized losses of $5.7 million. These securities are not subject to FASB ASC 325-10 and are evaluated using collateral-specific assumptions to estimate the expected future interest and principal cash flows. For the six months ended June 30, 2018 and 2017, our analysis indicated no OTTI on these securities.

During the first quarter of 2018, Old National sold a pooled trust security that fell within the scope of FASB ASC 325-10 (EITF 99-20). Proceeds from the sale were $1.8 million, which resulted in a loss of $0.9 million. Although Old National typically does not sell securities in an unrealized loss position, this security was sold because the final liquidation value was significantly higher than our assessment of value for this position.

 

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The table below summarizes the relevant characteristics of our pooled trust preferred securities as well as our single issuer trust preferred securities that are included in the “other securities” category in this footnote. Each of the pooled trust preferred securities support a more senior tranche of security holders. Both pooled trust preferred securities have experienced credit defaults. However, these securities have excess subordination and are not other-than-temporarily impaired as a result of their class hierarchy, which provides more loss protection.

 

Trust preferred securities

June 30, 2018

(dollars in thousands)      

  Class     Lowest
Credit
Rating (1)
    Amortized
Cost
    Fair
Value
    Unrealized
Gain/
(Loss)
    Realized
Losses
2018
    # of Issuers
Currently
Performing/
Remaining
    Actual
Deferrals
and Defaults
as a % of
Original
Collateral
    Expected
Defaults as
a % of
Remaining
Performing
Collateral
    Excess
Subordination
as a % of
Current
Performing
Collateral
 

Pooled trust preferred securities:

                   

Pretsl XXVII LTD

    B       B     $ 4,382     $ 2,602     $ (1,780   $ —         35/44       16.7     4.2     46.1

Trapeza Ser 13A

    A2A       BBB       9,505       5,603       (3,902     —         48/53       4.5     4.7     45.5
     

 

 

   

 

 

   

 

 

   

 

 

         
        13,887       8,205       (5,682     —            

Single Issuer trust preferred securities:

                   

JP Morgan Chase Cap XIII

      BBB-       4,783       4,550       (233     —            
     

 

 

   

 

 

   

 

 

   

 

 

         

Total

      $ 18,670     $ 12,755     $ (5,915   $ —            
     

 

 

   

 

 

   

 

 

   

 

 

         

 

(1) Lowest rating for the security provided by any nationally recognized credit rating agency.

NOTE 7 – LOANS HELD FOR SALE

Mortgage loans held for immediate sale in the secondary market were $26.2 million at June 30, 2018, compared to $17.9 million at December 31, 2017. Residential loans that Old National has originated with the intent to sell are recorded at fair value in accordance with FASB ASC 825-10, Financial Instruments. Conventional mortgage production is sold on a servicing retained basis. Certain loans, such as government guaranteed mortgage loans are sold on servicing released basis.

NOTE 8 – LOANS AND ALLOWANCE FOR LOAN LOSSES

Old National’s loans consist primarily of loans made to consumers and commercial clients in various industries including manufacturing, agribusiness, transportation, mining, wholesaling, and retailing. Most of Old National’s lending activity occurs within our principal geographic markets of Indiana, Kentucky, Michigan, Wisconsin, and Minnesota. Old National manages concentrations of credit exposure by industry, product, geography, customer relationship, and loan size. While loans to lessors of both residential and non-residential real estate exceed 10% of total loans, no individual sub-segment category within those broader categories reaches the 10% threshold.

 

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The composition of loans by lending classification was as follows:

 

(dollars in thousands)

   June 30,
2018
     December 31,
2017
 

Commercial (1)

   $ 2,962,895      $ 2,717,269  

Commercial real estate:

     

Construction

     490,990        374,306  

Other

     3,960,782        3,980,246  

Residential real estate

     2,153,973        2,167,053  

Consumer credit:

     

Home equity

     488,038        507,507  

Auto

     1,099,745        1,148,672  

Other

     139,206        223,068  
  

 

 

    

 

 

 

Total loans

     11,295,629        11,118,121  

Allowance for loan losses

     (53,660      (50,381
  

 

 

    

 

 

 

Net loans

   $ 11,241,969      $ 11,067,740  
  

 

 

    

 

 

 

 

(1) Includes direct finance leases of $24.8 million at June 30, 2018 and $29.5 million at December 31, 2017.

The risk characteristics of each loan portfolio segment are as follows:

Commercial

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

Commercial Real Estate

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

Included with commercial real estate are construction loans, which are underwritten utilizing independent appraisal reviews, sensitivity analysis of absorption and lease rates, financial analysis of the developers and property owners, and feasibility studies, if available. Construction loans are generally based on estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders (including Old National), sales of developed property, or an interim loan commitment from Old National until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions, and the availability of long-term financing.

The acquisition of Anchor (MN) on November 1, 2017 added $864.4 million of commercial real estate loans to our portfolio. At 208%, Old National Bank’s commercial real estate loans as a percentage of its risk-based capital remained well below the regulatory guideline limit of 300% at June 30, 2018.

 

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Table of Contents

Residential

With respect to residential loans that are secured by 1-4 family residences and are generally owner occupied, Old National typically establishes a maximum loan-to-value ratio and generally requires private mortgage insurance if that ratio is exceeded. Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas such as unemployment levels. Repayment can also be impacted by changes in residential property values. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

Consumer

Home equity loans are typically secured by a subordinate interest in 1-4 family residences, and consumer loans are secured by consumer assets such as automobiles or recreational vehicles. Some consumer loans are unsecured such as small installment loans and certain lines of credit. Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas such as unemployment levels. Repayment can also be impacted by changes in residential property or other collateral values. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers. Old National assumed student loans in the acquisition of Anchor (WI) in May 2016. Student loans are guaranteed by the government from 97% to 100% and totaled $68.2 million at December 31, 2017. Old National sold the remaining student loan portfolio totaling $64.9 million during the second quarter of 2018, resulting in a $2.2 million gain that is included in other income on the income statement.

Allowance for Loan Losses

The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses incurred in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, pools of homogeneous loans, assessments of the impact of current and anticipated economic conditions on the portfolio, and historical loss experience. The allowance is increased through a provision charged to operating expense. Loans deemed to be uncollectible are charged to the allowance. Recoveries of loans previously charged-off are added to the allowance.

We utilize a PD and LGD model as a tool to determine the adequacy of the allowance for loan losses for performing commercial and commercial real estate loans. The PD is forecast using a transition matrix to determine the likelihood of a customer’s AQR migrating from its current AQR to any other status within the time horizon. Transition rates are measured using Old National’s own historical experience. The model assumes that recent historical transition rates will continue into the future. The LGD is defined as credit loss incurred when an obligor of the bank defaults. The sum of all net charge-offs for a particular portfolio segment are divided by all loans that have defaulted over a given period of time. The expected loss derived from the model considers the PD, LGD, and exposure at default. Additionally, qualitative factors, such as changes in lending policies or procedures, and economic business conditions are also considered.

We use historic loss ratios adjusted for economic conditions to determine the appropriate level of allowance for residential real estate and consumer loans.

No allowance was brought forward on any of the acquired loans as any credit deterioration evident in the loans was included in the determination of the fair value of the loans at the acquisition date. An allowance for loan losses will be established for any subsequent credit deterioration or adverse changes in expected cash flows.

 

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Table of Contents

Old National’s activity in the allowance for loan losses for the three and six months ended June 30, 2018 and 2017 was as follows:

 

(dollars in thousands)

   Commercial     Commercial
Real Estate
    Residential     Consumer     Total  
          

Three Months Ended June 30, 2018

          

Balance at beginning of period

   $ 19,591     $ 20,796     $ 1,763     $ 8,231     $ 50,381  

Charge-offs

     (472     (430     (295     (1,857     (3,054

Recoveries

     249       583       1,697       1,358       3,887  

Provision

     2,019       1,549       (1,298     176       2,446  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ 21,387     $ 22,498     $ 1,867     $ 7,908     $ 53,660  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Three Months Ended June 30, 2017

          

Balance at beginning of period

   $ 22,108     $ 17,953     $ 1,736     $ 8,037     $ 49,834  

Charge-offs

     (411     (1,068     (313     (1,588     (3,380

Recoveries

     789       1,522       28       838       3,177  

Provision

     (2,121     2,247       360       869       1,355  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ 20,365     $ 20,654     $ 1,811     $ 8,156     $ 50,986  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Six Months Ended June 30, 2018

          

Balance at beginning of period

   $ 19,246     $ 21,436     $ 1,763     $ 7,936     $ 50,381  

Charge-offs

     (717     (433     (657     (3,932     (5,739

Recoveries

     760       1,067       1,845       2,520       6,192  

Provision

     2,098       428       (1,084     1,384       2,826  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ 21,387     $ 22,498     $ 1,867     $ 7,908     $ 53,660  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Six Months Ended June 30, 2017

          

Balance at beginning of period

   $ 21,481     $ 18,173     $ 1,643     $ 8,511     $ 49,808  

Charge-offs

     (881     (1,636     (727     (3,375     (6,619

Recoveries

     1,392       2,747       107       1,849       6,095  

Provision

     (1,627     1,370       788       1,171       1,702  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ 20,365     $ 20,654     $ 1,811     $ 8,156     $ 50,986  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents

The following table provides Old National’s recorded investment in loans by portfolio segment at June 30, 2018 and December 31, 2017 and other information regarding the allowance:

 

(dollars in thousands)

   Commercial      Commercial
Real Estate
     Residential      Consumer      Total  

June 30, 2018

              

Allowance for loan losses:

              

Individually evaluated for impairment

   $ 5,871      $ 8,162      $ —        $ —        $ 14,033  

Collectively evaluated for impairment

     15,409        14,267        1,865        7,760        39,301  

Loans acquired with deteriorated credit quality

     107        69        2        148        326  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total allowance for loan losses

   $ 21,387      $ 22,498      $ 1,867      $ 7,908      $ 53,660  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Loans and leases outstanding:

              

Individually evaluated for impairment

   $ 34,055      $ 75,320      $ —        $ —        $ 109,375  

Collectively evaluated for impairment

     2,924,481        4,355,891        2,143,658        1,722,747        11,146,777  

Loans acquired with deteriorated credit quality

     4,359        20,561        10,315        4,242        39,477  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans and leases outstanding

   $ 2,962,895      $ 4,451,772      $ 2,153,973      $ 1,726,989      $ 11,295,629  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2017

              

Allowance for loan losses:

              

Individually evaluated for impairment

   $ 3,424      $ 6,654      $ —        $ —        $ 10,078  

Collectively evaluated for impairment

     15,790        14,782        1,763        7,802        40,137  

Loans acquired with deteriorated credit quality

     32                      134        166  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total allowance for loan losses

   $ 19,246      $ 21,436      $ 1,763      $ 7,936      $ 50,381  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Loans and leases outstanding:

              

Individually evaluated for impairment

   $ 26,270      $ 66,061      $ —        $ —        $ 92,331  

Collectively evaluated for impairment

     2,685,847        4,266,665        2,155,750        1,874,002        10,982,264  

Loans acquired with deteriorated credit quality

     5,152        21,826        11,303        5,245        43,526  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans and leases outstanding

   $ 2,717,269      $ 4,354,552      $ 2,167,053      $ 1,879,247      $ 11,118,121  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Credit Quality

Old National’s management monitors the credit quality of its loans in an on-going manner. Internally, management assigns an AQR to each non-homogeneous commercial and commercial real estate loan in the portfolio, with the exception of certain FICO-scored small business loans. The primary determinants of the AQR are based upon the reliability of the primary source of repayment and the past, present, and projected financial condition of the borrower. The AQR will also consider current industry conditions. Major factors used in determining the AQR can vary based on the nature of the loan, but commonly include factors such as debt service coverage, internal cash flow, liquidity, leverage, operating performance, debt burden, FICO scores, occupancy, interest rate sensitivity, and expense burden. Old National uses the following definitions for risk ratings:

Criticized. Special mention loans that have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.

Classified – Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Classified – Nonaccrual. Loans classified as nonaccrual have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection in full, on the basis of currently existing facts, conditions, and values, in doubt.

 

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Table of Contents

Classified – Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as nonaccrual, with the added characteristic that the weaknesses make collection in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Pass rated loans are those loans that are other than criticized, classified – substandard, classified – nonaccrual, or classified – doubtful.

The risk category of commercial and commercial real estate loans by class of loans at June 30, 2018 and December 31, 2017 was as follows:

 

(dollars in thousands)    Commercial      Commercial
Real Estate -
Construction
     Commercial
Real Estate -
Other
 

Corporate Credit Exposure

Credit Risk Profile by

Internally Assigned Grade

   June 30,
2018
     December 31,
2017
     June 30,
2018
     December 31,
2017
     June 30,
2018
     December 31,
2017
 
                 

Grade:

                 

Pass

   $ 2,815,085      $ 2,577,824      $ 467,663      $ 357,438      $ 3,765,884      $ 3,762,896  

Criticized

     70,168        74,876        14,882        14,758        69,841        98,451  

Classified - substandard

     41,382        37,367        —          —          62,595        58,584  

Classified - nonaccrual

     29,390        24,798        8,445        2,110        28,376        30,108  

Classified - doubtful

     6,870        2,404        —          —          34,086        30,207  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 2,962,895      $ 2,717,269      $ 490,990      $ 374,306      $ 3,960,782      $ 3,980,246  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Old National considers the performance of the loan portfolio and its impact on the allowance for loan losses. For residential and consumer loan classes, Old National also evaluates credit quality based on the aging status of the loan and by payment activity. The following table presents the recorded investment in residential and consumer loans based on payment activity at June 30, 2018 and December 31, 2017:

 

            Consumer  

(dollars in thousands)

   Residential      Home
Equity
     Auto      Other  

June 30, 2018

           

Performing

   $ 2,130,775      $ 483,350      $ 1,097,256      $ 137,666  

Nonperforming

     23,198        4,688        2,489        1,540  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 2,153,973      $ 488,038      $ 1,099,745      $ 139,206  
  

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2017

           

Performing

   $ 2,144,882      $ 502,322      $ 1,145,977      $ 217,819  

Nonperforming

     22,171        5,185        2,695        5,249  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 2,167,053      $ 507,507      $ 1,148,672      $ 223,068  
  

 

 

    

 

 

    

 

 

    

 

 

 

Impaired Loans

Large commercial credits are subject to individual evaluation for impairment. Retail credits and other small balance credits that are part of a homogeneous group are not tested for individual impairment unless they are modified as a TDR. A loan is considered impaired when it is probable that contractual interest and principal payments will not be collected either for the amounts or by the dates as scheduled in the loan agreement. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported net, at the present value of estimated cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Old National’s policy, for all but PCI loans, is to recognize interest income on impaired loans unless the loan is placed on nonaccrual status.

 

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Table of Contents

The following table shows Old National’s impaired loans at June 30, 2018 and December 31, 2017, respectively. Only purchased loans that have experienced subsequent impairment since the date acquired (excluding loans acquired with deteriorated credit quality) are included in the table below.

 

(dollars in thousands)

   Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
 

June 30, 2018

        

With no related allowance recorded:

        

Commercial

   $ 19,587      $ 20,337      $ —    

Commercial Real Estate - Other

     44,862        48,214        —    

Residential

     2,271        2,292        —    

Consumer

     1,483        1,601        —    

With an allowance recorded:

        

Commercial

     14,468        14,520        5,871  

Commercial Real Estate - Construction

     8,445        9,249        2,680  

Commercial Real Estate - Other

     22,013        22,065        5,482  

Residential

     935        935        47  

Consumer

     1,917        1,917        96  
  

 

 

    

 

 

    

 

 

 

Total

   $ 115,981      $ 121,130      $ 14,176  
  

 

 

    

 

 

    

 

 

 

December 31, 2017

        

With no related allowance recorded:

        

Commercial

   $ 20,557      $ 21,483      $ —    

Commercial Real Estate - Other

     38,678        44,564        —    

Residential

     2,443        2,464        —    

Consumer

     1,685        2,105        —    

With an allowance recorded:

        

Commercial

     5,713        5,713        3,424  

Commercial Real Estate - Construction

     905        1,371        401  

Commercial Real Estate - Other

     26,478        26,902        6,253  

Residential

     870        870        44  

Consumer

     2,211        2,228        110  
  

 

 

    

 

 

    

 

 

 

Total

   $ 99,540      $ 107,700      $ 10,232  
  

 

 

    

 

 

    

 

 

 

 

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The average balance of impaired loans during the three and six months ended June 30, 2018 and 2017 are included in the table below.

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 

(dollars in thousands)

   2018      2017      2018      2017  

Average Recorded Investment

           

With no related allowance recorded:

           

Commercial

   $ 20,228      $ 25,817      $ 20,073      $ 26,038  

Commercial Real Estate - Other

     43,893        34,682        41,771        32,598  

Residential

     2,189        2,376        2,274        2,121  

Consumer

     1,741        1,717        1,722        1,420  

With an allowance recorded:

           

Commercial

     11,846        8,448        10,091        7,996  

Commercial Real Estate - Construction

     4,675        —          4,675        —    

Commercial Real Estate - Other

     21,439        22,916        24,246        28,911  

Residential

     942        1,147        918        1,125  

Consumer

     1,970        2,069        2,050        2,021  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 108,923      $ 99,172      $ 107,820      $ 102,230  
  

 

 

    

 

 

    

 

 

    

 

 

 

Old National does not record interest on nonaccrual loans until principal is recovered. Interest income recognized on impaired loans during the three and six months ended June 30, 2018 and 2017 was immaterial.

For all loan classes, a loan is generally placed on nonaccrual status when principal or interest becomes 90 days past due unless it is well secured and in the process of collection, or earlier when concern exists as to the ultimate collectibility of principal or interest. Interest accrued during the current year on such loans is reversed against earnings. Interest accrued in the prior year, if any, is charged to the allowance for loan losses. Cash interest received on these loans is applied to the principal balance until the principal is recovered or until the loan returns to accrual status. Loans may be returned to accrual status when all the principal and interest amounts contractually due are brought current, remain current for a prescribed period, and future payments are reasonably assured.

Loans accounted for under FASB ASC Topic 310-30 accrue interest, even though they may be contractually past due, as any nonpayment of contractual principal or interest is considered in the periodic re-estimation of expected cash flows and is included in the resulting recognition of current period loan loss provision or prospective yield adjustments.

 

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Old National’s past due financing receivables at June 30, 2018 and December 31, 2017 were as follows:

 

(dollars in thousands)

   30-59 Days
Past Due
     60-89 Days
Past Due
     Past Due
90 Days or
More and
Accruing
     Nonaccrual (1)      Total
Past Due
     Current  

June 30, 2018

                 

Commercial

   $ 1,118      $ 3      $ 85      $ 36,260      $ 37,466      $ 2,925,429  

Commercial Real Estate:

                 

Construction

     —          —          —          8,445        8,445        482,545  

Other

     378        953        —          62,462        63,793        3,896,989  

Residential

     21,871        4,563        389        23,198        50,021        2,103,952  

Consumer:

                 

Home equity

     780        1,043        627        4,688        7,138        480,900  

Auto

     5,584        1,259        319        2,489        9,651        1,090,094  

Other

     330        379        155        1,540        2,404        136,802  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans

   $ 30,061      $ 8,200      $ 1,575      $ 139,082      $ 178,918      $ 11,116,711  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2017

                 

Commercial

   $ 986      $ 360      $ 144      $ 27,202      $ 28,692      $ 2,688,577  

Commercial Real Estate:

                 

Construction

     —          —          —          2,110        2,110        372,196  

Other

     2,247        89        —          60,315        62,651        3,917,595  

Residential

     18,948        3,416        —          22,171        44,535        2,122,518  

Consumer:

                 

Home equity

     1,467        230        68        5,185        6,950        500,557  

Auto

     6,487        1,402        532        2,695        11,116        1,137,556  

Other

     3,967        1,514        150        5,249        10,880        212,188  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans

   $ 34,102      $ 7,011      $ 894      $ 124,927      $ 166,934      $ 10,951,187  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Includes purchased credit impaired loans of $11.3 million at June 30, 2018 and $12.6 million at December 31, 2017 that are categorized as nonaccrual for credit analysis purposes because the collection of principal or interest is doubtful. However, these loans are accounted for under FASB ASC 310-30 and accordingly treated as performing assets.

Loan Participations

Old National has loan participations, which qualify as participating interests, with other financial institutions. At June 30, 2018, these loans totaled $820.2 million, of which $412.8 million had been sold to other financial institutions and $407.4 million was retained by Old National. The loan participations convey proportionate ownership rights with equal priority to each participating interest holder; involve no recourse (other than ordinary representations and warranties) to, or subordination by, any participating interest holder; all cash flows are divided among the participating interest holders in proportion to each holder’s share of ownership; and no holder has the right to pledge the entire financial asset unless all participating interest holders agree.

Troubled Debt Restructurings

Old National may choose to restructure the contractual terms of certain loans. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit Old National by increasing the ultimate probability of collection.

Any loans that are modified are reviewed by Old National to identify if a TDR has occurred, which is when for economic or legal reasons related to a borrower’s financial difficulties, Old National Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status. The modification of the terms of such loans include one or a combination of the following: a reduction of the stated interest rate of the loan, an extension of the maturity date at a stated rate of interest lower than the current market rate of new debt with similar risk, or a permanent reduction of the recorded investment of the loan.

 

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Loans modified in a TDR are typically placed on nonaccrual status until we determine the future collection of principal and interest is reasonably assured, which generally requires that the borrower demonstrate a period of performance according to the restructured terms for six months.

If we are unable to resolve a nonperforming loan issue, the credit will be charged off when it is apparent there will be a loss. For large commercial type loans, each relationship is individually analyzed for evidence of apparent loss based on quantitative benchmarks or subjectively based upon certain events or particular circumstances. Generally, Old National charges off small commercial loans scored through our small business credit center with contractual balances under $250,000 that are 90 days or more delinquent and do not have adequate collateral support. For residential and consumer loans, a charge off is recorded at the time foreclosure is initiated or when the loan becomes 120 to 180 days past due, whichever is earlier.

For commercial TDRs, an allocated reserve is established within the allowance for loan losses for the difference between the carrying value of the loan and its computed value. To determine the value of the loan, one of the following methods is selected: (1) the present value of expected cash flows discounted at the loan’s original effective interest rate, (2) the loan’s observable market price, or (3) the fair value of the collateral value, if the loan is collateral dependent. The allocated reserve is established as the difference between the carrying value of the loan and the collectable value. If there are significant changes in the amount or timing of the loan’s expected future cash flows, impairment is recalculated and the valuation allowance is adjusted accordingly.

When a residential or consumer loan is identified as a TDR, the loan is typically written down to its collateral value less selling costs.

The following table presents activity in TDRs for the six months ended June 30, 2018 and 2017:

 

(dollars in thousands)

   Commercial     Commercial
Real Estate
    Residential     Consumer     Total  

Six Months Ended June 30, 2018

          

Balance at beginning of period

   $ 12,088     $ 34,705     $ 3,315     $ 3,895     $ 54,003  

(Charge-offs)/recoveries

     (151     (22     23       (22     (172

Payments

     (3,978     (969     (69     (907     (5,923

Additions

     1,084       1,213       502       432       3,231  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ 9,043     $ 34,927     $ 3,771     $ 3,398     $ 51,139  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Six Months Ended June 30, 2017

          

Balance at beginning of period

   $ 16,802     $ 18,327     $ 2,985     $ 2,602     $ 40,716  

(Charge-offs)/recoveries

     (64     360       —         (97     199  

Payments

     (6,116     (3,057     (283     (785     (10,241

Additions

     9,442       17,429       938       1,924       29,733  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ 20,064     $ 33,059     $ 3,640     $ 3,644     $ 60,407  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

TDRs included with nonaccrual loans totaled $34.0 million at June 30, 2018 and December 31, 2017. Old National has allocated specific reserves to customers whose loan terms have been modified in TDRs totaling $4.8 million at June 30, 2018 and $5.7 million at December 31, 2017. At June 30, 2018, Old National had committed to lend an additional $4.0 million to customers with outstanding loans that are classified as TDRs.

 

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The pre-modification and post-modification outstanding recorded investments of loans modified as TDRs during the six months ended June 30, 2018 and 2017 are the same except for when the loan modifications involve the forgiveness of principal. The following table presents loans by class modified as TDRs that occurred during the six months ended June 30, 2018 and 2017:

 

(dollars in thousands)

   Number
of Loans
     Pre-modification
Outstanding Recorded
Investment
     Post-modification
Outstanding Recorded
Investment
 

Six Months Ended June 30, 2018

        

TDR:

        

Commercial

     2      $ 1,084      $ 1,084  

Commercial Real Estate - Other

     2        1,213        1,213  

Residential

     1        502        502  

Consumer

     1        432        432  
  

 

 

    

 

 

    

 

 

 

Total

     6      $ 3,231      $ 3,231  
  

 

 

    

 

 

    

 

 

 

Six Months Ended June 30, 2017

        

TDR:

        

Commercial

     6      $ 9,442      $ 9,442  

Commercial Real Estate - Other

     10        17,429        17,429  

Residential

     6        938        938  

Consumer

     5        1,924        1,924  
  

 

 

    

 

 

    

 

 

 

Total

     27      $ 29,733      $ 29,733  
  

 

 

    

 

 

    

 

 

 

The TDRs that occurred during the six months ended June 30, 2018 did not have a material impact on the allowance for loan losses and resulted in no charge-offs during the six months ended June 30, 2018. The TDRs that occurred during the six months ended June 30, 2017 increased the allowance for loan losses by $3.4 million and resulted in no charge-offs.

A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms.

TDRs for which there was a payment default within twelve months following the modification were insignificant during the six months ended June 30, 2018 and 2017.

The terms of certain other loans were modified during 2018 that did not meet the definition of a TDR. It is our process to review all classified and criticized loans that, during the period, have been renewed, have entered into a forbearance agreement, have gone from principal and interest to interest only, or have extended the maturity date. In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on its debt in the foreseeable future without the modification. The evaluation is performed under our internal underwriting policy. We also evaluate whether a concession has been granted or if we were adequately compensated through a market interest rate, additional collateral or a bona fide guarantee. We also consider whether the modification was insignificant relative to the other terms of the agreement or the delay in a payment.

PCI loans are not considered impaired until after the point at which there has been a degradation of cash flows below our expected cash flows at acquisition. If a PCI loan is subsequently modified, and meets the definition of a TDR, it will be removed from PCI accounting and accounted for as a TDR only if the PCI loan was being accounted for individually. If the PCI loan is being accounted for as part of a pool, it will not be removed from the pool. As of June 30, 2018, it has not been necessary to remove any loans from PCI accounting.

In general, once a modified loan is considered a TDR, the loan will always be considered a TDR, and therefore impaired, until it is paid in full, otherwise settled, sold or charged off. However, guidance also permits for loans to be removed from TDR status when subsequently restructured under these circumstances: (1) at the time of the subsequent restructuring, the borrower is not experiencing financial difficulties, and this is documented by a current

 

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credit evaluation at the time of the restructuring, (2) under the terms of the subsequent restructuring agreement, the institution has granted no concession to the borrower; and (3) the subsequent restructuring agreement includes market terms that are no less favorable than those that would be offered for a comparable new loan. For loans subsequently restructured that have cumulative principal forgiveness, the loan should continue to be measured in accordance with ASC 310-10, Receivables – Overall. However, consistent with ASC 310-40-50-2, Troubled Debt Restructurings by Creditors, Creditor Disclosure of Troubled Debt Restructurings, the loan would not be required to be reported in the years following the restructuring if the subsequent restructuring meets both of these criteria: (1) has an interest rate at the time of the subsequent restructuring that is not less than a market interest rate; and (2) is performing in compliance with its modified terms after the subsequent restructuring.

Purchased Credit Impaired Loans

Purchased loans acquired in a business combination are recorded at estimated fair value on their purchase date with no carryover of the related allowance for loan and lease losses. In determining the estimated fair value of purchased loans, management considers a number of factors including, among others, the remaining life of the acquired loans, estimated prepayments, estimated loss ratios, estimated value of the underlying collateral, and net present value of cash flows expected to be received. Purchased loans are accounted for in accordance with guidance for certain loans acquired in a transfer (ASC 310-30), when the loans have evidence of credit deterioration since origination and it is probable at the date of acquisition that the acquirer will not collect all contractually required principal and interest payments. The difference between contractually required payments and the cash flows expected to be collected at acquisition is referred to as the non-accretable difference. Subsequent decreases to the expected cash flows will generally result in a provision for loan and lease losses. Subsequent increases in expected cash flows will result in a reversal of the provision for loan losses to the extent of prior charges and then an adjustment to accretable yield, which would have a positive impact on interest income prospectively.

Old National has purchased loans for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected. For these loans that meet the criteria of ASC 310-30 treatment, the carrying amount was as follows:

 

(dollars in thousands)

   June 30,
2018
     December 31,
2017
 
     

Commercial

   $ 4,359      $ 5,152  

Commercial real estate

     20,561        21,826  

Residential

     4,242        11,303  

Consumer

     10,315        5,245  
  

 

 

    

 

 

 

Carrying amount

     39,477        43,526  

Allowance for loan losses

     (326      (166
  

 

 

    

 

 

 

Carrying amount, net of allowance

   $ 39,151      $ 43,360  
  

 

 

    

 

 

 

The outstanding balance of loans accounted for under ASC 310-30, including contractual principal, interest, fees and penalties, was $240.9 million at June 30, 2018 and $235.9 million at December 31, 2017.

The accretable difference on PCI loans is the difference between the expected cash flows and the net present value of expected cash flows with such difference accreted into earnings using the effective yield method over the term of the loans. Accretion recorded as loan interest income totaled $7.1 million during the six months ended June 30, 2018 and $7.3 million during the six months ended June 30, 2017. Improvement in cash flow expectations has resulted in a reclassification from nonaccretable difference to accretable yield as shown in the table below.

 

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Accretable yield of PCI loans, or income expected to be collected, is as follows:

 

     Six Months Ended
June 30,
 

(dollars in thousands)

   2018      2017  

Balance at beginning of period

   $ 27,835      $ 33,603  

Accretion of income

     (7,073      (7,330

Reclassifications from (to) nonaccretable difference

     3,466        594  

Disposals/other adjustments

     21        183  
  

 

 

    

 

 

 

Balance at end of period

   $ 24,249      $ 27,050  
  

 

 

    

 

 

 

Included in Old National’s allowance for loan losses is $0.3 million related to the purchased loans disclosed above at June 30, 2018 and $0.2 million at December 31, 2017.

PCI loans purchased during 2017 for which it was probable at acquisition that all contractually required payments would not be collected were as follows:

 

(dollars in thousands)

   Anchor (MN) (1)  

Contractually required payments

   $ 16,898  

Nonaccretable difference

     (4,787
  

 

 

 

Cash flows expected to be collected at acquisition

     12,111  

Accretable yield

     (1,556
  

 

 

 

Fair value of acquired loans at acquisition

   $ 10,555  
  

 

 

 

 

(1) Old National acquired Anchor (MN) effective November 1, 2017.

Income would not be recognized on certain purchased loans if Old National could not reasonably estimate cash flows to be collected. Old National had no purchased loans for which it could not reasonably estimate cash flows to be collected.

NOTE 9 – OTHER REAL ESTATE OWNED

The following table presents activity in other real estate owned for the six months ended June 30, 2018 and 2017:

 

     Six Months Ended
June 30,
 

(dollars in thousands)

   2018      2017  

Balance at beginning of period

   $ 8,810      $ 18,546  

Additions

     1,175        950  

Sales

     (5,625      (6,552

Impairment

     (631      (1,873
  

 

 

    

 

 

 

Balance at end of period (1)

   $ 3,729      $ 11,071  
  

 

 

    

 

 

 

 

(1) Includes repossessed personal property of $0.3 million at June 30, 2018 and $0.2 million at June 30, 2017.

At June 30, 2018, foreclosed residential real estate property included in the table above totaled $1.3 million. At June 30, 2018, consumer mortgage loans collateralized by residential real property that were in the process of foreclosure totaled $6.3 million.

 

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Table of Contents

NOTE 10 – PREMISES AND EQUIPMENT

The composition of premises and equipment at June 30, 2018 and December 31, 2017 was as follows:

 

(dollars in thousands)

   June 30,
2018
     December 31,
2017
 

Land

   $ 70,628      $ 73,046  

Buildings

     339,378        343,833  

Furniture, fixtures, and equipment

     98,793        94,254  

Leasehold improvements

     40,165        38,918  
  

 

 

    

 

 

 

Total

     548,964        550,051  

Accumulated depreciation

     (99,660      (91,977
  

 

 

    

 

 

 

Premises and equipment, net

   $ 449,304      $ 458,074  
  

 

 

    

 

 

 

Depreciation expense was $5.9 million for the three months ended June 30, 2018 and $11.8 million for the six months ended June 30, 2018, compared to $5.2 million for the three months ended June 30, 2017 and $10.4 million for the six months ended June 30, 2017.

Operating Leases

Old National rents certain premises and equipment under operating leases, which expire at various dates. Many of these leases require the payment of property taxes, insurance premiums, maintenance, and other costs. In some cases, rentals are subject to increase in relation to a cost-of-living index. The leases have original terms ranging from two years and six months to twenty-five years, and Old National has the right, at its option, to extend the terms of certain leases for four additional successive terms of five years. Old National does not have any material sub-lease agreements. Rent expense was $4.5 million for the three months ended June 30, 2018 and $8.9 million for the six months ended June 30, 2018, compared to $3.8 million for the three months ended June 30, 2017 and $7.7 million for the six months ended June 30, 2017.

Old National had deferred gains remaining associated with prior sale leaseback transactions totaling $7.3 million at June 30, 2018 and $8.2 million at December 31, 2017. The gains will be recognized over the remaining term of the leases. The leases had original terms ranging from five to twenty-four years.

Capital Leases

Old National leases two branch buildings and certain equipment under capital leases. See Note 16 to the consolidated financial statements for detail regarding these leases.

NOTE 11 – GOODWILL AND OTHER INTANGIBLE ASSETS

The following table shows the changes in the carrying amount of goodwill for the six months ended June 30, 2018 and 2017:

 

     Six Months Ended
June 30,
 

(dollars in thousands)

   2018      2017  

Balance at beginning of period

   $ 828,051      $ 655,018  

Acquisition adjustments

     753        —    
  

 

 

    

 

 

 

Balance at end of period

   $ 828,804      $ 655,018  
  

 

 

    

 

 

 

Goodwill is reviewed annually for impairment. No events or circumstances since the August 31, 2017 annual impairment test were noted that would indicate it was more likely than not a goodwill impairment exists. During the six months ended June 30, 2018, Old National recorded a $0.8 million increase to goodwill associated with the acquisition of Anchor (MN).

 

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The gross carrying amount and accumulated amortization of other intangible assets at June 30, 2018 and December 31, 2017 were as follows:

 

(dollars in thousands)

  

 

     Gross
Carrying
Amount
     Accumulated
Amortization
and Impairment
     Net
Carrying
Amount
 

June 30, 2018

           

Core deposit

      $ 108,268      $ (69,065    $ 39,203  

Customer trust relationships

 

     16,547        (10,333      6,214  
  

 

 

    

 

 

    

 

 

 

Total intangible assets

 

   $ 124,815      $ (79,398    $ 45,417  
  

 

 

    

 

 

    

 

 

 

December 31, 2017

 

Core deposit

      $ 108,923      $ (62,874    $ 46,049  

Customer trust relationships

 

     16,547        (9,533      7,014  

Customer loan relationships

 

     4,413        (4,380      33  
  

 

 

    

 

 

    

 

 

 

Total intangible assets

 

   $ 129,883      $ (76,787    $ 53,096  
  

 

 

    

 

 

    

 

 

 

Other intangible assets consist of core deposit intangibles and customer relationship intangibles and are being amortized primarily on an accelerated basis over their estimated useful lives, generally over a period of 5 to 15 years. During the six months ended June 30, 2018, Old National recorded a $0.7 million decrease to core deposit intangibles related to the updated valuation associated with the acquisition of Anchor (MN).

Old National reviews other intangible assets for possible impairment whenever events or changes in circumstances indicate that carrying amounts may not be recoverable. No impairment charges were recorded during the six months ended June 30, 2018 or 2017. Total amortization expense associated with intangible assets was $7.0 million for the six months ended June 30, 2018 and $5.8 million for the six months ended June 30, 2017.

Estimated amortization expense for future years is as follows:

 

(dollars in thousands)

      

2018 remaining

   $ 6,399  

2019

     11,010  

2020

     8,672  

2021

     6,417  

2022

     4,595  

Thereafter

     8,324  
  

 

 

 

Total

   $ 45,417  
  

 

 

 

NOTE 12 – LOAN SERVICING RIGHTS

At June 30, 2018, loan servicing rights derived from loans sold with servicing retained totaled $24.3 million, compared to $24.7 million at December 31, 2017. Loans serviced for others are not reported as assets. The principal balance of loans serviced for others was $3.306 billion at June 30, 2018, compared to $3.321 billion at December 31, 2017. Approximately 99.7% of the loans serviced for others at June 30, 2018 were residential mortgage loans. Custodial escrow balances maintained in connection with serviced loans were $37.8 million at June 30, 2018 and $8.9 million at December 31, 2017.

 

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The following table summarizes the carrying values and activity related to loan servicing rights and the related valuation allowance for the six months ended June 30, 2018 and 2017:

 

    

Six Months Ended

June 30,

 

(dollars in thousands)

   2018      2017  

Balance at beginning of period

   $ 24,690      $ 25,629  

Additions

     1,951        1,976  

Amortization

     (2,323      (2,507
  

 

 

    

 

 

 

Balance before valuation allowance at end of period

     24,318        25,098  
  

 

 

    

 

 

 

Valuation allowance:

     

Balance at beginning of period

     (29      (68

(Additions)/recoveries

     14        (7
  

 

 

    

 

 

 

Balance at end of period

     (15      (75
  

 

 

    

 

 

 

Loan servicing rights, net

   $ 24,303      $ 25,023  
  

 

 

    

 

 

 

At June 30, 2018, the fair value of servicing rights was $27.0 million, which was determined using a discount rate of 13% and a weighted average prepayment speed of 115% PSA. At December 31, 2017, the fair value of servicing rights was $25.8 million, which was determined using a discount rate of 13% and a weighted average prepayment speed of 140% PSA.

NOTE 13 – QUALIFIED AFFORDABLE HOUSING PROJECTS AND OTHER TAX CREDIT INVESTMENTS

Old National is a limited partner in several tax-advantaged limited partnerships whose purpose is to invest in approved qualified affordable housing, renewable energy, or other renovation or community revitalization projects. As of June 30, 2018, Old National expects to recover its remaining investments using the tax credits that are generated by the investments.

The following table summarizes Old National’s investments in qualified affordable housing projects and other tax credit investments at June 30, 2018 and December 31, 2017:

 

(dollars in thousands)         June 30, 2018      December 31, 2017  

Investment

  

Accounting Method

   Investment      Unfunded
Commitment (1)
     Investment      Unfunded
Commitment
 

LIHTC

   Proportional amortization    $ 29,802      $ 6,719      $ 31,183      $ 15,553  

FHTC

   Equity      5,201        10,710        10,645        12,040  

CReED

   Equity      704        1,502        704        1,502  

Renewable Energy

   Equity      15,136        18,588        22,364        19,771  
     

 

 

    

 

 

    

 

 

    

 

 

 

Total

      $ 50,843      $ 37,519      $ 64,896      $ 48,866  
     

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) All commitments will be paid by Old National by 2027.

 

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The following table summarizes the amortization expense and tax benefit recognized for Old National’s qualified affordable housing projects and other tax credit investments for the three and six months ended June 30, 2018 and 2017:

 

(dollars in thousands)

   Amortization
Expense (1)
     Tax Expense
(Benefit)
Recognized (2)
 

Three Months Ended June 30, 2018

     

LIHTC

   $ 643      $ (831

FHTC

     5,444        (1,948

Renewable Energy

     6,414        (2,882
  

 

 

    

 

 

 

Total

   $ 12,501      $ (5,661
  

 

 

    

 

 

 

Three Months Ended June 30, 2017

     

LIHTC

   $ 940      $ (1,298

FHTC

     —          (1,519

CReED (3)

     —          (606
  

 

 

    

 

 

 

Total

   $ 940      $ (3,423
  

 

 

    

 

 

 

Six Months Ended June 30, 2018

     

LIHTC

   $ 1,282      $ (1,662

FHTC

     5,444        (3,896

Renewable Energy

     7,129        (6,296
  

 

 

    

 

 

 

Total

   $ 13,855      $ (11,854
  

 

 

    

 

 

 

Six Months Ended June 30, 2017

     

LIHTC

   $ 1,881      $ (2,595

FHTC

     —          (3,039

CReED (3)

     —          (606
  

 

 

    

 

 

 

Total

   $ 1,881      $ (6,240
  

 

 

    

 

 

 

 

(1) The amortization expense for the LIHTC investments is included in our income tax expense. The amortization expense for the FHTC and Renewable Energy tax credits is included in noninterest expense.
(2) All of the tax benefits recognized are included in our income tax expense. The tax benefit recognized for the FHTC and Renewable Energy investments primarily reflects the tax credits generated from the investments, and excludes the net tax expense (benefit) of the investments’ income (loss).
(3) The CReED tax credit investment qualifies for an Indiana state tax credit.

NOTE 14 – SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

Securities sold under agreements to repurchase are secured borrowings. Old National pledges investment securities to secure these borrowings. The following table presents securities sold under agreements to repurchase and related weighted-average interest rates at or for the six months ended June 30:

 

(dollars in thousands)

   2018     2017  

Outstanding at June 30,

   $ 347,511     $ 298,094  

Average amount outstanding

     337,612       330,285  

Maximum amount outstanding at any month-end

     347,511       351,897  

Weighted average interest rate:

    

During the six months ended June 30,

     0.47     0.36

At June 30,

     0.59       0.41  

 

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The following table presents the contractual maturity of our secured borrowings and class of collateral pledged:

 

     At June 30, 2018  
     Remaining Contractual Maturity of the Agreements  

(dollars in thousands)

   Overnight and
Continuous
     Up to
30 Days
     30-90 Days      Greater Than
90 days
     Total  

Repurchase Agreements:

              

U.S. Treasury and agency securities

   $ 347,511      $ —        $ —        $ —        $ 347,511  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 347,511      $ —        $ —        $ —        $ 347,511  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The fair value of securities pledged to secure repurchase agreements may decline. Old National has pledged securities valued at 109% of the gross outstanding balance of repurchase agreements at June 30, 2018 to manage this risk.

NOTE 15 – FEDERAL HOME LOAN BANK ADVANCES

The following table summarizes Old National Bank’s FHLB advances at June 30, 2018 and December 31, 2017:

 

     June 30,      December 31,  

(dollars in thousands)

   2018      2017  

FHLB advances (fixed rates 1.50% to 6.08% and variable rates 2.23% to 2.50%) maturing July 2018 to June 2028

   $ 1,756,730      $ 1,610,531  

ASC 815 fair value hedge and other basis adjustments

     578        (952
  

 

 

    

 

 

 

Total other borrowings

   $ 1,757,308      $ 1,609,579  
  

 

 

    

 

 

 

FHLB advances had weighted-average rates of 2.29% at June 30, 2018 and 1.55% at December 31, 2017. Investment securities and residential real estate loans collateralize these borrowings up to 140% of outstanding debt.

Contractual maturities of FHLB advances at June 30, 2018 were as follows:

 

(dollars in thousands)

      

Due in 2018

   $ 626,567  

Due in 2019

     201,494  

Due in 2020

     100,000  

Due in 2021

     20,000  

Due in 2022

     58,500  

Thereafter

     750,169  

ASC 815 fair value hedge and other basis adjustments

     578  
  

 

 

 

Total

   $ 1,757,308  
  

 

 

 

 

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NOTE 16 – OTHER BORROWINGS

The following table summarizes Old National’s other borrowings at June 30, 2018 and December 31, 2017:

 

     June 30,      December 31,  

(dollars in thousands)

   2018      2017  

Old National Bancorp:

     

Senior unsecured notes (fixed rate 4.125%) maturing August 2024

   $ 175,000      $ 175,000  

Unamortized debt issuance costs related to senior unsecured notes

     (949      (1,026

Junior subordinated debentures (variable rates of 3.68% to 6.22%) maturing April 2032 to September 2037

     60,310        60,310  

Other basis adjustments

     (3,318      (3,585

Old National Bank:

     

Capital lease obligations

     5,326        5,389  

Subordinated debentures (fixed rate 5.75%)

     12,000        12,000  

Other

     1,872        694  
  

 

 

    

 

 

 

Total other borrowings

   $ 250,241      $ 248,782  
  

 

 

    

 

 

 

Contractual maturities of other borrowings at June 30, 2018 were as follows:

 

(dollars in thousands)

      

Due in 2018

   $ 1,286  

Due in 2019

     137  

Due in 2020

     147  

Due in 2021

     160  

Due in 2022

     172  

Thereafter

     251,956  

Unamortized debt issuance costs and other basis adjustments

     (3,617
  

 

 

 

Total

   $ 250,241  
  

 

 

 

Senior Notes

In August 2014, Old National issued $175.0 million of senior unsecured notes with a 4.125% interest rate. These notes pay interest on February 15 and August 15. The notes mature on August 15, 2024.

Junior Subordinated Debentures

Junior subordinated debentures related to trust preferred securities are classified in “other borrowings.” With the addition of Anchor (MN) assets, these securities now qualify as Tier 2 capital for regulatory purposes, subject to certain limitations. Prior to the fourth quarter of 2017, these securities qualified as Tier 1 capital for regulatory purposes.

Through various acquisitions, Old National assumed junior subordinated debenture obligations related to various trusts that issued trust preferred securities. Old National guarantees the payment of distributions on the trust preferred securities issued by the trusts. Proceeds from the issuance of each of these securities were used to purchase junior subordinated debentures with the same financial terms as the securities issued by the trusts.

Old National, at any time, may redeem the junior subordinated debentures at par and, thereby cause a redemption of the trust preferred securities in whole or in part.

 

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The following table summarizes the terms of our outstanding junior subordinated debentures at June 30, 2018:

 

(dollars in thousands)                     Rate at      
          Issuance           June 30,      

Name of Trust

  

Issuance Date

   Amount     

Rate

   2018    

Maturity Date

VFSC Capital Trust I

   April 2002    $ 3,093      3-month LIBOR plus 3.70%      6.22   April 22, 2032

VFSC Capital Trust II

   October 2002      4,124      3-month LIBOR plus 3.45%      5.79   November 7, 2032

VFSC Capital Trust III

   April 2004      3,093      3-month LIBOR plus 2.80%      5.12   September 8, 2034

St. Joseph Capital Trust II

   March 2005      5,000      3-month LIBOR plus 1.75%      4.08   March 20, 2035

Anchor Capital Trust III

   August 2005      5,000      3-month LIBOR plus 1.55%      3.89   September 30, 2035

Tower Capital Trust 2

   December 2005      8,000      3-month LIBOR plus 1.34%      3.68   December 4, 2035

Home Federal Statutory Trust I

   September 2006      15,000      3-month LIBOR plus 1.65%      3.99   September 15, 2036

Monroe Bancorp Capital Trust I

   July 2006      3,000      3-month LIBOR plus 1.60%      3.95   October 7, 2036

Monroe Bancorp Statutory Trust II

   March 2007      5,000      3-month LIBOR plus 1.60%      3.94   June 15, 2037

Tower Capital Trust 3

   December 2006      9,000      3-month LIBOR plus 1.69%      3.99   September 15, 2037
     

 

 

         

Total

      $ 60,310          
     

 

 

         

Subordinated Debentures

On November 1, 2017, Old National assumed $12.0 million of subordinated fixed-to-floating notes related to the acquisition of Anchor (MN). The subordinated debentures have a 5.75% fixed rate of interest through October 29, 2020. From October 30, 2020 to the October 30, 2025 maturity date, the debentures have a floating rate of interest equal to the three-month LIBOR rate plus 4.356%.

Capital Lease Obligations

On January 1, 2004, Old National entered into a long-term capital lease obligation for a branch office building in Owensboro, Kentucky, which extends for 25 years with one renewal option for 10 years. The economic substance of this lease is that Old National is financing the acquisition of the building through the lease and accordingly, the building is recorded as an asset and the lease is recorded as a liability. The fair value of the capital lease obligation was estimated using a discounted cash flow analysis based on Old National’s current incremental borrowing rate for similar types of borrowing arrangements.

On May 1, 2016, Old National acquired Anchor (WI), assuming a five-year capital lease obligation for equipment.

On November 1, 2017, Old National assumed a capital lease obligation for a banking center in Arden Hills, Minnesota related to the acquisition of Anchor (MN). The remaining base term of the lease is five years with one renewal option of ten years. For purposes of measuring the lease obligation, we determined that we would be “reasonably assured” to exercise the renewal option. The fair value of the capital lease obligation was estimated using a discounted cash flow analysis based on a market rate for similar types of borrowing arrangements. Based on the above assumptions, Old National measured the capital lease obligation at $1.5 million as of the date of acquisition.

 

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At June 30, 2018, the future minimum lease payments under the capital lease arrangements were as follows:

 

(dollars in thousands)

      

2018

   $ 284  

2019

     589  

2020

     589  

2021

     589  

2022

     589  

Thereafter

     9,275  
  

 

 

 

Total minimum lease payments

     11,915  

Less amounts representing interest

     (6,589
  

 

 

 

Present value of net minimum lease payments

   $ 5,326  
  

 

 

 

 

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NOTE 17 – ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following table summarizes the changes within each classification of AOCI, net of tax, for the three and six months ended June 30, 2018 and 2017:

 

(dollars in thousands)

   Unrealized Gains
and Losses on
Available-for-Sale
Securities
    Unrealized Gains
and Losses on
Held-to-Maturity
Securities
    Gains and
Losses on
Cash Flow
Hedges
    Defined
Benefit
Pension
Plans
    Total  

Three Months Ended June 30, 2018

          

Balance at beginning of period

   $ (52,605   $ (9,737   $ 1,126     $ (310   $ (61,526

Other comprehensive income (loss) before reclassifications

     (5,615     —         1,143       —         (4,472

Amounts reclassified from AOCI to income (1)

     (1,136     402       8       21       (705
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ (59,356   $ (9,335   $ 2,277     $ (289   $ (66,703
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Three Months Ended June 30, 2017

          

Balance at beginning of period

   $ (29,992   $ (13,015   $ (5,240   $ (318   $ (48,565

Other comprehensive income (loss) before reclassifications

     19,492       —         (1,480     —         18,012  

Amounts reclassified from AOCI to income (1)

     (1,957     298       1,075       17       (567
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ (12,457   $ (12,717   $ (5,645   $ (301   $ (31,120
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Six Months Ended June 30, 2018

          

Balance at beginning of period

   $ (35,557   $ (12,107   $ (2,337   $ (271   $ (50,272

Other comprehensive income (loss) before reclassifications

     (14,486     4,514       4,587       —         (5,385

Amounts reclassified from AOCI to income (1)

     (1,730     858       588       41       (243

Amount reclassified from AOCI to retained earnings for cumulative effect of change in accounting principle (2)

     —         —         (52     —         (52

Amounts reclassified from AOCI to retained earnings related to the Tax Cuts and Jobs Act of 2017 (3)

     (7,583     (2,600     (509     (59     (10,751
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ (59,356   $ (9,335   $ 2,277     $ (289   $ (66,703
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Six Months Ended June 30, 2017

          

Balance at beginning of period

   $ (39,012   $ (13,310   $ (6,715   $ (335   $ (59,372

Other comprehensive income (loss) before reclassifications

     29,459       —         (1,120     —         28,339  

Amounts reclassified from AOCI to income (1)

     (2,904     593       2,190       34       (87
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ (12,457   $ (12,717   $ (5,645   $ (301   $ (31,120
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) See table below for details about reclassifications to income.
(2) See Note 3 for details about reclassification from AOCI to beginning retained earnings resulting from the adoption of ASU 2017-12.
(3) See Note 3 for details about reclassification from AOCI to beginning retained earnings resulting from the adoption of ASU 2018-02.

 

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The following table summarizes the significant amounts reclassified out of each component of AOCI for the three months ended June 30, 2018 and 2017:

 

Details about AOCI Components

   Amount Reclassified
from AOCI
    

Affected Line Item in the

Statement of Income

     Three Months Ended
June 30,
      

(dollars in thousands)

   2018      2017       

Unrealized gains and losses on available-for-sale securities

   $ 1,494      $ 3,075      Net securities gains
     (358      (1,118    Income tax (expense) benefit
  

 

 

    

 

 

    
   $ 1,136      $ 1,957      Net income
  

 

 

    

 

 

    

Unrealized gains and losses on held-to-maturity securities

   $ (521    $ (453    Interest income (expense)
     119        155      Income tax (expense) benefit
  

 

 

    

 

 

    
   $ (402    $ (298    Net income
  

 

 

    

 

 

    

Gains and losses on cash flow hedges Interest rate contracts

   $ (10    $ (1,734    Interest income (expense)
     2        659      Income tax (expense) benefit
  

 

 

    

 

 

    
   $ (8    $ (1,075    Net income
  

 

 

    

 

 

    

Amortization of defined benefit pension items Actuarial gains (losses)

   $ (27    $ (27    Salaries and employee benefits
     6        10      Income tax (expense) benefit
  

 

 

    

 

 

    
   $ (21    $ (17    Net income
  

 

 

    

 

 

    

Total reclassifications for the period

   $ 705      $ 567      Net income
  

 

 

    

 

 

    

 

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The following table summarizes the significant amounts reclassified out of each component of AOCI for the six months ended June 30, 2018 and 2017:

 

Details about AOCI Components

   Amount Reclassified
from AOCI
    

Affected Line Item in the

Statement of Income

     Six Months Ended
June 30,
      

(dollars in thousands)

   2018      2017       

Unrealized gains and losses on available-for-sale securities

   $ 2,282      $ 4,575      Net securities gains
     (552      (1,671    Income tax (expense) benefit
  

 

 

    

 

 

    
   $ 1,730      $ 2,904      Net income
  

 

 

    

 

 

    

Unrealized gains and losses on held-to-maturity securities

   $ (1,112    $ (902    Interest income/(expense)
     254        309      Income tax (expense) benefit
  

 

 

    

 

 

    
   $ (858    $ (593    Net income
  

 

 

    

 

 

    

Gains and losses on cash flow hedges Interest rate contracts

   $ (779    $ (3,533    Interest income/(expense)
     191        1,343      Income tax (expense) benefit
  

 

 

    

 

 

    
   $ (588    $ (2,190    Net income
  

 

 

    

 

 

    

Amortization of defined benefit pension items Actuarial gains/(losses)

   $ (54    $ (54    Salaries and employee benefits
     13        20      Income tax (expense) benefit
  

 

 

    

 

 

    
   $ (41    $ (34    Net income
  

 

 

    

 

 

    

Total reclassifications for the period

   $ 243      $ 87      Net income
  

 

 

    

 

 

    

NOTE 18 – EMPLOYEE BENEFIT PLANS

Retirement Plan

Old National had a funded noncontributory defined benefit plan (the “Retirement Plan”) that had been frozen since December 31, 2005. During the first quarter of 2016, we notified plan participants of our intent to terminate the Retirement Plan effective May 15, 2016. During October 2016, the Retirement Plan settled plan liabilities through either lump sum distributions to plan participants or annuity contracts purchased from a third-party insurance company that provided for the payment of vested benefits to those participants that did not elect the lump sum option. At June 30, 2018, there were no remaining plan assets.

Employee Stock Ownership Plan

The Employee Stock Ownership and Savings Plan (the “401(k) Plan”) permits employees to participate the first month following one month of service. During the second quarter of 2018, Old National increased its match to 75% of employee compensation deferral contributions of the first 4% of compensation, and 50% of the next 4% of compensation. The change was retroactive for all of 2018. For 2017, we matched 50% of employee compensation deferral contributions, up to 6% of compensation. Contribution expense under the 401(k) Plan was $3.1 million in the three months ended June 30, 2018 and $4.6 million in the six months ended June 30, 2018, compared to $1.2 million in the three months ended June 30, 2017 and $2.4 million in the six months ended June 30, 2017.

 

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NOTE 19 – SHARE-BASED COMPENSATION

At June 30, 2018, Old National had 4.4 million shares remaining available for issuance under the Company’s Amended and Restated 2008 Incentive Compensation Plan. The granting of awards to key employees is typically in the form of restricted stock awards or units.

Restricted Stock Awards

Old National granted 212 thousand time-based restricted stock awards to certain key officers during the six months ended June 30, 2018, with shares vesting generally over a thirty-six month period. Compensation expense is recognized on a straight-line basis over the vesting period. Shares are subject to certain restrictions and risk of forfeiture by the participants. At June 30, 2018, unrecognized compensation expense was estimated to be $6.1 million for unvested restricted stock awards. The cost is expected to be recognized over a weighted-average period of 2.2 years.

Old National recorded share-based compensation expense, net of tax, related to restricted stock awards of $1.1 million, net of tax, during the six months ended June 30, 2018, compared to $0.9 million, net of tax, during the six months ended June 30, 2017.

Restricted Stock Units

Old National granted 288 thousand shares of performance based restricted stock units to certain key officers during the six months ended June 30, 2018, with shares vesting at the end of a thirty-six month period based on the achievement of certain targets. For certain awards, the level of performance could increase or decrease the percentage of shares earned. Compensation expense is recognized on a straight-line basis over the vesting period. Shares are subject to certain restrictions and risk of forfeiture by the participants. At June 30, 2018, unrecognized compensation expense was estimated to be $5.8 million. The cost is expected to be recognized over a weighted-average period of 2.0 years.

Old National recorded share-based compensation expense, net of tax, related to restricted stock units of $1.6 million during the six months ended June 30, 2018, compared to $1.0 million during the six months ended June 30, 2017.

Stock Options

Old National has not granted stock options since 2009. However, Old National did acquire stock options through prior year acquisitions. Old National did not record any share-based compensation expense related to these stock options during the six months ended June 30, 2018 or 2017.

Stock Appreciation Rights

Old National has never granted stock appreciation rights. However, Old National did acquire stock appreciation rights through a prior year acquisition. Old National did not record any incremental expense associated with the conversion of these stock appreciation rights during the six months ended June 30, 2018 or 2017. At June 30, 2018, 62 thousand stock appreciation rights remained outstanding.

 

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NOTE 20 – INCOME TAXES

Following is a summary of the major items comprising the differences in taxes from continuing operations computed at the federal statutory rate and as recorded in the consolidated statements of income:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 

(dollars in thousands)

   2018     2017     2018     2017  

Provision at statutory rate (1)

   $ 10,153     $ 17,303     $ 21,270     $ 33,572  

Tax-exempt income:

        

Tax-exempt interest

     (2,237     (3,672     (4,428     (7,374

Section 291/265 interest disallowance

     73       64       135       121  

Company-owned life insurance income

     (510     (741     (1,057     (1,493
  

 

 

   

 

 

   

 

 

   

 

 

 

Tax-exempt income

     (2,674     (4,349     (5,350     (8,746
  

 

 

   

 

 

   

 

 

   

 

 

 

State income taxes

     1,028       195       2,216       1,046  

Interim period effective rate adjustment

     933       (286     1,025       (741

Tax credit investments - federal

     (4,973     (1,877     (10,741     (3,753

Other, net

     (122     (402     882       (303
  

 

 

   

 

 

   

 

 

   

 

 

 

Income tax expense

   $ 4,345     $ 10,584     $ 9,302     $ 21,075  
  

 

 

   

 

 

   

 

 

   

 

 

 

Effective tax rate

     9.0     21.4     9.2     22.0

 

(1) The statutory rate was 21% for the three and six months ended June 30, 2018, compared to 35% for the three and six months ended June 30, 2017.

In accordance with ASC 740-270, Accounting for Interim Reporting, the provision for income taxes was recorded at June 30, 2018 and 2017 based on the current estimate of the effective annual rate.

The lower effective tax rate during the three and six months ended June 30, 2018 when compared to the three and six months ended June 30, 2017 is primarily the result of the lowering of the federal corporate tax rate to 21% in 2018 and an increase in federal tax credits available. On December 22, 2017, the Tax Cuts and Jobs Act (“H.R. 1”) was enacted into legislation. Under ASC 740, the effects of changes in tax rates and laws are recognized in the period in which the new legislation is enacted. Accordingly, Old National recorded an estimated $39.3 million for the revaluation of Old National’s deferred tax assets in December 2017.

Shortly after the enactment date, the SEC issued SAB 118, which addresses the situations where the accounting for changes in tax laws is complete, incomplete but can be reasonably estimated, and incomplete and cannot be reasonably estimated. SAB 118 also permits a measurement period of up to one year from the date of enactment to refine the provisional accounting. During the six months ended June 30, 2018, immaterial adjustments made to the preliminary valuation of assets acquired and liabilities assumed in the acquisition of Anchor (MN) impacted the estimated revaluation of Old National’s deferred tax assets. Old National completed its analysis of H.R. 1 during the second quarter of 2018.

Unrecognized Tax Benefits

Old National and its subsidiaries file a consolidated U.S. federal income tax return, as well as filing various state returns. Unrecognized state income tax benefits are reported net of their related deferred federal income tax benefit.

 

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A reconciliation of the beginning and ending amounts of unrecognized tax benefits was as follows:

 

     Six Months Ended
June 30,
 

(dollars in thousands)

   2018      2017  

Balance at beginning of period

   $ 874      $ 777  

Additions based on tax positions related to the current year

     —          70  
  

 

 

    

 

 

 

Balance at end of period

   $ 874      $ 847  
  

 

 

    

 

 

 

If recognized, approximately $0.9 million of unrecognized tax benefits, net of interest, would favorably affect the effective income tax rate in future periods. Old National expects the total amount of unrecognized tax benefits to decrease by approximately $0.3 million in the next twelve months.

Net Deferred Tax Assets

Significant components of net deferred tax assets (liabilities) were as follows at June 30, 2018 and December 31, 2017:

 

(dollars in thousands)

   June 30,
2018
     December 31,
2017
 

Deferred Tax Assets

     

Allowance for loan losses, net of recapture

   $ 13,842      $ 12,958  

Benefit plan accruals

     12,146        11,080  

Alternative minimum tax credit

     2,545        25,084  

Unrealized losses on benefit plans

     94        108  

Net operating loss carryforwards

     32,915        39,631  

Federal tax credits

     12,050        5,516  

Other-than-temporary impairment

     36        1,424  

Deferred gain on securities

     2,052        —    

Acquired loans

     23,976        29,669  

Lease exit obligation

     1,290        1,337  

Unrealized losses on available-for-sale investment securities

     18,733        14,011  

Unrealized losses on held-to-maturity investment securities

     2,746        3,630  

Unrealized losses on hedges

     —          923  

Tax credit investments

     862        —    

Other real estate owned

     181        369  

Other, net

     2,405        829  
  

 

 

    

 

 

 

Total deferred tax assets

     125,873        146,569  
  

 

 

    

 

 

 

Deferred Tax Liabilities

     

Accretion on investment securities

     (451      (493

Purchase accounting

     (15,972      (16,718

Loan servicing rights

     (5,970      (6,058

Premises and equipment

     (9,512      (10,052

Prepaid expenses

     (1,277      (1,277

Tax credit investments

     —          (168

Unrealized gains on hedges

     (742      —    

Other, net

     (1,762      (946
  

 

 

    

 

 

 

Total deferred tax liabilities

     (35,686      (35,712
  

 

 

    

 

 

 

Net deferred tax assets

   $ 90,187      $ 110,857  
  

 

 

    

 

 

 

Through the acquisition of Anchor (WI) in the second quarter of 2016 and Lafayette Savings Bank in the fourth quarter of 2014, both former thrifts, Old National Bank’s retained earnings at June 30, 2018 include base-year bad debt reserves, created for tax purposes prior to 1988, totaling $52.8 million. Of this total, $50.9 million was

 

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acquired from Anchor (WI), and $1.9 million was acquired from Lafayette Savings Bank. Base-year reserves are subject to recapture in the unlikely event that Old National Bank (1) makes distributions in excess of current and accumulated earnings and profits, as calculated for federal income tax purposes, (2) redeems its stock, or (3) liquidates. Old National Bank has no intention of making such a nondividend distribution. Accordingly, under current accounting principles, a related deferred income tax liability of $13.0 million has not been recognized.

No valuation allowance was recorded at June 30, 2018 or December 31, 2017 because, based on current expectations, Old National believes it will generate sufficient income in future years to realize deferred tax assets. Old National has federal net operating loss carryforwards totaling $104.5 million at June 30, 2018 and $130.7 million at December 31, 2017. This federal net operating loss was acquired from the acquisition of Anchor (WI) in 2016. If not used, the federal net operating loss carryforwards will expire from 2028 to 2033. Old National has alternative minimum tax (“AMT”) credit carryforwards totaling $22.6 million at June 30, 2018 and $25.1 million at December 31, 2017. The enactment of H.R. 1 eliminates the parallel tax system known as the AMT and allows any existing AMT credits to be used to reduce regular tax or be refunded from 2018 to 2021. ASC 740 allows for the reclassification of the AMT credit from a deferred tax asset to a current tax asset, except for the amount limited by section 382. Old National has $2.5 million of AMT credit carryforward subject to section 382 limitations. The $2.5 million is maintained in deferred tax assets and the remaining $20.1 million has been reclassified to a current tax asset. Old National has federal tax credit carryforwards of $12.1 million at June 30, 2018 and $5.5 million at December 31, 2017. The federal tax credits consist mainly of federal historic credits, energy efficient home credits, low income housing credits, and research and development credits that, if not used, will expire from 2025 to 2038. Old National has recorded state net operating loss carryforwards totaling $183.4 million at June 30, 2018 and $203.6 million at December 31, 2017. If not used, the state net operating loss carryforwards will expire from 2024 to 2033. Old National has state tax credit carryforwards totaling $0.7 million at June 30, 2018 and $1.3 million at December 31, 2017. The state tax credits will not expire.

The federal and recorded state net operating loss carryforwards are subject to an annual limitation under Internal Revenue Code section 382. Old National believes that all of the recorded net operating loss carryforwards will be used prior to expiration.

NOTE 21 – DERIVATIVE FINANCIAL INSTRUMENTS

As discussed in Note 3, Old National adopted ASU 2017-12 in the first quarter of 2018. This adoption primarily impacted our existing cash flow and fair value hedges related to certain FHLB advances. For cash flow hedges as of the date of adoption, the transition guidance in paragraph 815-20-65-3(d) eliminated the separate measurement of ineffectiveness by means of a cumulative-effect adjustment to accumulated other comprehensive income with a corresponding adjustment to the opening balance of retained earnings. For fair value hedges of interest rate risk, the provisions of paragraph 815-25-35-13 permit Old National to elect to modify the measurement methodology to be based on the benchmark rate component of the contractual coupon cash flows without dedesignation of the hedging relationship. The measurement methodology modification shall be applied as of the hedging relationship’s original inception date. The cumulative effect of applying this election shall be recognized as an adjustment to the basis adjustment of the hedged item recognized on the balance sheet with a corresponding adjustment to the opening balance of retained earnings as of the initial application date.

As part of our overall interest rate risk management, Old National uses derivative instruments, including interest rate swaps, caps, and floors. The notional amount of these derivative instruments was $1.034 billion at June 30, 2018 and $708.5 million at December 31, 2017. These derivative financial instruments at June 30, 2018 consisted of $408.5 million notional amount of receive-fixed, pay-variable interest rate swaps on certain of its FHLB advances and $625.0 million notional amount of pay-fixed, receive-variable interest rate swaps on certain of its FHLB advances. Derivative financial instruments at December 31, 2017 consisted of $33.5 million notional amount of receive-fixed, pay-variable interest rate swaps on certain of its FHLB advances and $675.0 million notional amount of pay-fixed, receive-variable interest rate swaps on certain of its FHLB advances. These hedges were entered into to manage interest rate risk. Derivative instruments are recognized on the balance sheet at their fair value and are not reported on a net basis.

 

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In accordance with ASC 815-20-35-1, subsequent changes in fair value for a hedging instrument that has been designated and qualifies as part of a hedging relationship should be accounted for in the following manner:

Cash flow hedges: changes in fair value will be recognized as a component in other comprehensive income.

Fair value hedges: changes in fair value will be recognized concurrently in earnings.

Consistent with this guidance, as long as a hedging instrument is designated and the results of the effectiveness testing support that the instrument qualifies for hedge accounting treatment, 100% of the periodic changes in fair value of the hedging instrument will be accounted for as outlined above. This is the case whether or not economic mismatches exist in the hedging relationship. As a result, there will be no periodic measurement or recognition of ineffectiveness. Rather, the full impact of hedge gains and losses will be recognized in the period in which the hedged transactions impact earnings.

While separate measurement and presentation of ineffectiveness is being eliminated, paragraph 815-20-45-1A requires the change in fair value of the hedging instrument that is included in the assessment of hedge effectiveness be presented in the same income statement line item that is used to present the earnings effect of the hedged item.

Commitments to fund certain mortgage loans (interest rate lock commitments) and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. These derivative contracts do not qualify for hedge accounting. At June 30, 2018, the notional amount of the interest rate lock commitments was $59.3 million and forward commitments were $76.1 million. At December 31, 2017, the notional amount of the interest rate lock commitments was $29.9 million and forward commitments were $41.2 million. It is our practice to enter into forward commitments for the future delivery of residential mortgage loans to third party investors when interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from our commitment to fund the loans.

Old National also enters into derivative instruments for the benefit of its customers. The notional amounts of these customer derivative instruments and the offsetting counterparty derivative instruments were $827.6 million at June 30, 2018. The notional amounts of these customer derivative instruments and the offsetting counterparty derivative instruments were $826.6 million at December 31, 2017. These derivative contracts do not qualify for hedge accounting. These instruments include interest rate swaps, caps, and collars. Commonly, Old National will economically hedge significant exposures related to these derivative contracts entered into for the benefit of customers by entering into offsetting contracts with approved, reputable, independent counterparties with substantially matching terms.

Old National enters into derivative financial instruments as part of its foreign currency risk management strategies. These derivative instruments consist of foreign currency forward contracts to accommodate the business needs of its customers. Old National does not designate these foreign currency forward contracts for hedge accounting treatment. The notional amounts of these foreign currency forward contracts and the offsetting counterparty derivative instruments were $2.1 million at June 30, 2018 and $0.8 million at December 31, 2017.

Credit risk arises from the possible inability of counterparties to meet the terms of their contracts. Old National’s exposure is limited to the replacement value of the contracts rather than the notional, principal, or contract amounts. There are provisions in our agreements with the counterparties that allow for certain unsecured credit exposure up to an agreed threshold. Exposures in excess of the agreed thresholds are collateralized. In addition, we minimize credit risk through credit approvals, limits, and monitoring procedures.

Amounts reported in AOCI related to cash flow hedges will be reclassified to interest income or interest expense as interest payments are received or paid on Old National’s derivative instruments. During the next 12 months, we estimate that $2.0 million will be reclassified to interest income and $0.8 million will be reclassified to interest expense.

 

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The following table summarizes the fair value of derivative financial instruments utilized by Old National:

 

(dollars in thousands)

   Balance
Sheet
Location
     Fair
Value
     Balance
Sheet
Location
     Fair
Value
 

June 30, 2018

           

Derivatives designated as hedging instruments

           

Interest rate contracts

     Other assets      $ 4,871        Other liabilities      $ 1,656  
     

 

 

       

 

 

 

Total derivatives designated as hedging instruments

      $ 4,871         $ 1,656  
     

 

 

       

 

 

 

Derivatives not designated as hedging instruments

           

Interest rate contracts

     Other assets      $ 8,524        Other liabilities      $ 19,148  

Mortgage contracts

     Other assets        1,537        Other liabilities        352  

Foreign currency contracts

     Other assets        61        Other liabilities        40  
     

 

 

       

 

 

 

Total derivatives not designated as hedging instruments

      $ 10,122         $ 19,540  
     

 

 

       

 

 

 

Total

      $ 14,993         $ 21,196  
     

 

 

       

 

 

 

December 31, 2017

           

Derivatives designated as hedging instruments

           

Interest rate contracts

     Other assets      $ 3,351        Other liabilities      $ 5,351  
     

 

 

       

 

 

 

Total derivatives designated as hedging instruments

      $ 3,351         $ 5,351  
     

 

 

       

 

 

 

Derivatives not designated as hedging instruments

           

Interest rate contracts

     Other assets      $ 10,012        Other liabilities      $ 10,933  

Mortgage contracts

     Other assets        747        Other liabilities        —    

Foreign currency contracts

     Other assets        8        Other liabilities        8  
     

 

 

       

 

 

 

Total derivatives not designated as hedging instruments

      $ 10,767         $ 10,941  
     

 

 

       

 

 

 

Total

      $ 14,118         $ 16,292  
     

 

 

       

 

 

 

The effect of derivative instruments in fair value hedging relationships on the consolidated statements of income for the three and six months ended June 30, 2018 and 2017 were as follows:

 

(dollars in thousands)                       Gain (Loss)
Recognized
in Income on
Related
Hedged
Items
 

Derivatives in

Fair Value Hedging

Relationships               

 

Location of Gain or

(Loss) Recognized in

in Income on

Derivative

  Gain (Loss)
Recognized
in Income on
Derivative
    Hedged Items
in Fair Value
Hedging
Relationships
   

Location of Gain or
(Loss) Recognized in
in Income on Related

Hedged Item

 

Three Months Ended June 30, 2018

         

Interest rate contracts

  Interest income/(expense)   $ (944     Fixed-rate debt     Interest income/(expense)   $ 934  

Three Months Ended June 30, 2017

         

Interest rate contracts

  Interest income/(expense)   $ 77       Fixed-rate debt     Interest income/(expense)   $ (25

Six Months Ended June 30, 2018

         

Interest rate contracts

  Interest income/(expense)   $ (1,663     Fixed-rate debt     Interest income/(expense)   $ 1,655  

Six Months Ended June 30, 2017

         

Interest rate contracts

  Interest income/(expense)   $ (178     Fixed-rate debt     Interest income/(expense)   $ 265  

The difference between the gain (loss) recognized in income on derivatives and the gain (loss) recognized in income on the related hedged items represents hedge ineffectiveness. In addition, the net swap settlements that accrue each period are also reported in interest expense.

 

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The effect of derivative instruments in cash flow hedging relationships on the consolidated statements of income for the three and six months ended June 30, 2018 and 2017 were as follows:

 

          Three Months Ended
June 30,
     Three Months Ended
June 30,
 

(dollars in thousands)

        2018      2017      2018      2017  

Derivatives in

Cash Flow Hedging

Relationships          

  

Location of Gain or

(Loss) Reclassified

from AOCI into Income

(Effective Portion)

   Gain (Loss)
Recognized in Other
Comprehensive
Income on Derivative
(Effective Portion)
     Gain (Loss)
Reclassified from
AOCI into

Income (Effective
Portion)
 

Interest rate contracts

   Interest income/(expense)    $ 1,516      $ (2,387    $ (10 )     $ (1,734
     

 

 

    

 

 

    

 

 

    

 

 

 
          Six Months Ended
June 30,
     Six Months Ended
June 30,
 

(dollars in thousands)

        2018      2017      2018      2017  

Derivatives in

Cash Flow Hedging

Relationships          

  

Location of Gain or

(Loss) Reclassified

from AOCI into Income

(Effective Portion)

   Gain (Loss)
Recognized in Other
Comprehensive
Income on Derivative
(Effective Portion)
     Gain (Loss)
Reclassified from
AOCI into

Income (Effective
Portion)
 

Interest rate contracts

   Interest income/(expense)    $ 6,079      $ (1,807    $ (779 )     $ (3,533
     

 

 

    

 

 

    

 

 

    

 

 

 

The ineffective portion and amount excluded from effectiveness testing related to derivatives in cash flow hedging relationships was immaterial for the three and six months ended June 30, 2018 and 2017.

The effect of derivatives not designated as hedging instruments on the consolidated statements of income for the three and six months ended June 30, 2018 and 2017 were as follows:

 

          Three Months Ended
June 30,
 

(dollars in thousands)

        2018      2017  

Derivatives Not Designated as

Hedging Instruments               

  

Location of Gain or (Loss)

Recognized in Income on

Derivative

   Gain (Loss)
Recognized in Income on
Derivative
 

Interest rate contracts (1)

   Other income/(expense)    $ 27      $ 13  

Mortgage contracts

   Mortgage banking revenue      (201      451  

Foreign currency contracts

   Other income/(expense)      6        —    
     

 

 

    

 

 

 

Total

      $ (168 )     $ 464  
     

 

 

    

 

 

 
          Six Months Ended
June 30,
 

(dollars in thousands)

        2018      2017  

Derivatives Not Designated as

Hedging Instruments               

  

Location of Gain or (Loss)

Recognized in Income on

Derivative

   Gain (Loss)
Recognized in Income on
Derivative
 

Interest rate contracts (1)

   Other income/(expense)    $ 27      $ 23  

Mortgage contracts

   Mortgage banking revenue      437        (1,043

Foreign currency contracts

   Other income/(expense)      23        —    
     

 

 

    

 

 

 

Total

      $ 487      $ (1,020
     

 

 

    

 

 

 

 

(1) Includes the valuation differences between the customer and offsetting swaps.

 

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NOTE 22 – COMMITMENTS AND CONTINGENCIES

Litigation

In the normal course of business, Old National Bancorp and its subsidiaries have been named, from time to time, as defendants in various legal actions. Certain of the actual or threatened legal actions may include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages.

Old National contests liability and/or the amount of damages as appropriate in each pending matter. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or indeterminate damages or where investigations and proceedings are in the early stages, Old National cannot predict with certainty the loss or range of loss, if any, related to such matters, how or if such matters will be resolved, when they will ultimately be resolved, or what the eventual settlement, or other relief, if any, might be. Subject to the foregoing, Old National believes, based on current knowledge and after consultation with counsel, that the outcome of such pending matters will not have a material adverse effect on the consolidated financial condition of Old National, although the outcome of such matters could be material to Old National’s operating results and cash flows for a particular future period, depending on, among other things, the level of Old National’s revenues or income for such period. Old National will accrue for a loss contingency if (1) it is probable that a future event will occur and confirm the loss and (2) the amount of the loss can be reasonably estimated.

Old National is not currently involved in any material litigation.

Credit-Related Financial Instruments

In the normal course of business, Old National’s banking affiliates have entered into various agreements to extend credit, including loan commitments of $3.218 billion and standby letters of credit of $85.7 million at June 30, 2018. At June 30, 2018, approximately $2.986 billion of the loan commitments had fixed rates and $232.0 million had floating rates, with the floating interest rates ranging from 0.99% to 15%. At December 31, 2017, loan commitments totaled $3.144 billion and standby letters of credit totaled $68.7 million. These commitments are not reflected in the consolidated financial statements. The allowance for unfunded loan commitments totaled $3.2 million at June 30, 2018 and $3.1 million at December 31, 2017.

Old National had credit extensions with various unaffiliated banks related to letter of credit commitments issued on behalf of Old National’s clients totaling $12.1 million at June 30, 2018 and $12.4 million at December 31, 2017. Old National provided collateral to the unaffiliated banks to secure credit extensions totaling $9.2 million at June 30, 2018 and $11.5 million at December 31, 2017. Old National did not provide collateral for the remaining credit extensions.

NOTE 23 – FINANCIAL GUARANTEES

Old National holds instruments, in the normal course of business with clients, that are considered financial guarantees in accordance with FASB ASC 460-10 (FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others), which requires Old National to record the instruments at fair value. Standby letters of credit guarantees are issued in connection with agreements made by clients to counterparties. Standby letters of credit are contingent upon failure of the client to perform the terms of the underlying contract. Credit risk associated with standby letters of credit is essentially the same as that associated with extending loans to clients and is subject to normal credit policies. The term of these standby letters of credit is typically one year or less. At June 30, 2018, the notional amount of standby letters of credit was $85.7 million, which represented the maximum amount of future funding requirements, and the carrying value was $0.4 million. At December 31, 2017, the notional amount of standby letters of credit was $68.7 million, which represented the maximum amount of future funding requirements, and the carrying value was $0.4 million.

Old National is a party in risk participation transactions of interest rate swaps, which had total notional amount of $30.8 million at June 30, 2018.

 

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NOTE 24 – SEGMENT INFORMATION

Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Old National Bank, Old National’s bank subsidiary, is the only significant subsidiary upon which management makes decisions regarding how to allocate resources and assess performance. Each of the branches of Old National Bank provide a group of similar community banking services, including such products and services as commercial, real estate and consumer loans, time deposits, checking and savings accounts, cash management, brokerage, trust, and investment advisory services. The individual bank branches located throughout our Midwest footprint have similar operating and economic characteristics. While the chief decision maker monitors the revenue streams of the various products, services, and regional locations, operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the community banking services and branch locations are considered by management to be aggregated into one reportable operating segment, community banking.

NOTE 25 – FAIR VALUE

FASB ASC 820-10 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC 820-10 also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair values:

 

    Level 1 – Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 

    Level 2 – Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

 

    Level 3 – Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

Old National used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Investment securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Discounted cash flows are calculated using swap and LIBOR curves plus spreads that adjust for loss severities, volatility, credit risk, and optionality. During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.

Residential loans held for sale: The fair value of loans held for sale is determined using quoted prices for a similar asset, adjusted for specific attributes of that loan (Level 2).

Derivative financial instruments: The fair values of derivative financial instruments are based on derivative valuation models using market data inputs as of the valuation date (Level 2).

 

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Assets and liabilities measured at fair value on a recurring basis, including financial assets and liabilities for which we have elected the fair value option, are summarized below:

 

            Fair Value Measurements at June 30, 2018 Using  

(dollars in thousands)

   Carrying
Value
     Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 

Financial Assets

           

Trading securities

   $ 5,596      $ 5,596      $ —        $ —    

Investment securities available-for-sale:

           

U.S. Treasury

     5,257        5,257        —          —    

U.S. government-sponsored entities and agencies

     568,231        —          568,231        —    

Mortgage-backed securities - Agency

     1,448,526        —          1,448,526        —    

States and political subdivisions

     797,533        —          793,505        4,028  

Pooled trust preferred securities

     8,205        —          —          8,205  

Other securities

     353,913        30,259        323,654        —    

Residential loans held for sale

     26,198        —          26,198        —    

Derivative assets

     14,993        —          14,993        —    

Financial Liabilities

           

Derivative liabilities

     21,196        —          21,196        —    
            Fair Value Measurements at December 31, 2017 Using  

(dollars in thousands)

   Carrying
Value
     Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 

Financial Assets

           

Trading securities

   $ 5,584      $ 5,584      $ —        $ —    

Investment securities available-for-sale:

           

U.S. Treasury

     5,551        5,551        —          —    

U.S. government-sponsored entities and agencies

     664,286        —          664,286        —    

Mortgage-backed securities - Agency

     1,667,682        —          1,667,682        —    

States and political subdivisions

     530,193        —          530,193     

Pooled trust preferred securities

     8,448        —          —          8,448  

Other securities

     320,047        30,965        289,082        —    

Residential loans held for sale

     17,930        —          17,930        —    

Derivative assets

     14,118        —          14,118        —    

Financial Liabilities

           

Derivative liabilities

     16,292        —          16,292        —    

 

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The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3):

 

(dollars in thousands)

   Pooled Trust
Preferred
Securities
     States and
Political
Subdivisions
 

Six Months Ended June 30, 2018

     

Balance at beginning of period

   $ 8,448      $ —    

Accretion (amortization) of discount

     10        (18

Sales/payments received

     (305      —    

Increase (decrease) in fair value of securities

     52        (15

Transfers into Level 3

     —          4,061  
  

 

 

    

 

 

 

Balance at end of period

   $ 8,205      $ 4,028  
  

 

 

    

 

 

 

Six Months Ended June 30, 2017

     

Balance at beginning of period

   $ 8,119      $ —    

Accretion of discount

     8        —    

Sales/payments received

     (212      —    

Increase (decrease) in fair value of securities

     182        —    
  

 

 

    

 

 

 

Balance at end of period

   $ 8,097      $ —    
  

 

 

    

 

 

 

The accretion or amortization of discounts on securities in the table above is included in interest income. An increase in fair value is reflected in the balance sheet as an increase in the fair value of investment securities available-for-sale, an increase in accumulated other comprehensive income, which is included in shareholders’ equity, and a decrease in other assets related to the tax impact. A decrease in fair value is reflected in the balance sheet as a decrease in the fair value of investment securities available-for-sale, a decrease in accumulated other comprehensive income, which is included in shareholders’ equity, and an increase in other assets related to the tax impact. Old National transferred a $4.1 million state and political subdivisions security to Level 3 during the six months ended June 30, 2018 because Old National could no longer obtain evidence of observable inputs.

The table below provides quantitative information about significant unobservable inputs used in fair value measurements within Level 3 of the fair value hierarchy:

 

(dollars in thousands)

   Fair Value      Valuation
Techniques
    

Unobservable

Input

   Range (Weighted
Average)
 

June 30, 2018

           

Pooled trust preferred securities

   $ 8,205        Discounted cash flow      Constant prepayment rate (a)      0.00%  
         Additional asset defaults (b)      3.4% - 4.4% (4.1%)  
         Expected asset recoveries (c)      0.00%  

State and political subdivisions

     4,028        Discounted cash flow     

No observable inputs

Local municipality issuance Old National owns 100% Carried at par

     N/A  

December 31, 2017

           

Pooled trust preferred securities

   $ 8,448        Discounted cash flow      Constant prepayment rate (a)      0.00%  
         Additional asset defaults (b)      4.2% - 9.6% (7.5%)  
         Expected asset recoveries (c)   

 

0.0% - 4.1% (0.6%)

 

 

(a) Assuming no prepayments.
(b) Each currently performing pool asset is assigned a default probability based on the banking environment, which is adjusted for specific issuer evaluation, of 0%, 50%, or 100%.
(c) Each currently defaulted pool asset is assigned a recovery probability based on specific issuer evaluation of 0%, 25%, or 100%.

Significant changes in any of the unobservable inputs used in the fair value measurement in isolation would result in a significant change to the fair value measurement. The pooled trust preferred securities Old National owns are subordinate note classes that rely on an ongoing cash flow stream to support their values. The senior note classes

 

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receive the benefit of prepayments to the detriment of subordinate note classes since the ongoing interest cash flow stream is reduced by the early redemption. Generally, a change in prepayment rates or additional pool asset defaults has an impact that is directionally opposite from a change in the expected recovery of a defaulted pool asset.

Assets measured at fair value on a non-recurring basis at June 30, 2018 are summarized below:

 

            Fair Value Measurements at June 30, 2018 Using  

(dollars in thousands)

   Carrying
Value
     Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 

Collateral Dependent Impaired Loans:

           

Commercial loans

   $ 4,000      $ —        $ —        $ 4,000  

Commercial real estate loans

     20,375        —          —          20,375  

Foreclosed Assets:

           

Commercial real estate

     762        —          —          762  

Loan servicing rights

     158        —          158        —    

Impaired commercial and commercial real estate loans that are deemed collateral dependent are valued based on the fair value of the underlying collateral. These estimates are based on the most recently available appraisals with certain adjustments made based on the type of property, age of appraisal, current status of the property, and other related factors to estimate the current value of the collateral. These impaired commercial and commercial real estate loans had a principal amount of $37.1 million, with a valuation allowance of $12.7 million at June 30, 2018. Old National recorded provision expense associated with these loans totaling $4.9 million for the three months ended June 30, 2018 and $6.5 million for the six months ended June 30, 2018. Old National recorded provision expense associated with impaired commercial and commercial real estate loans that were deemed collateral dependent totaling $5.1 million for the three months ended June 30, 2017 and $6.2 million for the six months ended June 30, 2017.

Other real estate owned and other repossessed property is measured at fair value less costs to sell and had a net carrying amount of $0.8 million at June 30, 2018. The estimates of fair value are based on the most recently available appraisals with certain adjustments made based on the type of property, age of appraisal, current status of the property, and other related factors to estimate the current value of the collateral. There were write-downs of other real estate owned of $0.1 million for the three months ended June 30, 2018 and $0.4 million for the six months ended June 30, 2018. There were write-downs of other real estate owned of $0.8 million for the three months ended June 30, 2017 and $1.6 million for the six months ended June 30, 2017.

Loan servicing rights are evaluated for impairment based upon the fair value of the rights as compared to the carrying amount. If the carrying amount of an individual tranche exceeds fair value, impairment is recorded on that tranche so that the servicing asset is carried at fair value. Fair value is determined at a tranche level, based on market prices for comparable mortgage servicing contracts when available, or alternatively based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model utilizes a discount rate, weighted average prepayment speed, and other economic factors that market participants would use in estimating future net servicing income and that can be validated against available market data (Level 2). The valuation allowance for loan servicing rights with impairments at June 30, 2018 totaled $15 thousand. Old National recorded recoveries associated with these loan servicing rights totaling $4 thousand for the three months ended June 30, 2018 and $14 thousand for the six months ended June 30, 2018. There were impairments of loan servicing rights totaling $25 thousand for the three months ended June 30, 2017 and $7 thousand for the six months ended June 30, 2017.

 

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Assets measured at fair value on a non-recurring basis at December 31, 2017 are summarized below:

 

            Fair Value Measurements at December 31, 2017 Using  

(dollars in thousands)

   Carrying
Value
     Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 

Collateral Dependent Impaired Loans:

           

Commercial loans

   $ 2,217      $ —        $ —        $ 2,217  

Commercial real estate loans

     26,319        —          —          26,319  

Foreclosed Assets:

           

Commercial real estate

     1,726        —          —          1,726  

Residential

     55        —          —          55  

Loan servicing rights

     2,964        —          2,964        —    

At December 31, 2017, impaired commercial and commercial real estate loans had a principal amount of $38.6 million, with a valuation allowance of $10.1 million.

Other real estate owned and other repossessed property had a net carrying amount of $1.8 million at December 31, 2017.

The valuation allowance for loan servicing rights with impairments at December 31, 2017 totaled $29 thousand.

 

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The table below provides quantitative information about significant unobservable inputs used in fair value measurements within Level 3 of the fair value hierarchy:

 

(dollars in thousands)

   Fair Value     

Valuation
Techniques

  

Unobservable

Input

   Range (Weighted
Average)
 

June 30, 2018

           

Collateral Dependent Impaired Loans

 

        

Commercial loans

   $ 4,000      Fair value of collateral    Discount for type of property, age of appraisal, and current status      25% - 35% (30%)  

Commercial real estate loans

     20,375      Fair value of collateral    Discount for type of property, age of appraisal and current status      0% - 20% (10%)  

Foreclosed Assets

           

Commercial real estate

     762      Fair value of collateral    Discount for type of property, age of appraisal, and current status      8% - 41% (21%)  

December 31, 2017

           

Collateral Dependent Impaired Loans

 

        

Commercial loans

   $ 2,217      Fair value of collateral    Discount for type of property, age of appraisal, and current status      0% - 98% (49%)  

Commercial real estate loans

     26,319      Fair value of collateral    Discount for type of property, age of appraisal and current status      10% - 78% (32%)  

Foreclosed Assets

           

Commercial real estate

     1,726      Fair value of collateral    Discount for type of property, age of appraisal, and current status      7% - 25% (18%)  

Residential (1)

     55      Fair value of collateral    Discount for type of property, age of appraisal, and current status      39%  

 

(1) There was only one foreclosed residential asset at December 31, 2017, so no range or weighted average rate is reported.

Financial instruments recorded using fair value option

Under FASB ASC 825-10, we may elect to report most financial instruments and certain other items at fair value on an instrument-by instrument basis with changes in fair value reported in net income. After the initial adoption, the election is made at the acquisition of an eligible financial asset, financial liability or firm commitment or when certain specified reconsideration events occur. The fair value election may not be revoked once an election is made.

We have elected the fair value option for residential loans held for sale. For these loans, interest income is recorded in the consolidated statements of income based on the contractual amount of interest income earned on the financial assets (except any that are on nonaccrual status). None of these loans are 90 days or more past due, nor are any on nonaccrual status. Included in the income statement is interest income for loans held for sale totaling $40 thousand for the three months ended June 30, 2018 and $62 thousand for the six months ended June 30, 2018. Included in the income statement is interest income for loans held for sale totaling $41 thousand for the three months ended June 30, 2017 and $69 thousand for the six months ended June 30, 2017.

Residential loans held for sale

Old National has elected the fair value option for newly originated conforming fixed-rate and adjustable-rate first mortgage loans held for sale. These loans are intended for sale and are hedged with derivative instruments. Old National has elected the fair value option to mitigate accounting mismatches in cases where hedge accounting is complex and to achieve operational simplification. The fair value option was not elected for loans held for investment.

 

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The difference between the aggregate fair value and the aggregate remaining principal balance for loans for which the fair value option has been elected at June 30, 2018 and December 31, 2017 was as follows:

 

(dollars in thousands)

   Aggregate
Fair Value
     Difference      Contractual
Principal
 

June 30, 2018

        

Residential loans held for sale

   $ 26,198      $ 967      $ 25,231  
  

 

 

    

 

 

    

 

 

 

December 31, 2017

        

Residential loans held for sale

   $ 17,930      $ 546      $ 17,384  
  

 

 

    

 

 

    

 

 

 

Accrued interest at period end is included in the fair value of the instruments.

The following table presents the amount of gains and losses from fair value changes included in income before income taxes for financial assets carried at fair value:

 

(dollars in thousands)

   Other
Gains and
(Losses)
     Interest
Income
     Interest
(Expense)
     Total Changes
in Fair Values
Included in
Current Period
Earnings
 

Three Months Ended June 30, 2018

           

Residential loans held for sale

   $ 387      $ 3      $ —        $ 390  
  

 

 

    

 

 

    

 

 

    

 

 

 

Three Months Ended June 30, 2017

           

Residential loans held for sale

   $ 279      $ 1      $ —        $ 280  
  

 

 

    

 

 

    

 

 

    

 

 

 

Six Months Ended June 30, 2018

           

Residential loans held for sale

   $ 422      $ 3      $ (4    $ 421  
  

 

 

    

 

 

    

 

 

    

 

 

 

Six Months Ended June 30, 2017

           

Residential loans held for sale

   $ 697      $ 2      $ —        $ 699  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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The carrying amounts and estimated fair values of financial instruments not carried at fair value on the balance sheet at June 30, 2018 and December 31, 2017 were as follows:

 

            Fair Value Measurements at June 30, 2018 Using  

(dollars in thousands)

   Carrying
Value
     Quoted Prices in
Active Markets
for Identical
Assets

(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 

Financial Assets

           

Cash, due from banks, money market, and other interest-earning investments

   $ 273,874      $ 273,874      $ —        $ —    

Investment securities held-to-maturity:

           

U.S. government-sponsored entities and agencies

     73,570        —          71,284        —    

Mortgage-backed securities - Agency

     139,594        —          135,784        —    

State and political subdivisions

     312,554        —          317,529        —    

FHLB/Federal Reserve Bank stock

     136,206        N/A        N/A        N/A  

Loans, net:

           

Commercial

     2,941,508        —          —          2,845,502  

Commercial real estate

     4,429,274        —          —          4,330,899  

Residential real estate

     2,152,106        —          —          2,117,999  

Consumer credit

     1,719,081        —          —          1,669,906  

Accrued interest receivable

     81,290        13        23,122        58,155  

Financial Liabilities

           

Deposits:

           

Noninterest-bearing demand deposits

   $ 3,600,793      $ 3,600,793      $ —        $ —    

Checking, NOW, savings, and money market interest-bearing deposits

     7,171,033        7,171,033        —          —    

Time deposits

     1,824,550        —          1,822,203        —    

Federal funds purchased and interbank borrowings

     175,044        175,044        —          —    

Securities sold under agreements to repurchase

     347,511        347,511        —          —    

FHLB advances

     1,757,308        —          —          1,747,022  

Other borrowings

     250,241        —          249,150        —    

Accrued interest payable

     7,510        —          7,510        —    

Standby letters of credit

     397        —          —          397  

Off-Balance Sheet Financial Instruments

           

Commitments to extend credit

   $ —        $ —        $ —        $ 3,847  

 

N/A = not applicable

 

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            Fair Value Measurements at December 31, 2017 Using  

(dollars in thousands)

   Carrying
Value
     Quoted Prices in
Active Markets
for Identical
Assets

(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 

Financial Assets

           

Cash, due from banks, money market, and other interest-earning investments

   $ 290,432      $ 290,432      $ —        $ —    

Investment securities held-to-maturity:

           

Mortgage-backed securities - Agency

     6,903        —          7,056        —    

State and political subdivisions

     677,160        —          720,647        —    

FHLB/Federal Reserve Bank stock

     119,686        N/A        N/A        N/A  

Loans, net:

           

Commercial

     2,698,023        —          —          2,707,385  

Commercial real estate

     4,333,116        —          —          4,347,949  

Residential real estate

     2,165,290        —          —          2,210,951  

Consumer credit

     1,871,311        —          —          1,998,194  

Accrued interest receivable

     87,102        16        24,001        63,085  

Financial Liabilities

           

Deposits:

           

Noninterest-bearing demand deposits

   $ 3,680,807      $ 3,680,807      $ —        $ —    

Checking, NOW, savings, and money market interest-bearing deposits

     7,290,521        7,290,521        —          —    

Time deposits

     1,634,436        —          1,620,685        —    

Federal funds purchased and interbank borrowings

     335,033        335,033        —          —    

Securities sold under agreements to repurchase

     384,810        359,810        25,133        —    

FHLB advances

     1,609,579        —          —          1,607,189  

Other borrowings

     248,782        —          250,443        —    

Accrued interest payable

     7,029        —          7,029        —    

Standby letters of credit

     351        —          —          351  

Off-Balance Sheet Financial Instruments

           

Commitments to extend credit

   $ —        $ —        $ —        $ 2,449  

 

N/A = not applicable

The methods utilized to estimate the fair value of financial instruments at December 31, 2017 did not necessarily represent an exit price. In accordance with our adoption of ASU 2016-01 in 2018, the methods utilized to measure the fair value of financial instruments at June 30, 2018 represent an approximation of exit price, however, an actual exit price may differ.

 

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

The following discussion is an analysis of our results of operations for the three and six months ended June 30, 2018 and 2017, and financial condition as of June 30, 2018, compared to June 30, 2017 and December 31, 2017. This discussion and analysis should be read in conjunction with the consolidated financial statements and related notes. This discussion contains forward-looking statements concerning our business that are based on estimates and involves certain risks and uncertainties. Therefore, future results could differ significantly from our current expectations and the related forward-looking statements.

 

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FINANCIAL HIGHLIGHTS

The following table sets forth certain financial highlights of Old National:

 

     Three Months Ended     Six Months Ended  
(dollars and shares in thousands,    June 30,     March 31,     June 30,     June 30,  

except per share data)                

   2018     2018     2017     2018     2017  

Income Statement:

          

Net interest income

   $ 131,963     $ 128,572     $ 104,333     $ 260,535     $ 210,134  

Taxable equivalent adjustment (1)

     2,825       2,767       5,643       5,592       11,331  

Provision for loan losses

     2,446       380       1,355       2,826       1,702  

Noninterest income (2)

     49,289       41,905       49,271       91,194       92,191  

Noninterest expense (2)

     130,460       117,157       102,811       247,617       204,702  

Net income

     44,001       47,983       38,854       91,984       74,846  

Common Share Data:

          

Weighted average diluted shares

     152,568       152,370       135,697       152,483       135,641  

Net income (diluted)

   $ 0.29     $ 0.31     $ 0.28     $ 0.60     $ 0.55  

Cash dividends

     0.13       0.13       0.13       0.26       0.26  

Common dividend payout ratio (3)

     45     41     46     43     47

Book value

   $ 14.44     $ 14.32     $ 13.92     $ 14.44     $ 13.92  

Stock price

     18.60       16.90       17.25       18.60       17.25  

Tangible common book value (4)

     8.70       8.55       8.85       8.70       8.85  

Performance Ratios:

          

Return on average assets

     1.01     1.10     1.05     1.06     1.01

Return on average common equity

     8.06       8.86       8.33       8.46       8.11  

Return on tangible common equity (4)

     14.09       15.62       13.56       14.71       13.11  

Return on average tangible common equity (4)

     14.28       15.80       13.82       15.04       13.60  

Net interest margin (4)

     3.55       3.45       3.42       3.50       3.46  

Efficiency ratio (2)(4)

     69.58       65.84       64.05       67.76       64.35  

Net charge-offs (recoveries) to average loans

     (0.03     0.01       0.01       (0.01     0.01  

Allowance for loan losses to ending loans

     0.48       0.45       0.55       0.48       0.55  

Non-performing loans to ending loans

     1.38       1.28       1.51       1.38       1.51  

Balance Sheet:

          

Total loans

   $ 11,295,629     $ 11,238,682     $ 9,232,040     $ 11,295,629     $ 9,232,040  

Total assets

     17,482,990       17,496,287       14,957,281       17,482,990       14,957,281  

Total deposits

     12,596,376       12,788,600       10,683,714       12,596,376       10,683,714  

Total borrowed funds

     2,530,104       2,371,292       2,259,918       2,530,104       2,259,918  

Total shareholders’ equity

     2,200,215       2,179,118       1,886,594       2,200,215       1,886,594  

Nonfinancial Data:

          

Full-time equivalent employees

     2,683       2,721       2,652       2,683       2,652  

Banking centers

     183       191       188       183       188  

 

(1) Calculated using the federal statutory tax rate in effect of 21% for the three and six months ended June 30, 2018 and three months ended March 31, 2018 and 35% for the three and six months ended June 30, 2017.
(2) For the three months ended March 31, 2018, amounts reflect the reclassification of $0.5 million of agency costs from data processing expense to investment product fees revenue as a result of the implementation of the revenue recognition accounting standard.
(3) Cash dividends per share divided by net income per share (basic).
(4) Represents a non-GAAP financial measure. Refer to the “Non-GAAP Financial Measures” section for reconciliations to GAAP financial measures.

 

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NON-GAAP FINANCIAL MEASURES

Non-GAAP financial measures exclude certain items that are included in the financial results presented in accordance with GAAP. Management believes these non-GAAP financial measures enhance an investor’s understanding of the financial results of Old National by providing a meaningful basis for period-to-period comparisons, assisting in operating results analysis, and predicting future performance.

The following table presents GAAP to non-GAAP reconciliations.

 

(dollars and shares in thousands,   

Three Months Ended

June 30,

   

Six Months Ended

June 30,

 

except per share data)                

   2018     2017     2018     2017  

Tangible common book value:

        

Shareholders’ equity (GAAP)

   $ 2,200,215     $ 1,886,594     $ 2,200,215     $ 1,886,594  

Deduct: Goodwill

     828,804       655,018       828,804       655,018  

Intangible assets

     45,417       31,876       45,417       31,876  
  

 

 

   

 

 

   

 

 

   

 

 

 

Tangible shareholders’ equity (non-GAAP)

   $ 1,325,994     $ 1,199,700     $ 1,325,994     $ 1,199,700  
  

 

 

   

 

 

   

 

 

   

 

 

 

Period end common shares

     152,351       135,516       152,351       135,516  

Tangible common book value

     8.70       8.85       8.70       8.85  

Return on tangible common equity:

        

Net income (GAAP)

   $ 44,001     $ 38,854     $ 91,984     $ 74,846  

Add: Intangible amortization (net of tax)

     2,699       1,807       5,550       3,770  
  

 

 

   

 

 

   

 

 

   

 

 

 

Tangible net income (non-GAAP)

   $ 46,700     $ 40,661     $ 97,534     $ 78,616  
  

 

 

   

 

 

   

 

 

   

 

 

 

Tangible shareholders’ equity (non-GAAP) (see above)

   $ 1,325,994     $ 1,199,700     $ 1,325,994     $ 1,199,700  

Return on tangible common equity

     14.09     13.56     14.71     13.11

Return on average tangible common equity:

        

Tangible net income (non-GAAP) (see above)

   $ 46,700     $ 40,661     $ 97,534     $ 78,616  

Average shareholders’ equity (GAAP)

   $ 2,183,604     $ 1,865,318     $ 2,174,878     $ 1,845,598  

Deduct: Average goodwill

     828,804       655,018       828,474       655,018  

Average intangible assets

     47,052       33,189       49,061       34,635  
  

 

 

   

 

 

   

 

 

   

 

 

 

Average tangible shareholders’ equity (non-GAAP)

   $ 1,307,748     $ 1,177,111     $ 1,297,343     $ 1,155,945  
  

 

 

   

 

 

   

 

 

   

 

 

 

Return on average tangible common equity

     14.28     13.82     15.04     13.60

Net interest margin:

        

Net interest income (GAAP)

   $ 131,963     $ 104,333     $ 260,535     $ 210,134  

Taxable equivalent adjustment

     2,825       5,643       5,592       11,331  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income - taxable equivalent basis (non-GAAP)

   $ 134,788     $ 109,976     $ 266,127     $ 221,465  
  

 

 

   

 

 

   

 

 

   

 

 

 

Average earning assets

   $ 15,176,711     $ 12,844,504     $ 15,191,220     $ 12,793,962  

Net interest margin

     3.55     3.42     3.50     3.46

Efficiency ratio:

        

Noninterest expense (GAAP)

   $ 130,460     $ 102,811     $ 247,617     $ 204,702  

Deduct: Intangible amortization expense

     3,416       2,781       7,025       5,801  
  

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted noninterest expense (non-GAAP)

   $ 127,044     $ 100,030     $ 240,592     $ 198,901  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income - taxable equivalent basis (non-GAAP) (see above)

   $ 134,788     $ 109,976     $ 266,127     $ 221,465  

Noninterest income

     49,289       49,271       91,194       92,191  

Deduct: Net securities gains (losses)

     1,494       3,075       2,282       4,575  
  

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted total revenue (non-GAAP)

   $ 182,583     $ 156,172     $ 355,039     $ 309,081  
  

 

 

   

 

 

   

 

 

   

 

 

 

Efficiency ratio

     69.58     64.05     67.76     64.35

 

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Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited. Although these non-GAAP financial measures are frequently used by investors to evaluate a company, they have limitations as analytical tools, and should not be considered in isolation, or as a substitute for analyses of results as reported under GAAP. These non-GAAP measures are not necessarily comparable to similar measures that may be represented by other companies.

EXECUTIVE SUMMARY

During the second quarter of 2018, net income was $44.0 million, or $0.29 per diluted share. Net income was $38.9 million, or $0.28 per diluted share, for the second quarter of 2017.

Management’s strategy is basic banking – loan growth, fee income, and expense management. Simply put, our low-cost core deposits fuel our commercial loan growth. That loan growth is filtered through our staunch credit process. Underpinning all that we do is management’s focus on controlling costs. Management is committed to driving and sustaining positive operating leverage.

We continue to benefit from re-mixing our earning assets by replacing lower yielding assets, like indirect auto loans, with higher yielding assets, like commercial loans.

Loan Growth: Our loan balances, excluding loans held for sale, grew $56.9 million to $11.296 billion at June 30, 2018 compared to $11.239 billion at March 31, 2018. Commercial and industrial loans continue to be the driver of our loan growth. This is attributable to our focus on our growth markets as well as our earning asset re-mix strategy. Commercial loan growth was partially offset by the sale of the student loan portfolio totaling $64.9 million during the second quarter of 2018.

Net Interest Income: For the six months ended June 30, 2018, compared to the six months ended June 30, 2017 our net interest income increased primarily due to volume from the Anchor (MN) acquisition in November 2017 and increased loan yields. This was further augmented by our low cost of deposits over the same period. The second quarter of 2018 compared to the first quarter of 2018 increased similarly with increased commercial and industrial loan volume outpacing a slight increase in deposit and borrowing costs.

Fee Income: Fee income decreased slightly to $91.2 million from $92.2 million for the six months ended June 30, 2018 when compared to the six months ended June 30, 2017 due to lower capital markets income and lower securities gains, partially offset by the volume increases due to the acquisition of Anchor (MN) in November 2017. For the second quarter of 2018 compared to the first quarter of 2018, our fee income increased to $49.3 million from $41.9 million, substantially due to a few larger items in other income and seasonality in wealth management fee income and mortgage banking revenue.

Expenses: Noninterest expenses increased $42.9 million, or 21%, for the six months ended June 30, 2018 when compared to the six months ended June 30, 2017. The increase was primarily attributable to higher expenses associated with the Anchor (MN) partnership. Also contributing to the increase in noninterest expense was amortization of tax credit investments totaling $12.6 million for the six months ended June 30, 2018 reflecting the completion of investment tax credit projects during 2018. As previously disclosed, we have consolidated 157 branches since the beginning of 2011 and have entered into a branch purchase and assumption agreement for the sale of ten Old National branches in Wisconsin to Marine Credit Union of La Crosse, Wisconsin. The branch sale includes the assumption of approximately $261 million in deposits and no loans. Subject to regulatory approval and other terms and conditions, the sale is expected to close in the fourth quarter of 2018. For the remainder of 2018, we are evaluating the Old National franchise for additional consolidation opportunities.

We remain an active looker and a selective, disciplined buyer in demographically accretive markets when it comes to future partnerships. We believe our ability to bring an enhanced product set and a larger balance sheet with better capital allows a potential partner to better serve their clients. As previously disclosed, we do not feel compelled to enter into a partnership.

 

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RESULTS OF OPERATIONS

The following table sets forth certain income statement information of Old National for the three and six months ended June 30, 2018 and 2017:

 

     Three Months Ended           Six Months Ended        
     June 30,     %     June 30,     %  

(dollars in thousands)

   2018     2017     Change     2018     2017     Change  

Income Statement Summary:

            

Net interest income

   $ 131,963     $ 104,333       26.5   $ 260,535     $ 210,134       24.0

Provision for loan losses

     2,446       1,355       80.5       2,826       1,702       66.0  

Noninterest income

     49,289       49,271       0.0       91,194       92,191       (1.1

Noninterest expense

     130,460       102,811       26.9       247,617       204,702       21.0  

Other Data:

            

Return on average common equity

     8.06     8.33       8.46     8.11  

Return on tangible common equity (1)

     14.09       13.56         14.71       13.11    

Return on average tangible common equity (1)

     14.28       13.82         15.04       13.60    

Efficiency ratio (1)

     69.58       64.05         67.76       64.35    

Tier 1 leverage ratio

     8.30       8.65         8.30       8.65    

Net charge-offs (recoveries) to average loans

     (0.03     0.01         (0.01     0.01    

 

(1) Represents a non-GAAP financial measure. Refer to “Non-GAAP Financial Measures” section for reconciliations to GAAP financial measures.

Net Interest Income

Net interest income is the most significant component of our earnings, comprising 74% of revenues for the six months ended June 30, 2018. Net interest income and margin are influenced by many factors, primarily the volume and mix of earning assets, funding sources, and interest rate fluctuations. Other factors include the level of accretion income on purchased loans, prepayment risk on mortgage and investment-related assets, and the composition and maturity of earning assets and interest-bearing liabilities.

The Federal Reserve increased the discount rate 25 basis points at both of their March and June 2018 meetings. The rate increases were driven by the Federal Reserve’s inflation and wage pressure expectations in conjunction with a moderately expanding economy. The Treasury yield curve flattened as short-term rates rose while long-term interest rates remained flat. Collectively, these factors marginally improved the outlook for our net interest income and margin.

Loans typically generate more interest income than investment securities with similar maturities. Funding from client deposits generally costs less than wholesale funding sources. Factors such as general economic activity, Federal Reserve monetary policy, and price volatility of competing alternative investments, can also exert significant influence on our ability to optimize the mix of assets and funding and the net interest income and margin.

 

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Net interest income is the excess of interest received from earning assets over interest paid on interest-bearing liabilities. For analytical purposes, net interest income is also presented in the table that follows, adjusted to a taxable equivalent basis to reflect what our tax-exempt assets would need to yield in order to achieve the same after-tax yield as a taxable asset. We used the federal statutory tax rate in effect of 21% for the three and six months ended June 30, 2018, compared to 35% for the three and six months ended June 30, 2017. This analysis portrays the income tax benefits associated in tax-exempt assets and helps to facilitate a comparison between taxable and tax-exempt assets. Management believes that it is a standard practice in the banking industry to present net interest margin and net interest income on a fully taxable equivalent basis. Therefore, management believes these measures provide useful information for both management and investors by allowing them to make peer comparisons.

 

     Three Months Ended     Six Months Ended  
     June 30,     June 30,  

(dollars in thousands)

   2018     2017     2018     2017  

Net interest income

   $ 131,963     $ 104,333     $ 260,535     $ 210,134  

Conversion to fully taxable equivalent

     2,825       5,643       5,592       11,331  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income - taxable equivalent basis

   $ 134,788     $ 109,976     $ 266,127     $ 221,465  
  

 

 

   

 

 

   

 

 

   

 

 

 

Average earning assets

   $ 15,176,711     $ 12,844,504     $ 15,191,220     $ 12,793,962  

Net interest margin

     3.48     3.25     3.43     3.28

Net interest margin - taxable equivalent basis

     3.55     3.42     3.50     3.46

The increase in net interest income for the three and six months ended June 30, 2018 when compared to the same periods in 2017 was primarily due to higher average earning assets of $2.332 billion in the three months ended June 30, 2018 when compared to the three months ended June 30, 2017 and $2.397 billion in the six months ended June 30, 2018 when compared to the six months ended June 30, 2017. Partially offsetting the higher average earning assets were higher average interest-bearing liabilities of $1.612 billion in the three months ended June 30, 2018 when compared to the three months ended June 30, 2017 and $1.642 billion in the six months ended June 30, 2018 when compared to the six months ended June 30, 2017. Interest income in the three and six months ended June 30, 2018 included lower fully taxable equivalent interest income resulting from the income tax rate decrease to 21% in 2018. Net interest income for the three and six months ended June 30, 2018 and 2017 included accretion income (interest income in excess of contractual interest income) associated with acquired loans. Accretion income totaled $11.5 million in the three months ended June 30, 2018 and $22.5 million in the six months June 30, 2018, compared to $9.7 million in the three months ended June 30, 2017 and $22.3 million in the six months ended June 30, 2017. We expect accretion income on our PCI loans to decrease over time, but this may be offset by future acquisitions.

 

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The following tables present the average balance sheet for each major asset and liability category, its related interest income and yield, or its expense and rate for the three and six months ended June 30, 2018 and 2017.

 

     Three Months Ended     Three Months Ended  

(dollars in thousands)

   June 30, 2018     June 30, 2017  
     Average     Income (1)/      Yield/     Average     Income (1)/      Yield/  
     Balance     Expense      Rate     Balance     Expense      Rate  

Earning Assets

              

Money market and other interest-earning investments

   $ 51,724     $ 117        0.91   $ 27,222     $ 55        0.80

Investment securities:

              

Treasury and government sponsored agencies

     648,778       3,387        2.09     575,940       2,798        1.94

Mortgage-backed securities

     1,588,140       8,904        2.24     1,485,582       7,590        2.04

States and political subdivisions

     1,118,395       10,591        3.79     1,122,769       13,375        4.76

Other securities

     507,646       3,909        3.08     446,521       2,866        2.57
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total investment securities

     3,862,959       26,791        2.77     3,630,812       26,629        2.93
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Loans: (2)

              

Commercial

     2,873,781       32,527        4.48     1,938,751       19,352        3.95

Commercial real estate

     4,449,839       57,251        5.09     3,240,318       39,830        4.86

Residential real estate loans

     2,177,587       22,208        4.08     2,127,867       21,268        4.00

Consumer

     1,760,821       17,667        4.02     1,879,534       16,718        3.57
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total loans

     11,262,028       129,653        4.57     9,186,470       97,168        4.21
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total earning assets

     15,176,711     $ 156,561        4.11     12,844,504     $ 123,852        3.84
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Less: Allowance for loan losses

     (51,493          (50,937     

Non-earning Assets

              

Cash and due from banks

     205,617            200,209       

Other assets

     2,086,822            1,860,676       
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total assets

   $ 17,417,657          $ 14,854,452       
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Interest-Bearing Liabilities

              

Checking and NOW accounts

   $ 3,097,635     $ 969        0.13   $ 2,643,123     $ 511        0.08

Savings accounts

     3,036,936       1,777        0.23     2,944,314       1,209        0.16

Money market accounts

     1,103,177       702        0.26     684,911       146        0.09

Time deposits

     1,810,328       5,691        1.26     1,441,998       2,858        0.80
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing deposits

     9,048,076       9,139        0.41     7,714,346       4,724        0.25
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Federal funds purchased and interbank borrowings

     140,471       647        1.85     166,690       422        1.02

Securities sold under agreements to repurchase

     332,599       434        0.52     329,182       334        0.41

FHLB advances

     1,713,832       8,824        2.07     1,443,453       6,017        1.67

Other borrowings

     249,291       2,729        4.38     219,085       2,379        4.34
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total borrowed funds

     2,436,193       12,634        2.08     2,158,410       9,152        1.70
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing liabilities

   $ 11,484,269     $ 21,773        0.76   $ 9,872,756     $ 13,876        0.56
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Noninterest-Bearing Liabilities

              

Demand deposits

   $ 3,602,732          $ 2,988,147       

Other liabilities

     147,052            128,231       

Shareholders’ equity

     2,183,604            1,865,318       
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total liabilities and shareholders’ equity

   $ 17,417,657          $ 14,854,452       
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Net interest rate spread

          3.35          3.28

Net interest margin (3)

          3.55          3.42

Taxable equivalent adjustment

     $ 2,825          $ 5,643     

 

(1) Interest income is reflected on a fully taxable equivalent basis.
(2) Includes loans held for sale.
(3) Net interest margin is defined as net interest income on a tax equivalent basis as a percentage of average earning assets.

 

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     Six Months Ended     Six Months Ended  

(dollars in thousands)

   June 30, 2018     June 30, 2017  
     Average     Income (1)/      Yield/     Average     Income (1)/      Yield/  
     Balance     Expense      Rate     Balance     Expense      Rate  

Earning Assets

              

Money market and other interest-earning investments

   $ 59,089     $ 207        0.71   $ 27,352     $ 86        0.63

Investment securities:

              

Treasury and government sponsored agencies

     655,897       6,811        2.08     558,279       5,579        2.00

Mortgage-backed securities

     1,610,252       18,424        2.29     1,498,414       15,408        2.06

States and political subdivisions

     1,161,386       21,069        3.63     1,128,042       26,981        4.78

Other securities

     483,685       7,578        3.13     445,881       5,694        2.55
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total investment securities

     3,911,220       53,882        2.76     3,630,616       53,662        2.96
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Loans: (2)

              

Commercial

     2,817,050       60,733        4.29     1,913,480       38,440        4.00

Commercial real estate

     4,422,075       113,037        5.08     3,205,853       80,154        4.97

Residential real estate loans

     2,177,003       43,680        4.01     2,134,681       42,522        3.98

Consumer

     1,804,783       35,495        3.97     1,881,980       33,144        3.55
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total loans

     11,220,911       252,945        4.50     9,135,994       194,260        4.25
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total earning assets

     15,191,220     $ 307,034        4.04     12,793,962     $ 248,008        3.87
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Less: Allowance for loan losses

     (51,225          (50,824     

Non-earning Assets

              

Cash and due from banks

     202,392            197,927       

Other assets

     2,088,299            1,869,215       
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total assets

   $ 17,430,686          $ 14,810,280       
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Interest-Bearing Liabilities

              

Checking and NOW accounts

   $ 3,082,619     $ 1,788        0.12   $ 2,614,627     $ 967        0.07

Savings accounts

     3,044,748       3,120        0.21     2,957,020       2,367        0.16

Money market accounts

     1,130,939       1,248        0.22     695,890       295        0.09

Time deposits

     1,773,859       10,238        1.16     1,441,218       5,478        0.77
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing deposits

     9,032,165       16,394        0.37     7,708,755       9,107        0.24
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Federal funds purchased and interbank borrowings

     200,578       1,664        1.67     177,818       778        0.88

Securities sold under agreements to repurchase

     337,612       793        0.47     330,285       590        0.36

FHLB advances

     1,694,871       16,604        1.98     1,436,752       11,329        1.59

Other borrowings

     249,062       5,452        4.38     219,025       4,739        4.33
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total borrowed funds

     2,482,123       24,513        1.99     2,163,880       17,436        1.62
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing liabilities

   $ 11,514,288     $ 40,907        0.72   $ 9,872,635     $ 26,543        0.54
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Noninterest-Bearing Liabilities

              

Demand deposits

   $ 3,583,027          $ 2,952,797       

Other liabilities

     158,493            139,250       

Shareholders’ equity

     2,174,878            1,845,598       
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total liabilities and shareholders’ equity

   $ 17,430,686          $ 14,810,280       
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Net interest rate spread

          3.32          3.33

Net interest margin (3)

          3.50          3.46

Taxable equivalent adjustment

     $ 5,592          $ 11,331     

 

(1) Interest income is reflected on a fully taxable equivalent basis.
(2) Includes loans held for sale.
(3) Net interest margin is defined as net interest income on a tax equivalent basis as a percentage of average earning assets.

 

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The following table presents the dollar amount of changes in taxable equivalent net interest income attributable to changes in the average balances of assets and liabilities and the yields earned or rates paid for the three and six months ended June 30, 2018 and 2017.

 

     From Three Months Ended     From Six Months Ended  
     June 30, 2017 to Three     June 30, 2017 to Six  
     Months Ended June 30, 2018     Months Ended June 30, 2018  
     Total      Attributed to     Total      Attributed to  

(dollars in thousands)

   Change      Volume     Rate     Change      Volume      Rate  

Interest Income

               

Money market and other interest-earning investments

   $ 62      $ 51     $ 11     $ 121      $ 105      $ 16  

Investment securities (1)

     162        1,657       (1,495     220        4,006        (3,786

Loans (1)

     32,485        22,944       9,541       58,685        45,729        12,956  
  

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

Total interest income

     32,709        24,652       8,057       59,026        49,840        9,186  
  

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

Interest Expense

               

Checking and NOW deposits

     458        115       343       821        221        600  

Savings deposits

     568        45       523       753        77        676  

Money market deposits

     556        177       379       953        331        622  

Time deposits

     2,833        942       1,891       4,760        1,585        3,175  

Federal funds purchased and interbank borrowings

     225        (94     319       886        141        745  

Securities sold under agreements to repurchase

     100        4       96       203        14        189  

FHLB advances

     2,807        1,259       1,548       5,275        2,278        2,997  

Other borrowings

     350        329       21       713        654        59  
  

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

Total interest expense

     7,897        2,777       5,120       14,364        5,301        9,063  
  

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

Net interest income

   $ 24,812      $ 21,875     $ 2,937     $ 44,662      $ 44,539      $ 123  
  

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

The variance not solely due to rate or volume is allocated equally between the rate and volume variances.

 

(1) Interest on investment securities and loans includes the effect of taxable equivalent adjustments of $1.1 million and $1.8 million, respectively, during the three months ended June 30, 2018; and $2.1 million and $3.5 million, respectively, during the six months ended June 30, 2018; using the federal statutory rate in effect of 21%.

The increase in the net interest margin on a fully taxable equivalent basis for the three and six months ended June 30, 2018 when compared to the same periods in 2017 was primarily due to higher yield on interest earning assets and a change in the mix of average interest earning assets and interest-bearing liabilities, partially offset by higher costs of interest-bearing liabilities. The yield on interest earning assets increased 27 basis points and the cost of interest-bearing liabilities increased 20 basis points in the quarterly year-over-year comparison. The yield on interest earning assets is calculated by dividing annualized taxable equivalent net interest income by average interest earning assets while the cost of interest-bearing liabilities is calculated by dividing annualized interest expense by average interest-bearing liabilities. Accretion income represented 30 basis points of the net interest margin for the three months ended June 30, 2018 and 2017. The increase in the net interest margin for the six months ended June 30, 2018 was also partially offset by lower yields associated with accretion income on acquired loans. Accretion income represented 30 basis points of the net interest margin for the six months ended June 30, 2018, compared to 35 basis points of the net interest margin for the six months ended June 30, 2017. The yield on interest earning assets increased 17 basis points and the cost of interest-bearing liabilities increased 18 basis points in the six months ended June 30, 2018 when compared to the six months ended June 30, 2017.

Average earning assets were $15.177 billion for the three months ended June 30, 2018, compared to $12.845 billion for the three months ended June 30, 2017, an increase of $2.332 billion, or 18%. Average earning assets were $15.191 billion for the six months ended June 30, 2018, compared to $12.794 billion for the six months ended June 30, 2017, an increase of $2.397 billion, or 19%. The increases in average earning assets were primarily due to our acquisition of Anchor (MN) in November 2017. The loan portfolio including loans held for sale, which generally has an average yield higher than the investment portfolio, was approximately 74% of average interest earning assets for the six months ended June 30, 2018, compared to 71% for the six months ended June 30, 2017.

 

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Average loans including loans held for sale increased $2.076 billion for the three months ended June 30, 2018 and $2.085 billion for the six months ended June 30, 2018 when compared to the same periods in 2017 reflecting organic loan growth, as well as an increase attributable to loans acquired from Anchor (MN) in November 2017. Loans including loans held for sale attributable to the Anchor (MN) acquisition totaled $1.595 billion as of the closing date of the acquisition, which was November 1, 2017.

Average investments increased $232.1 million for the three months ended June 30, 2018 and $280.6 million for the six months ended June 30, 2018 when compared to the same periods in 2017 reflecting the Anchor (MN) acquisition.

Average noninterest-bearing deposits increased $614.6 million for the three months ended June 30, 2018 and $630.2 million for the six months ended June 30, 2018 when compared to the same periods in 2017. Average interest-bearing deposits increased $1.334 billion for the three months ended June 30, 2018 and $1.323 billion for the six months ended June 30, 2018 when compared to the same periods in 2017. The increases in average deposits also reflected the Anchor (MN) acquisition.

Average borrowed funds increased $277.8 million for the three months ended June 30, 2018 and $318.2 million for the six months ended June 30, 2018 when compared to the same periods in 2017 primarily due to increased funding needed as a result of growth in our loan portfolio that outpaced deposit growth.

Provision for Loan Losses

The provision for loan losses was $2.4 million for the three months ended June 30, 2018, compared to $1.4 million for the three months ended June 30, 2017. Net recoveries totaled $0.8 million during the three months ended June 30, 2018, compared to net charge-offs of $0.2 million during the three months ended June 30, 2017. The provision for loan losses was $2.8 million for the six months ended June 30, 2018, compared to $1.7 million for the six months ended June 30, 2017. Net recoveries totaled $0.5 million during the six months ended June 30, 2018, compared to net charge-offs of $0.5 million during the six months ended June 30, 2017. The higher provision for loan losses is the result of loan growth and increases in the allowance for loan losses related to loans individually evaluated for impairment, partially offset by lower incurred loss rate expectations. Continued loan growth in future periods, a decline in our current level of recoveries, or an increase in charge-offs could result in an increase in provision expense.

 

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Noninterest Income

We generate revenues in the form of noninterest income through client fees, sales commissions, and other gains and losses from our core banking franchise and other related businesses, such as wealth management, investment consulting, and investment products. The following table details the components in noninterest income for the three and six months ended June 30, 2018 and 2017:

 

     Three Months Ended            Six Months Ended         
     June 30,      %     June 30,      %  

(dollars in thousands)

   2018      2017      Change     2018      2017      Change  

Wealth management fees

   $ 9,746      $ 9,679        0.7   $ 18,772      $ 18,678        0.5

Service charges on deposit accounts

     10,765        10,040        7.2       21,524        19,883        8.3  

Debit card and ATM fees

     5,080        4,436        14.5       9,945        8,672        14.7  

Mortgage banking revenue

     5,189        5,186        0.1       9,381        9,412        (0.3

Investment product fees

     5,066        5,004        1.2       10,097        9,993        1.0  

Capital markets income

     896        2,747        (67.4     1,394        3,778        (63.1

Company-owned life insurance

     2,430        2,117        14.8       5,035        4,266        18.0  

Net securities gains (losses)

     1,494        3,075        (51.4     2,282        4,575        (50.1

Recognition of deferred gain on sale leaseback transactions

     394        538        (26.8     789        1,075        (26.6

Other income

     8,229        6,449        27.6       11,975        11,859        1.0  
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total noninterest income

   $ 49,289      $ 49,271        0.0   $ 91,194      $ 92,191        (1.1 )% 
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

The increase in noninterest income for the three months ended June 30, 2018 when compared to the three months ended June 30, 2017 was primarily due to higher noninterest income attributable to the Anchor (MN) acquisition. These increases were substantially offset by 2017 recoveries on loans originated by AnchorBank (WI) that had been fully charged-off prior to the acquisition totaling $1.6 million, lower capital markets income, and lower net securities gains.

The decrease in noninterest income for the six months ended June 30, 2018 when compared to the six months ended June 30, 2017 was primarily due to 2017 recoveries on loans originated by AnchorBank (WI) that had been fully charged-off prior to the acquisition totaling $3.1 million, lower net securities gains, and lower capital markets income. These decreases were substantially offset by higher noninterest income attributable to the Anchor (MN) acquisition.

Service charges and overdraft fees increased $0.7 million for the three months ended June 30, 2018 and $1.6 million for the six months ended June 30, 2018 when compared to the same periods in 2017 primarily due to higher service charges and overdraft fees attributable to the Anchor (MN) acquisition.

Debit card and ATM fees increased $0.6 million for the three months ended June 30, 2018 and $1.3 million for the six months ended June 30, 2018 when compared to the same periods in 2017 primarily due to higher interchange income attributable to the Anchor (MN) acquisition.

Capital markets income is comprised of customer interest rate swap fees, foreign currency exchange fees, and net gains (losses) on foreign currency adjustments. Capital markets income decreased $1.9 million for the three months ended June 30, 2018 and $2.4 million for the six months ended June 30, 2018 when compared to the same periods in 2017 primarily due to lower customer interest rate swap fees.

Net securities gains decreased $1.6 million for the three months ended June 30, 2018 and $2.3 million for the six months ended June 30, 2018 when compared to the same periods in 2017 primarily due to lower realized gains on sales of available-for-sale securities in 2018.

Other income increased $1.8 million for the three months ended June 30, 2018 when compared to the three months ended June 30, 2017 primarily due to a $2.2 million gain on the sale of our student loan portfolio in the second quarter of 2018 and higher other income attributable to the Anchor (MN) acquisition. These increases were partially offset by lower other income resulting from second quarter 2017 recoveries on loans originated by AnchorBank (WI) that had been fully charged-off prior to the acquisition totaling $1.6 million and lower gains on sales of fixed assets totaling $1.2 million.

 

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Noninterest Expense

The following table details the components in noninterest expense for the three and six months ended June 30, 2018 and 2017:

 

     Three Months Ended            Six Months Ended         
     June 30,      %     June 30,      %  

(dollars in thousands)

   2018      2017      Change     2018      2017      Change  

Salaries and employee benefits

   $ 66,592      $ 57,606        15.6   $ 130,771      $ 114,170        14.5

Occupancy

     12,873        10,539        22.1       26,153        22,673        15.3  

Equipment

     3,728        3,350        11.3       7,293        6,577        10.9  

Marketing

     3,962        3,673        7.9       7,659        6,723        13.9  

Data processing

     9,724        8,226        18.2       18,124        15,834        14.5  

Communication

     2,772        2,288        21.2       5,836        4,702        24.1  

Professional fees

     2,923        4,077        (28.3     5,653        6,728        (16.0

Loan expenses

     1,843        1,693        8.9       3,587        3,324        7.9  

Supplies

     903        594        52.0       1,625        1,173        38.5  

FDIC assessment

     3,161        2,130        48.4       5,806        4,617        25.8  

Other real estate owned expense

     196        1,009        (80.6     545        2,124        (74.3

Amortization of intangibles

     3,416        2,781        22.8       7,025        5,801        21.1  

Amortization of tax credit investments

     11,858        —          N/M       12,574        —          N/M  

Other expense

     6,509        4,845        34.3       14,966        10,256        45.9  
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total noninterest expense

   $ 130,460      $ 102,811        26.9   $ 247,617      $ 204,702        21.0
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

N/M = Not meaningful

Noninterest expense increased $27.6 million for the three months ended June 30, 2018 when compared to the three months ended June 30, 2017 primarily due to amortization of tax credit investments totaling $11.9 million for the three months ended June 30, 2018 reflecting the completion of investment tax credit projects during 2018. Also contributing to the increase in noninterest expense were $9.5 million of operating expenses and $2.4 million of acquisition and integration costs associated with Anchor (MN).

Noninterest expense increased $42.9 million for the six months ended June 30, 2018 when compared to the six months ended June 30, 2017 primarily due to $21.0 million of operating expenses and $4.7 million of acquisition and integration costs associated with Anchor (MN). Also contributing to the increase in noninterest expense was amortization of tax credit investments totaling $12.6 million for the six months ended June 30, 2018 reflecting the completion of investment tax credit projects during 2018.

Salaries and benefits is the largest component of noninterest expense. Salaries and benefits increased $9.0 million for the three months ended June 30, 2018 and $16.6 million for the six months ended June 30, 2018 when compared to the same periods in 2017 primarily due to higher salaries and benefits associated with the Anchor (MN) acquisition and higher profit sharing expenses. During the second quarter of 2018, Old National increased its 401(k) match to 75% of employee compensation deferral contributions of the first 4% of compensation, and 50% of the next 4% of compensation. The change was retroactive for all of 2018. For 2017, we matched 50% of employee compensation deferral contributions, up to 6% of compensation.

Occupancy expenses increased $2.3 million for the three months ended June 30, 2018 and $3.5 million for the six months ended June 30, 2018 when compared to the same periods in 2017 primarily due to higher occupancy expenses attributable to the Anchor (MN) acquisition. Also contributing to the increases in occupancy expenses were higher real estate taxes of $0.7 million in the three months ended June 30, 2018 and $0.9 million for the six months ended June 30, 2018 when compared to the same periods in 2017.

 

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Data processing expenses increased $1.5 million for the three months ended June 30, 2018 and $2.3 million for the six months ended June 30, 2018 when compared to the same periods in 2017 primarily due to integration expenses associated with the Anchor (MN) acquisition.

Communication expenses increased $0.5 million for the three months ended June 30, 2018 and $1.1 million for the six months ended June 30, 2018 when compared to the same periods in 2017 primarily due to integration expenses associated with the Anchor (MN) acquisition.

Professional fees decreased $1.2 million for the three months ended June 30, 2018 and $1.1 million for the six months ended June 30, 2018 when compared to the same periods in 2017 primarily due to $1.0 million of pre-tax expenses recorded in the second quarter of 2017 related to an initiative to improve how we serve our clients and increase efficiency.

FDIC assessment expenses increased $1.0 million for the three months ended June 30, 2018 and $1.2 million for the six months ended June 30, 2018 when compared to the same periods in 2017 primarily due to the addition of Anchor (MN).

Amortization of intangibles increased $0.6 million for the three months ended June 30, 2018 and $1.2 million for the six months ended June 30, 2018 when compared to the same periods in 2017 primarily due to amortization of core deposit intangibles related to the Anchor (MN) acquisition.

Amortization of tax credit investments was $11.9 million for the three months ended June 30, 2018 and $12.6 million for the six months ended June 30, 2018 reflecting the completion of investment tax credit projects during 2018. There was no amortization related to tax credit investments recorded in noninterest expense for the three or six months ended June 30, 2017. We anticipate amortization of tax credit investments including discrete tax items of approximately $15 million to $18 million in the second half of 2018. The recognition of tax credit amortization expense is contingent upon the successful rehabilitation of a historic building or completion of a solar project within the reporting period. Many factors including weather, labor availability, building regulations, inspections, and other unexpected construction delays related to a rehabilitation project can cause a project to exceed its estimated completion date. See Note 13 to the consolidated financial statements for additional information on our tax credit investments.

Other expense increased $4.7 million for the six months ended June 30, 2018 when compared to the six months ended June 30, 2017 primarily due to higher other expense associated with the Anchor (MN) acquisition and higher impairments of long-lived assets totaling $2.1 million in the six months ended June 30, 2018 related to branch consolidations.

Provision for Income Taxes

We record a provision for income taxes currently payable and for income taxes payable or benefits to be received in the future, which arise due to timing differences in the recognition of certain items for financial statement and income tax purposes. The major difference between the effective tax rate applied to our financial statement income and the federal statutory tax rate is caused by a tax benefit from our tax credit investments and interest on tax-exempt securities and loans. The provision for income taxes, as a percentage of pre-tax income, was 9.0% for the three months ended June 30, 2018, compared to 21.4% for the three months ended June 30, 2017. The provision for income taxes, as a percentage of pre-tax income, was 9.2% for the six months ended June 30, 2018, compared to 22.0% for the six months ended June 30, 2017. In accordance with ASC 740-270, Accounting for Interim Reporting, the provision for income taxes was recorded at June 30, 2018 based on the current estimate of the effective annual rate. The lower effective tax rate during the three and six months ended June 30, 2018 when compared to the same periods in 2017 was primarily the result of the lowering of the federal corporate tax rate to 21% in 2018 and an increase in federal tax credits available. See Note 20 to the consolidated financial statements for additional information.

 

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FINANCIAL CONDITION

Overview

At June 30, 2018, our assets were $17.483 billion, a $2.526 billion increase compared to assets of $14.957 billion at June 30, 2017, and a $35.3 million decrease compared to assets of $17.518 billion at December 31, 2017. The increase from June 30, 2017 to June 30, 2018 was primarily due to the acquisition of Anchor (MN) in November 2017, which had $2.222 billion in assets as of the closing date of the acquisition. Organic growth in our commercial loan portfolios also contributed to the June 30, 2017 to June 30, 2018 increase in assets.

Earning Assets

Our earning assets are comprised of investment securities, portfolio loans, loans held for sale, money market investments, interest earning accounts with the Federal Reserve, and trading securities. Earning assets were $15.225 billion at June 30, 2018, a $2.309 billion increase compared to earning assets of $12.916 billion at June 30, 2017, and a $16.0 million increase compared to earning assets of $15.209 billion at December 31, 2017.

Investment Securities

We classify the majority of our investment securities as available-for-sale to give management the flexibility to sell the securities prior to maturity if needed, based on fluctuating interest rates or changes in our funding requirements. However, we also have $73.6 million of U.S. government-sponsored entities and agencies securities, $139.6 million of fixed-rate mortgage-backed securities, and $312.6 million of state and political subdivision securities in our held-to-maturity investment portfolio at June 30, 2018.

Trading securities, which consist of mutual funds held in trusts associated with deferred compensation plans for former directors and executives, are recorded at fair value and totaled $5.6 million at June 30, 2018 compared to $5.2 million at June 30, 2017.

At June 30, 2018, the investment securities portfolio, including trading securities, was $3.849 billion compared to $3.624 billion at June 30, 2017, an increase of $224.8 million. Investment securities attributable to the Anchor (MN) acquisition totaled $308.8 million as of the closing date of the acquisition. Investment securities represented 25% of earning assets at June 30, 2018, compared to 28% at June 30, 2017 and 26% at December 31, 2017. Investment securities decreased as a percentage of total earning assets at June 30, 2018 when compared to June 30, 2017 due to a proportionately larger increase in loan balances. Stronger commercial loan demand in the future and management’s decision to deleverage the balance sheet could result in a reduction in the securities portfolio. At June 30, 2018, management does not intend to sell any securities in an unrealized loss position and does not believe we will be required to sell such securities.

The investment securities available-for-sale portfolio had net unrealized losses of $77.8 million at June 30, 2018, compared to net unrealized losses of $19.7 million at June 30, 2017, and net unrealized losses of $56.4 million at December 31, 2017. Net unrealized losses increased from December 31, 2017 to June 30, 2018 reflecting higher net unrealized losses on mortgage-backed securities primarily due to the effect of an increase in long-term interest rates.

The investment portfolio had an effective duration of 4.46 at June 30, 2018, compared to 4.25 at June 30, 2017, and 4.15 at December 31, 2017. Effective duration measures the percentage change in value of the portfolio in response to a change in interest rates. Generally, there is more uncertainty in interest rates over a longer average maturity, resulting in a higher duration percentage. The annualized average yields on investment securities, on a taxable equivalent basis, were 2.77% for the three months ended June 30, 2018, compared to 2.93% for the three months ended June 30, 2017. The annualized average yields on investment securities, on a taxable equivalent basis, were 2.76% for the six months ended June 30, 2018, compared to 2.96% for the six months ended June 30, 2017.

Loans Held for Sale

Mortgage loans held for immediate sale in the secondary market were $26.2 million at June 30, 2018, compared to $17.9 million at December 31, 2017. Certain mortgage loans are committed for sale at or prior to origination at a contracted price to an outside investor. Other mortgage loans held for immediate sale are hedged with TBA forward

 

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agreements and committed for sale when they are ready for delivery and remain on the Company’s balance sheet for a short period of time (typically 30 to 60 days). These loans are sold without recourse, beyond customary representations and warranties, and Old National has not experienced material losses arising from these sales. Mortgage originations are subject to volatility due to interest rates and home sales, among other factors.

We have elected the fair value option under FASB ASC 825-10 prospectively for residential loans held for sale. The aggregate fair value exceeded the unpaid principal balance by $1.0 million at June 30, 2018, compared to $0.5 million at December 31, 2017.

Commercial and Commercial Real Estate Loans

Commercial and commercial real estate loans are the largest classification within earning assets, representing 49% of earning assets at June 30, 2018, compared to 41% at June 30, 2017 and 47% at December 31, 2017. At June 30, 2018, commercial and commercial real estate loans were $7.415 billion, an increase of $2.153 billion, or 41%, compared to June 30, 2017, and an increase of $342.8 million, or 5%, compared to December 31, 2017. Commercial and commercial real estate loans attributable to the Anchor (MN) acquisition totaled $1.516 billion as of the closing date of the acquisition.

Residential Real Estate Loans

At June 30, 2018, residential real estate loans held in our loan portfolio were $2.154 billion, an increase of $54.6 million compared to June 30, 2017, and a decrease of $13.1 million compared to December 31, 2017. Residential real estate loans attributable to the Anchor (MN) acquisition totaled $34.0 million as of the closing date of the acquisition. Future increases in interest rates could result in a decline in the level of refinancings and new originations of residential real estate loans.

Consumer Loans

Consumer loans, including automobile loans and personal and home equity loans and lines of credit, decreased $144.1 million at June 30, 2018 compared to June 30, 2017, and decreased $152.3 million from December 31, 2017. Old National assumed student loans in the acquisition of Anchor (WI) in May 2016. Student loans are guaranteed by the government from 97% to 100% and totaled $68.2 million at December 31, 2017. Old National sold the remaining student loan portfolio totaling $64.9 million during the second quarter of 2018, resulting in a $2.2 million gain that is included in other income on the income statement. Consumer loans attributable to the Anchor (MN) acquisition totaled $43.9 million as of the closing date of the acquisition. We continue to see runoff in our less profitable indirect consumer loan portfolio.

Goodwill and Other Intangible Assets

Goodwill and other intangible assets at June 30, 2018 totaled $874.2 million, an increase of $187.3 million compared to $686.9 million at June 30, 2017. As of June 30, 2018, we have recorded $200.4 million of goodwill and other intangible assets associated with the acquisition of Anchor (MN).

Net Deferred Tax Assets

Net deferred tax assets decreased $56.6 million compared to June 30, 2017 primarily due to a revaluation of our deferred tax assets due to the enactment of the Tax Cuts and Jobs Act (“H.R. 1”), which lowered the federal corporate tax rate to 21%. Shortly after the enactment date, the SEC issued SAB 118, which addresses the situations where the accounting for changes in tax laws is complete, incomplete but can be reasonably estimated, and incomplete and cannot be reasonably estimated. SAB 118 also permits a measurement period of up to one year from the date of enactment to refine the provisional accounting. During the six months ended June 30, 2018, immaterial adjustments made to the preliminary valuation of assets acquired and liabilities assumed in the acquisition of Anchor (MN) impacted the estimated revaluation of Old National’s deferred tax assets. Old National completed its analysis of H.R. 1 during the second quarter of 2018. Future changes in the corporate tax rate could result in a change in value of Old National’s deferred tax assets and future income tax expense. See Note 20 to the consolidated financial statements for additional information.

 

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Other Assets

Other assets increased $21.5 million, or 16%, since June 30, 2017 primarily due to higher accrued income taxes. Old National reclassified $20.1 million from deferred tax assets related to alternative minimum tax credits to accrued income taxes in the six months ended June 30, 2018 as a result of the enactment of H.R. 1. See Note 20 to the consolidated financial statements for additional information.

Funding

Total funding, comprised of deposits and wholesale borrowings, was $15.126 billion at June 30, 2018, an increase of $2.182 billion from $12.944 billion at June 30, 2017, and a decrease of $57.5 million from $15.184 billion at December 31, 2017. Included in total funding were deposits of $12.596 billion at June 30, 2018, an increase of $1.912 billion from $10.684 billion at June 30, 2017, and a decrease of $9.4 million from $12.606 billion at December 31, 2017. Deposits attributable to the Anchor (MN) acquisition totaled $1.777 billion as of the closing date of the acquisition. Noninterest-bearing deposits increased $589.6 million from June 30, 2017 to June 30, 2018. Interest-bearing checking and NOW deposits increased $414.5 million from June 30, 2017 to June 30, 2018, while savings deposits increased $101.4 million. Money market deposits increased $418.2 million from June 30, 2017 to June 30, 2018, while time deposits increased $388.9 million.

We use wholesale funding to augment deposit funding and to help maintain our desired interest rate risk position. At June 30, 2018, wholesale borrowings, including federal funds purchased and interbank borrowings, securities sold under agreements to repurchase, FHLB advances, and other borrowings, totaled $2.530 billion, an increase of $270.2 million, or 12%, from June 30, 2017, and a decrease of $48.1 million, or 2%, from December 31, 2017. Wholesale funding as a percentage of total funding was 17% at June 30, 2018, June 30, 2017, and December 31, 2017. The increase in wholesale funding from June 30, 2017 to June 30, 2018 was due to increases in FHLB advances, securities sold under agreements to repurchase, and other borrowings, partially offset by a decrease in federal funds purchased and interbank borrowings.

Accrued Expenses and Other Liabilities

Accrued expenses and other liabilities increased $29.2 million, or 23%, from June 30, 2017 primarily due to an increase in unfunded commitments on various tax credit investments and increases in accrued incentives, severance, and profit sharing expenses. Accrued expenses and other liabilities decreased $23.6 million, or 13%, from December 31, 2017 primarily due to incentive and severance payments in the first half of 2018 and a decrease in unfunded commitments on various tax credit investments.

Capital

Shareholders’ equity totaled $2.200 billion at June 30, 2018, compared to $1.887 billion at June 30, 2017 and $2.154 billion at December 31, 2017. Shareholders’ equity at June 30, 2018 included $300.8 million from the 16.5 million shares of Common Stock that were issued in conjunction with the acquisition of Anchor (MN). We paid cash dividends of $0.26 per share in the six months ended June 30, 2018, which reduced equity by $39.6 million. The change in unrealized gains (losses) on available-for-sale investment securities decreased equity by $16.2 million during the six months ended June 30, 2018. The Company’s Common Stock is traded on the NASDAQ under the symbol “ONB” with 34,526 shareholders of record at June 30, 2018.

Capital Adequacy

Old National and the banking industry are subject to various regulatory capital requirements administered by the federal banking agencies. At June 30, 2018, Old National and its bank subsidiary exceeded the regulatory minimums and Old National Bank met the regulatory definition of well-capitalized based on the most recent regulatory definition.

 

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At June 30, 2018, Old National’s consolidated capital position remains strong as evidenced by the following comparisons of key industry ratios.

 

     Fully
Phased-In
Regulatory
Guidelines
    June 30,     December 31,  
     Minimum     2018     2017     2017  

Risk-based capital:

        

Tier 1 capital to total average assets (leverage ratio)

     4.00     8.30     8.65     8.28

Common equity Tier 1 capital to risk-adjusted total assets

     7.00       10.85       11.50       10.39  

Tier 1 capital to risk-adjusted total assets

     8.50       10.85       11.79       10.39  

Total capital to risk-adjusted total assets

     10.50       11.87       12.31       11.40  

Shareholders’ equity to assets

     N/A       12.58       12.61       12.30  

N/A = not applicable

At June 30, 2018, Old National Bank, Old National’s bank subsidiary, maintained a strong capital position as evidenced by the following comparisons of key industry ratios.

 

     Fully
Phased-In
                   
     Regulatory
Guidelines
    Well
Capitalized
    June 30,     December 31,  
     Minimum     Guidelines     2018     2017     2017  

Risk-based capital:

          

Tier 1 capital to total average assets (leverage ratio)

     4.00     5.00     8.92     8.61     8.93

Common equity Tier 1 capital to risk-adjusted total assets

     7.00       6.50       11.65       11.73       11.21  

Tier 1 capital to risk-adjusted total assets

     8.50       8.00       11.65       11.73       11.21  

Total capital to risk-adjusted total assets

     10.50       10.00       12.20       12.25       11.73  

RISK MANAGEMENT

Overview

Old National has adopted a Risk Appetite Statement to enable the Board of Directors, Executive Leadership Group, and Senior Management to better assess, understand, and mitigate the risks of Old National. The Risk Appetite Statement addresses the following major risks: strategic, market, liquidity, credit, operational/technology/cyber, regulatory/compliance/legal, reputational, and human resources. Our Chief Risk Officer is independent of management and reports directly to the Chair of the Board’s Enterprise Risk Management Committee. The following discussion addresses these major risks: credit, market, liquidity, operational/technology/cyber, and regulatory/compliance/legal.

Credit Risk

Credit risk represents the risk of loss arising from an obligor’s inability or failure to meet contractual payment or performance terms. Our primary credit risks result from our investment and lending activities.

Investment Activities

We carry a higher exposure to loss in our pooled trust preferred securities, which are collateralized debt obligations, due to illiquidity in that market and the performance of the underlying collateral. At June 30, 2018, we had pooled trust preferred securities with a fair value of $8.2 million, or less than 1% of the available-for-sale securities

 

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portfolio. These securities remained classified as available-for-sale and at June 30, 2018, the unrealized loss on our pooled trust preferred securities was approximately $5.7 million. The fair value of these securities should improve as we get closer to maturity, but not in all cases. During the first quarter of 2018, Old National sold a pooled trust security for proceeds of $1.8 million, which resulted in a loss of $0.9 million. There was no OTTI recorded during the six months ended June 30, 2018 or 2017.

All of our mortgage-backed securities are backed by U.S. government-sponsored or federal agencies. Municipal bonds, corporate bonds, and other debt securities are evaluated by reviewing the credit-worthiness of the issuer and general market conditions. See Note 6 to the consolidated financial statements for additional details about our investment security portfolio.

Counterparty Exposure

Counterparty exposure is the risk that the other party in a financial transaction will not fulfill its obligation. We define counterparty exposure as nonperformance risk in transactions involving federal funds sold and purchased, repurchase agreements, correspondent bank relationships, and derivative contracts with companies in the financial services industry. Old National manages exposure to counterparty risk in connection with its derivatives transactions by generally engaging in transactions with counterparties having ratings of at least A by Standard & Poor’s Rating Service or A2 by Moody’s Investors Service. Total credit exposure is monitored by counterparty and managed within limits that management believes to be prudent. Old National’s net counterparty exposure was an asset of $274.7 million at June 30, 2018.

Lending Activities

Commercial

Commercial and industrial loans are made primarily for the purpose of financing equipment acquisition, expansion, working capital, and other general business purposes. Lease financing consists of direct financing leases and are used by commercial customers to finance capital purchases ranging from computer equipment to transportation equipment. The credit decisions for these transactions are based upon an assessment of the overall financial capacity of the applicant. A determination is made as to the applicant’s ability to repay in accordance with the proposed terms as well as an overall assessment of the risks involved. In addition to an evaluation of the applicant’s financial condition, a determination is made of the probable adequacy of the primary and secondary sources of repayment, such as additional collateral or personal guarantees, to be relied upon in the transaction. Credit agency reports of the applicant’s credit history supplement the analysis of the applicant’s creditworthiness.

Commercial mortgages and construction loans are offered to real estate investors, developers, and builders primarily domiciled in the geographic market areas we serve: Indiana, Kentucky, Michigan, Wisconsin, and Minnesota. These loans are secured by first mortgages on real estate at LTV margins deemed appropriate for the property type, quality, location, and sponsorship. Generally, these LTV ratios do not exceed 80%. The commercial properties are predominantly non-residential properties such as retail centers, apartments, industrial properties and, to a lesser extent, more specialized properties. Substantially all of our commercial real estate loans are secured by properties located in our primary market area.

In the underwriting of our commercial real estate loans, we obtain appraisals for the underlying properties. Decisions to lend are based on the economic viability of the property and the creditworthiness of the borrower. In evaluating a proposed commercial real estate loan, we primarily emphasize the ratio of the property’s projected net cash flows to the loan’s debt service requirement. The debt service coverage ratio normally is not less than 120% and it is computed after deduction for a vacancy factor and property expenses as appropriate. In addition, a personal guarantee of the loan or a portion thereof is often required from the principal(s) of the borrower. In most cases, we require title insurance insuring the priority of our lien, fire, and extended coverage casualty insurance, and flood insurance, if appropriate, in order to protect our security interest in the underlying property. In addition, business interruption insurance or other insurance may be required.

Construction loans are underwritten against projected cash flows derived from rental income, business income from an owner-occupant, or the sale of the property to an end-user. We may mitigate the risks associated with these types of loans by requiring fixed-price construction contracts, performance and payment bonding, controlled disbursements, and pre-sale contracts or pre-lease agreements.

 

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Consumer

We offer a variety of first mortgage and junior lien loans to consumers within our markets, with residential home mortgages comprising our largest consumer loan category. These loans are secured by a primary residence and are underwritten using traditional underwriting systems to assess the credit risks of the consumer. Decisions are primarily based on LTV ratios, DTI ratios, liquidity, and credit scores. A maximum LTV ratio of 80% is generally required, although higher levels are permitted with mortgage insurance or other mitigating factors. We offer fixed rate mortgages and variable rate mortgages with interest rates that are subject to change every year after the first, third, fifth, or seventh year, depending on the product and are based on fully-indexed rates such as LIBOR. We do not offer payment-option facilities, sub-prime loans, or any product with negative amortization.

Home equity loans are secured primarily by second mortgages on residential property of the borrower. The underwriting terms for the home equity product generally permits borrowing availability, in the aggregate, up to 90% of the appraised value of the collateral property at the time of origination. We offer fixed and variable rate home equity loans, with variable rate loans underwritten at fully-indexed rates. Decisions are primarily based on LTV ratios, DTI ratios, and credit scores. We do not offer home equity loan products with reduced documentation.

Automobile loans include loans and leases secured by new or used automobiles. We originate automobile loans and leases primarily on an indirect basis through selected dealerships. We require borrowers to maintain collision insurance on automobiles securing consumer loans, with us listed as loss payee. Our procedures for underwriting automobile loans include an assessment of an applicant’s overall financial capacity, including credit history and the ability to meet existing obligations and payments on the proposed loan. Although an applicant’s creditworthiness is the primary consideration, the underwriting process also includes a comparison of the value of the collateral security to the proposed loan amount.

Old National assumed student loans in the acquisition of Anchor (WI) in May 2016. Student loans are guaranteed by the government from 97% to 100% and totaled $68.2 million at December 31, 2017. Old National sold the remaining student loan portfolio totaling $64.9 million during the second quarter of 2018, resulting in a $2.2 million gain that is included in other income on the income statement.

Asset Quality

Community-based lending personnel, along with region-based independent underwriting and analytic support staff, extend credit under guidelines established and administered by our Enterprise Risk Committee. This committee, which meets quarterly, is made up of outside directors. The committee monitors credit quality through its review of information such as delinquencies, credit exposures, peer comparisons, problem loans, and charge-offs. In addition, the committee reviews and approves recommended loan policy changes to assure it remains appropriate for the current lending environment.

We lend to commercial and commercial real estate clients in various industries including manufacturing, agribusiness, transportation, mining, wholesaling, and retailing. Old National manages concentrations of credit exposure by industry, product, geography, customer relationship, and loan size. While loans to lessors of both residential and non-residential real estate exceed 10% of total loans, no individual sub-segment category within those broader categories reaches the 10% threshold. At June 30, 2018, we had minimal exposure to foreign borrowers and no sovereign debt. Our policy is to concentrate our lending activity in the geographic market areas we serve, primarily Indiana, Kentucky, Michigan, Wisconsin, and Minnesota. We are experiencing a slow and gradual improvement in the economy of our principal markets. Management expects that trends in under-performing, criticized, and classified loans will be influenced by the degree to which the economy strengthens or weakens.

On November 1, 2017, Old National closed on its acquisition of Anchor (MN). As of the closing date of the acquisition, loans totaled $1.594 billion and other real estate owned totaled $1.1 million. In accordance with accounting for business combinations, there was no allowance brought forward on any of the acquired loans, as the credit losses evident in the loans were included in the determination of the fair value of the loans at the acquisition

 

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date. Old National reviewed the acquired loans and determined that as of June 30, 2018, $34.3 million met the definition of criticized and $37.5 million were considered classified (of which $22.8 million are reported with nonaccrual loans). Our current preference would be to work these loans and avoid foreclosure actions unless additional credit deterioration becomes apparent. These acquired impaired loans, along with $0.7 million of other real estate owned, are included in our summary of under-performing, criticized, and classified assets found below.

Summary of under-performing, criticized, and classified assets:

 

     June 30,     December 31,  

(dollars in thousands)

   2018     2017     2017  

Nonaccrual loans:

      

Commercial

   $ 36,260     $ 29,856     $ 27,202  

Commercial real estate

     70,907       63,051       62,425  

Residential real estate

     23,198       19,029       22,171  

Consumer

     8,717       13,583       13,129  
  

 

 

   

 

 

   

 

 

 

Total nonaccrual loans (1)

     139,082       125,519       124,927  

Renegotiated loans not on nonaccrual

     17,139       14,123       19,589  

Past due loans (90 days or more and still accruing):

      

Commercial

     85       2       144  

Residential real estate

     389       74       —    

Consumer

     1,101       125       750  
  

 

 

   

 

 

   

 

 

 

Total past due loans

     1,575       201       894  

Other real estate owned

     3,729       11,071       8,810  
  

 

 

   

 

 

   

 

 

 

Total under-performing assets

   $ 161,525     $ 150,914     $ 154,220  
  

 

 

   

 

 

   

 

 

 

Classified loans (includes nonaccrual, renegotiated, past due 90 days, and other problem loans)

   $ 249,708     $ 237,997     $ 226,583  

Other classified assets (2)

     3,149       7,449       4,556  

Criticized loans

     154,891       99,502       188,085  
  

 

 

   

 

 

   

 

 

 

Total criticized and classified assets

   $ 407,748     $ 344,948     $ 419,224  
  

 

 

   

 

 

   

 

 

 

Asset Quality Ratios:

      

Non-performing loans/total loans (3) (4)

     1.38     1.51     1.30

Under-performing assets/total loans and other real estate owned (3)

     1.43       1.63       1.39  

Under-performing assets/total assets

     0.92       1.01       0.88  

Allowance for loan losses/under-performing assets (5)

     33.22       33.78       32.67  

Allowance for loan losses/nonaccrual loans (1)

     38.58       40.62       40.33  

 

(1) Includes purchased credit impaired loans of approximately $11.3 million at June 30, 2018, $6.8 million at June 30, 2017, and $12.6 million at December 31, 2017 that are categorized as nonaccrual for credit analysis purposes because the collection of principal or interest is doubtful. However, these loans are accounted for under FASB ASC 310-30 and accordingly treated as performing assets.
(2) Includes 1 pooled trust preferred security and 1 insurance policy at June 30, 2018.
(3) Loans exclude loans held for sale.
(4) Non-performing loans include nonaccrual and renegotiated loans.
(5) Because the acquired loans were recorded at fair value in accordance with ASC 805 at the date of acquisition, the credit risk is incorporated in the fair value recorded. No allowance for loan losses is recorded on the acquisition date.

Under-performing assets totaled $161.5 million at June 30, 2018, compared to $150.9 million at June 30, 2017 and $154.2 million at December 31, 2017. Under-performing assets as a percentage of total loans and other real estate owned at June 30, 2018 were 1.43%, a decrease of 20 basis points from 1.63% at June 30, 2017 and an increase of 4 basis points from 1.39% at December 31, 2017.

Nonaccrual loans increased from June 30, 2017 primarily due to an increase in nonaccrual commercial and commercial real estate loans. Nonaccrual loans at June 30, 2018 include $22.8 million of loans related to the Anchor (MN) acquisition. As a percentage of nonaccrual loans, the allowance for loan losses was 38.58% at June 30, 2018, compared to 40.62% at June 30, 2017 and 40.33% at December 31, 2017. PCI loans that were included in the nonaccrual category for credit analysis purposes because the collection of principal or interest is doubtful totaled

 

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$11.3 million at June 30, 2018, compared to $6.8 million at June 30, 2017 and $12.6 million at December 31, 2017. However, they are accounted for under FASB ASC 310-30 and accordingly treated as performing assets.

Total criticized and classified assets were $407.7 million at June 30, 2018, an increase of $62.8 million from June 30, 2017, and a decrease of $11.5 million from December 31, 2017. Other classified assets include investment securities that fell below investment grade rating totaling $3.1 million at June 30, 2018, compared to $7.4 million at June 30, 2017 and $4.6 million at December 31, 2017.

Old National may choose to restructure the contractual terms of certain loans. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit Old National by increasing the ultimate probability of collection.

Any loans that are modified are reviewed by Old National to identify if a TDR has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, Old National Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status. The modification of the terms of such loans include one or a combination of the following: a reduction of the stated interest rate of the loan, an extension of the maturity date at a stated rate of interest lower than the current market rate of new debt with similar risk, or a permanent reduction of the recorded investment of the loan.

Loans modified in a TDR are typically placed on nonaccrual status until we determine the future collection of principal and interest is reasonably assured, which generally requires that the borrower demonstrate a period of performance according to the restructured terms for six months.

If we are unable to resolve a nonperforming loan issue, the credit will be charged off when it is apparent there will be a loss. For large commercial type loans, each relationship is individually analyzed for evidence of apparent loss based on quantitative benchmarks or subjectively based upon certain events or particular circumstances. Generally, Old National charges off small commercial loans scored through our small business credit center with contractual balances under $250,000 that are 90 days or more delinquent and do not have adequate collateral support. For residential and consumer loans, a charge off is recorded at the time foreclosure is initiated or when the loan becomes 120 to 180 days past due, whichever is earlier.

For commercial TDRs, an allocated reserve is established within the allowance for loan losses for the difference between the carrying value of the loan and its computed value. To determine the value of the loan, one of the following methods is selected: (1) the present value of expected cash flows discounted at the loan’s original effective interest rate, (2) the loan’s observable market price, or (3) the fair value of the collateral value, if the loan is collateral dependent. The allocated reserve is established as the difference between the carrying value of the loan and the collectable value. If there are significant changes in the amount or timing of the loan’s expected future cash flows, impairment is recalculated and the valuation allowance is adjusted accordingly.

When a residential or consumer loan is identified as a TDR, the loan is typically written down to its collateral value less selling costs.

At June 30, 2018, our TDRs consisted of $9.0 million of commercial loans, $34.9 million of commercial real estate loans, $3.8 million of residential loans, and $3.4 million of consumer loans totaling $51.1 million. Approximately $34.0 million of the TDRs at June 30, 2018 were included with nonaccrual loans. At December 31, 2017, our TDRs consisted of $12.1 million of commercial loans, $34.7 million of commercial real estate loans, $3.3 million of residential loans, and $3.9 million of consumer loans totaling $54.0 million. Approximately $34.0 million of the TDRs at December 31, 2017 were included with nonaccrual loans.

Old National has allocated specific reserves to customers whose loan terms have been modified in TDRs totaling $4.8 million at June 30, 2018 and $5.7 million of December 31, 2017. At June 30, 2018, Old National had committed to lend an additional $4.0 million to customers with outstanding loans that are classified as TDRs.

The terms of certain other loans were modified during 2018 that did not meet the definition of a TDR. It is our process to review all classified and criticized loans that, during the period, have been renewed, have entered into a forbearance agreement, have gone from principal and interest to interest only, or have extended the maturity date. In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the

 

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probability that the borrower will be in payment default on its debt in the foreseeable future without the modification. The evaluation is performed under our internal underwriting policy. We also evaluate whether a concession has been granted or if we were adequately compensated through a market interest rate, additional collateral, or a bona fide guarantee. We also consider whether the modification was insignificant relative to the other terms of the agreement or the delay in a payment.

PCI loans are not considered impaired until after the point at which there has been a degradation of cash flows below our expected cash flows at acquisition. If a PCI loan is subsequently modified, and meets the definition of a TDR, it will be removed from PCI accounting and accounted for as a TDR only if the PCI loan was being accounted for individually. If the PCI loan is being accounted for as part of a pool, it will not be removed from the pool. At June 30, 2018, it has not been necessary to remove any loans from PCI accounting.

In general, once a modified loan is considered a TDR, the loan will always be considered a TDR, and therefore impaired, until it is paid in full, otherwise settled, sold, or charged off. However, guidance also permits for loans to be removed from TDR status when subsequently restructured under these circumstances: (1) at the time of the subsequent restructuring, the borrower is not experiencing financial difficulties, and this is documented by a current credit evaluation at the time of the restructuring, (2) under the terms of the subsequent restructuring agreement, the institution has granted no concession to the borrower; and (3) the subsequent restructuring agreement includes market terms that are no less favorable than those that would be offered for a comparable new loan. For loans subsequently restructured that have cumulative principal forgiveness, the loan should continue to be measured in accordance with ASC 310-10, Receivables – Overall. However, consistent with ASC 310-40-50-2, Troubled Debt Restructurings by Creditors, Creditor Disclosure of Troubled Debt Restructurings, the loan would not be required to be reported in the years following the restructuring if the subsequent restructuring meets both of these criteria: (1) has an interest rate at the time of the subsequent restructuring that is not less than a market interest rate; and (2) is performing in compliance with its modified terms after the subsequent restructuring.

Allowance for Loan Losses and Reserve for Unfunded Commitments

Loan charge-offs, net of recoveries, totaled $(0.8) million for the three months ended June 30, 2018, compared to $0.2 million for the three months ended June 30, 2017. Annualized, net charge-offs (recoveries) to average loans were (0.03)% for the three months ended June 30, 2018 compared to 0.01% for the three months ended June 30, 2017. Loan charge-offs, net of recoveries, totaled $(0.5) million for the six months ended June 30, 2018, compared to $0.5 million for the six months ended June 30, 2017. Annualized, net charge-offs (recoveries) to average loans were (0.01)% for the six months ended June 30, 2018 compared to 0.01% for the six months ended June 30, 2017. Management will continue its efforts to reduce the level of non-performing loans and may consider the possibility of sales of troubled and non-performing loans, which could result in additional charge-offs to the allowance for loan losses.

To provide for the risk of loss inherent in extending credit, we maintain an allowance for loan losses. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses incurred in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, pools of homogeneous loans, assessments of the impact of current and anticipated economic conditions on the portfolio, and historical loss experience.

At June 30, 2018, the allowance for loan losses was $53.7 million, an increase of $2.7 million compared to $51.0 million at June 30, 2017, and an increase of $3.3 million compared to $50.4 million at December 31, 2017. Continued loan growth in future periods, a decline in our current level of recoveries, or an increase in charge-offs could result in an increase in provision expense.

As a percentage of total loans excluding loans held for sale, the allowance was 0.48% at June 30, 2018, compared to 0.55% at June 30, 2017 and 0.45% at December 31, 2017.

 

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The following table provides additional details of the components of the allowance for loan losses, including ASC 450, Contingencies, for loans collectively evaluated for impairment, ASC 310-10, Receivables, for loans individually evaluated for impairment, and ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, for loans acquired with deteriorated credit quality:

 

     Collectively      Individually      Acquired with         
     Evaluated for      Evaluated for      Deteriorated         

(dollars in thousands)

   Impairment      Impairment      Credit Quality      Total  

Loan balance

   $ 11,230,007      $ 114,089      $ 62,260      $ 11,406,356  

Remaining purchase discount

     (83,230      (4,714      (22,783      (110,727
  

 

 

    

 

 

    

 

 

    

 

 

 

Loans, net of discount

   $ 11,146,777      $ 109,375      $ 39,477      $ 11,295,629  
  

 

 

    

 

 

    

 

 

    

 

 

 

Allowance, January 1, 2018

   $ 40,137      $ 10,078      $ 166      $ 50,381  

Charge-offs

     (4,579      (1,145      (15      (5,739

Recoveries

     4,296        1,622        274        6,192  

Provision expense

     (553      3,478        (99      2,826  
  

 

 

    

 

 

    

 

 

    

 

 

 

Allowance, June 30, 2018

   $ 39,301      $ 14,033      $ 326      $ 53,660  
  

 

 

    

 

 

    

 

 

    

 

 

 

We maintain an allowance for losses on unfunded commercial lending commitments and letters of credit to provide for the risk of loss inherent in these arrangements. The allowance is computed using a methodology similar to that used to determine the allowance for loan losses, modified to take into account the probability of a drawdown on the commitment. The reserve for unfunded loan commitments is classified as a liability account on the balance sheet and totaled $3.2 million at June 30, 2018, compared to $3.1 million at December 31, 2017.

Market Risk

Market risk is the risk that the estimated fair value of our assets, liabilities, and derivative financial instruments will decline as a result of changes in interest rates or financial market volatility, or that our net income will be significantly reduced by interest rate changes.

The objective of our interest rate management process is to maximize net interest income while operating within acceptable limits established for interest rate risk and maintaining adequate levels of funding and liquidity.

Potential cash flows, sales, or replacement value of many of our assets and liabilities, especially those that earn or pay interest, are sensitive to changes in the general level of interest rates. This interest rate risk arises primarily from our normal business activities of gathering deposits and extending loans. Many factors affect our exposure to changes in interest rates, such as general economic and financial conditions, customer preferences, historical pricing relationships, and re-pricing characteristics of financial instruments. Our earnings can also be affected by the monetary and fiscal policies of the U.S. Government and its agencies, particularly the Federal Reserve.

In managing interest rate risk, we, through the Funds Management Committee, a committee of the Board of Directors, establish guidelines, for asset and liability management, including measurement of short and long-term sensitivities to changes in interest rates. Based on the results of our analysis, we may use different techniques to manage changing trends in interest rates including:

 

    adjusting balance sheet mix or altering interest rate characteristics of assets and liabilities;

 

    changing product pricing strategies;

 

    modifying characteristics of the investment securities portfolio; or

 

    using derivative financial instruments, to a limited degree.

A key element in our ongoing process is to measure and monitor interest rate risk using a model to quantify the impact of changing interest rates on Old National. The model quantifies the effects of various possible interest rate scenarios on projected net interest income. The model measures the impact on net interest income relative to a base case scenario. The base case scenario assumes that the balance sheet and interest rates are held at current levels. The model shows our projected net interest income sensitivity based on interest rate changes only and does not consider other forecast assumptions.

 

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The following table illustrates our projected net interest income sensitivity over a two year cumulative horizon based on the asset/liability model at June 30, 2018 and 2017:

 

     Immediate                           
     Rate Decrease            Immediate Rate Increase  
     -50            +100     +200     +300  

(dollars in thousands)

   Basis Points     Base      Basis Points     Basis Points     Basis Points  

June 30, 2018

           

Projected interest income:

           

Money market, other interest earning investments, and investment securities

   $ 227,659     $ 233,393      $ 245,518     $ 257,181     $ 268,650  

Loans

     939,145       995,782        1,107,966       1,219,560       1,331,076  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total interest income

     1,166,804       1,229,175        1,353,484       1,476,741       1,599,726  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Projected interest expense:

           

Deposits

     59,512       91,974        170,875       249,772       328,664  

Borrowings

     102,985       119,546        152,623       185,688       218,770  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total interest expense

     162,497       211,520        323,498       435,460       547,434  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net interest income

   $ 1,004,307     $ 1,017,655      $ 1,029,986     $ 1,041,281     $ 1,052,292  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Change from base

   $ (13,348      $ 12,331     $ 23,626     $ 34,637  

% change from base

     -1.31        1.21     2.32     3.40

June 30, 2017

           

Projected interest income:

           

Money market, other interest earning investments, and investment securities

   $ 221,572     $ 229,235      $ 239,969     $ 248,182     $ 257,766  

Loans

     681,078       728,701        822,228       914,769       1,006,899  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total interest income

     902,650       957,936        1,062,197       1,162,951       1,264,665  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Projected interest expense:

           

Deposits

     23,735       44,479        106,022       167,560       229,092  

Borrowings

     68,331       81,104        107,917       134,719       161,506  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total interest expense

     92,066       125,583        213,939       302,279       390,598  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net interest income

   $ 810,584     $ 832,353      $ 848,258     $ 860,672     $ 874,067  
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Change from base

   $ (21,769      $ 15,905     $ 28,319     $ 41,714  

% change from base

     -2.62        1.91     3.40     5.01

Our asset sensitivity decreased slightly year over year primarily due to changes in our balance sheet mix, investment duration, and prepayment speed behavior.

A key element in the measurement and modeling of interest rate risk is the re-pricing assumptions of our transaction deposit accounts, which have no contractual maturity dates. We assume this deposit base is comprised of both core and more volatile balances and consists of both noninterest-bearing and interest-bearing accounts. Core deposit balances are assumed to be less interest rate sensitive and provide longer term funding. Volatile balances are assumed to be more interest rate sensitive and shorter in term. As part of our semi-static balance sheet modeling, we assume interest rates paid on the volatile deposits move in conjunction with changes in interest rates, in order to retain these deposits. This may include current noninterest-bearing accounts.

Because the models are driven by expected behavior in various interest rate scenarios and many factors besides market interest rates affect our net interest income, we recognize that model outputs are not guarantees of actual results. For this reason, we model many different combinations of interest rates and balance sheet assumptions to understand our overall sensitivity to market interest rate changes, including shocks, yield curve flattening, yield curve steepening, as well as forecasts of likely interest rate scenarios. At June 30, 2018, our projected net interest income sensitivity based on the asset/liability models we utilize was within the limits of our interest rate risk policy for the scenarios tested.

 

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We use derivative instruments, primarily interest rate swaps, to mitigate interest rate risk, including certain cash flow hedges on variable-rate debt with a notional amount of $625 million at June 30, 2018. Our derivatives had an estimated fair value loss of $6.2 million at June 30, 2018, compared to an estimated fair value loss of $2.2 million at December 31, 2017. See Note 21 to the consolidated financial statements for further discussion of derivative financial instruments.

Liquidity Risk

Liquidity risk arises from the possibility that we may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The Funds Management Committee of the Board of Directors establishes liquidity risk guidelines and, along with the Balance Sheet Management Committee, monitors liquidity risk. The objective of liquidity management is to ensure we have the ability to fund balance sheet growth and meet deposit and debt obligations in a timely and cost-effective manner. Management monitors liquidity through a regular review of asset and liability maturities, funding sources, and loan and deposit forecasts. We maintain strategic and contingency liquidity plans to ensure sufficient available funding to satisfy requirements for balance sheet growth, properly manage capital markets’ funding sources and to address unexpected liquidity requirements.

Loan repayments and maturing investment securities are a relatively predictable source of funds. However, deposit flows, calls of investment securities and prepayments of loans and mortgage-related securities are strongly influenced by interest rates, the housing market, general and local economic conditions, and competition in the marketplace. We continually monitor marketplace trends to identify patterns that might improve the predictability of the timing of deposit flows or asset prepayments.

A time deposit maturity schedule for Old National Bank is shown in the following table at June 30, 2018.

 

(dollars in thousands)              

Maturity Bucket

   Amount      Rate  

2018

   $ 823,222        1.27

2019

     629,179        1.45  

2020

     178,299        1.40  

2021

     88,229        1.47  

2022

     46,234        1.46  

2023 and beyond

     59,387        1.73  
  

 

 

    

 

 

 

Total

   $ 1,824,550        1.37
  

 

 

    

 

 

 

Our ability to acquire funding at competitive prices is influenced by rating agencies’ views of our credit quality, liquidity, capital, and earnings. Moody’s Investor Service places us in an investment grade that indicates a low risk of default. For both Old National and Old National Bank:

 

    Moody’s Investor Service affirmed the Long-Term Rating of A3 of Old National’s senior unsecured/issuer rating on February 2, 2018.

 

    Moody’s Investor Service affirmed Old National Bank’s long-term deposit rating of Aa3 on February 2, 2018. The bank’s short-term deposit rating was affirmed at P-1 and the bank’s issuer rating was affirmed at A3.

The rating outlook from Moody’s Investor Service is negative. Moody’s Investor Service concluded a rating review of Old National Bank on February 2, 2018.

 

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The credit ratings of Old National and Old National Bank at June 30, 2018 are shown in the following table.

 

     Moody’s Investor Service  
     Long-term      Short-term  

Old National

     A3        N/A  

Old National Bank

     Aa3        P-1  

N/A = not applicable

Old National Bank maintains relationships in capital markets with brokers and dealers to issue certificates of deposit and short-term and medium-term bank notes as well. At June 30, 2018, Old National and its subsidiaries had the following availability of liquid funds and borrowings:

 

     Parent         

(dollars in thousands)

   Company      Subsidiaries  

Available liquid funds:

     

Cash and due from banks

   $ 71,296      $ 202,578  

Unencumbered government-issued debt securities

     —          1,137,328  

Unencumbered investment grade municipal securities

     —          501,554  

Unencumbered corporate securities

     —          135,286  

Availability of borrowings:

     

Amount available from Federal Reserve discount window*

     —          476,154  

Amount available from Federal Home Loan Bank Indianapolis*

     —          472,419  
  

 

 

    

 

 

 

Total available funds

   $ 71,296      $ 2,925,319  
  

 

 

    

 

 

 

 

* Based on collateral pledged

The Parent Company (Old National Bancorp) has routine funding requirements consisting primarily of operating expenses, dividends to shareholders, debt service, net derivative cash flows, and funds used for acquisitions. The Parent Company can obtain funding to meet its obligations from dividends and management fees collected from its subsidiaries, operating line of credit, and through the issuance of debt securities. Additionally, the Parent Company has a shelf registration in place with the SEC permitting ready access to the public debt and equity markets. At June 30, 2018, the Parent Company’s other borrowings outstanding were $231.0 million.

Federal banking laws regulate the amount of dividends that may be paid by banking subsidiaries without prior approval. Prior regulatory approval is required if dividends to be declared in any year would exceed net earnings of the current year plus retained net profits for the preceding two years. Prior regulatory approval to pay dividends was not required in 2017 and is not currently required.

Operational/Technology/Cyber Risk

Operational/technology/cyber risk is the potential that inadequate information systems, operational problems, breaches in internal controls, information security breaches, fraud, or unforeseen catastrophes will result in unexpected losses. We maintain frameworks, programs, and internal controls to prevent or minimize financial loss from failure of systems, people, or processes. This includes specific programs and frameworks intended to prevent or limit the effects of cyber risks including cyber-attacks or other information security breaches that might allow unauthorized transactions or unauthorized access to customer, associate, or company sensitive information. Metrics and measurements are used by Executive Leaders in the management of day-to-day operations to ensure effective customer service, minimization of service disruptions, and oversight of operational and cyber risk. We continually monitor and report on operational, technology, and cyber risks related to clients, products, and business practices; external and internal fraud; business disruptions and systems failures; cyber-attacks, information security or data breaches; damage to physical assets; and execution, delivery, and process management.

The Enterprise Risk Management Committee of the Board of Directors is responsible for the oversight, guidance, and monitoring of risks, including operational/technology/cyber risks, being taken by the Company. The monitoring is accomplished through on-going review of management reports, data on risks, policy limits and discussion on enterprise risk management strategies, policies, and risk assessments.

 

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Regulatory/Compliance/Legal Risk

Regulatory/compliance/legal risk is the risk that the Company violated or was not in compliance with applicable laws, regulations or practices, industry standards, or ethical standards. The legal portion assesses the risk that unenforceable contracts, lawsuits, or adverse judgments can disrupt or otherwise negatively impact the Company. The Board of Directors expects we will perform business in a manner compliant with applicable laws and/or regulations and expects issues to be identified, analyzed, and remediated in a timely and complete manner.

OFF-BALANCE SHEET ARRANGEMENTS

Off-balance sheet arrangements include commitments to extend credit and financial guarantees. Commitments to extend credit and financial guarantees are used to meet the financial needs of our customers. Our banking affiliates have entered into various agreements to extend credit, including loan commitments of $3.218 billion and standby letters of credit of $85.7 million at June 30, 2018. At June 30, 2018, approximately $2.986 billion of the loan commitments had fixed rates and $232.0 million had floating rates, with the floating rates ranging from 0.99% to 15%. At December 31, 2017, loan commitments were $3.144 billion and standby letters of credit were $68.7 million. The term of these off-balance sheet arrangements is typically one year or less.

Old National is a party in risk participation transactions of interest rate swaps, which had total notional amount of $30.8 million at June 30, 2018.

CONTRACTUAL OBLIGATIONS

The following table presents our significant fixed and determinable contractual obligations at June 30, 2018:

 

     Payments Due In         
     One Year      One to      Three to      Over         

(dollars in thousands)

   or Less (1)      Three Years      Five Years      Five Years      Total  

Deposits without stated maturity

   $ 10,771,826      $ —        $ —        $ —        $ 10,771,826  

IRAs, consumer, and brokered certificates of deposit

     823,222        807,478        134,463        59,387        1,824,550  

Federal funds purchased and interbank borrowings

     175,044        —          —          —          175,044  

Securities sold under agreements to repurchase

     347,511        —          —          —          347,511  

FHLB advances

     626,567        301,494        78,500        750,747        1,757,308  

Other borrowings

     1,286        284        332        248,339        250,241  

Fixed interest payments (2)

     20,123        66,165        60,491        113,089        259,868  

Operating leases

     9,698        35,519        31,001        71,742        147,960  

Other long-term liabilities (3)

     31,953        5,471        33        62        37,519  

 

(1) For the remaining six months of fiscal 2018.
(2) Our senior notes, subordinated notes, certain trust preferred securities, and certain FHLB advances have fixed rates ranging from 1.50% to 6.08%. All of our other long-term debt is at LIBOR based variable rates at June 30, 2018. The projected variable interest assumes no increase in LIBOR rates from June 30, 2018.
(3) Includes unfunded commitments on qualified affordable housing projects and other tax credit investments.

We rent certain premises and equipment under operating leases. See Note 10 to the consolidated financial statements for additional information on long-term lease arrangements.

We are party to various derivative contracts as a means to manage the balance sheet and our related exposure to changes in interest rates, to manage our residential real estate loan origination and sale activity, and to provide derivative contracts to our clients. Since the derivative liabilities recorded on the balance sheet change frequently and do not represent the amounts that may ultimately be paid under these contracts, these liabilities are not included in the table of contractual obligations presented above. Further discussion of derivative instruments is included in Note 21 to the consolidated financial statements.

 

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In the normal course of business, various legal actions and proceedings are pending against us and our affiliates which are incidental to the business in which they are engaged. Further discussion of contingent liabilities is included in Note 22 to the consolidated financial statements.

In addition, liabilities recorded under FASB ASC 740-10 (FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109) are not included in the table because the amount and timing of any cash payments cannot be reasonably estimated. Further discussion of income taxes and liabilities recorded under FASB ASC 740-10 is included in Note 20 to the consolidated financial statements.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our accounting policies are described in Note 1 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2017. Certain accounting policies require management to use significant judgment and estimates, which can have a material impact on the carrying value of certain assets and liabilities. We consider these policies to be critical accounting policies. The judgment and assumptions made are based upon historical experience or other factors that management believes to be reasonable under the circumstances. Because of the nature of the judgment and assumptions, actual results could differ from estimates, which could have a material effect on our financial condition and results of operations.

The following accounting policies materially affect our reported earnings and financial condition and require significant judgments and estimates. Management has reviewed these critical accounting estimates and related disclosures with our Audit Committee.

Goodwill

 

    Description. For acquisitions, we are required to record the assets acquired, including identified intangible assets, and the liabilities assumed at their fair value. These often involve 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. Under FASB ASC 350, Intangibles – Goodwill and Other, goodwill 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.

 

    Judgments and Uncertainties. The determination of fair values is based on valuations using management’s assumptions of future growth rates, future attrition, discount rates, multiples of earnings or other relevant factors.

 

    Effect if Actual Results Differ From Assumptions. Changes in these factors, as well as downturns in economic or business conditions, could have a significant adverse impact on the carrying value of goodwill and could result in impairment losses affecting our financials as a whole and our banking subsidiary in which the goodwill resides.

Allowance for Loan Losses

 

    Description. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred losses in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, pools of homogeneous loans, assessments of the impact of current and anticipated economic conditions on the portfolio, and historical loss experience. The allowance represents management’s best estimate, but significant downturns in circumstances relating to loan quality and economic conditions could result in a requirement for additional allowance. Likewise, an upturn in loan quality and improved economic conditions may allow a reduction in the required allowance. In either instance, unanticipated changes could have a significant impact on results of operations.

The allowance is increased through a provision charged to operating expense. Uncollectible loans are charged-off through the allowance. Recoveries of loans previously charged-off are added to the allowance.

 

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A loan is considered impaired when it is probable that contractual interest and principal payments will not be collected either for the amounts or by the dates as scheduled in the loan agreement. Our policy for recognizing income on impaired loans is to accrue interest unless a loan is placed on nonaccrual status. A loan is generally placed on nonaccrual status when principal or interest becomes 90 days past due unless it is well secured and in the process of collection, or earlier when concern exists as to the ultimate collectibility of principal or interest. We monitor the quality of our loan portfolio on an on-going basis and use a combination of detailed credit assessments by relationship managers and credit officers, historic loss trends, and economic and business environment factors in determining the allowance for loan losses. We record provisions for loan losses based on current loans outstanding, grade changes, mix of loans, and expected losses. A detailed loan loss evaluation on an individual loan basis for our highest risk loans is performed quarterly. Management follows the progress of the economy and how it might affect our borrowers in both the near and the intermediate term. We have a formalized and disciplined independent loan review program to evaluate loan administration, credit quality, and compliance with corporate loan standards. This program includes periodic, regular reviews of problem loan reports, delinquencies and charge-offs.

 

    Judgments and Uncertainties. We utilize a PD/LGD model as a tool to determine the adequacy of the allowance for loan losses for performing commercial and commercial real estate loans. The PD is forecast using a transition matrix to determine the likelihood of a customer’s AQR migrating from its current AQR to any other status within the time horizon. Transition rates are measured using Old National’s own historical experience. The model assumes that recent historical transition rates will continue into the future. The LGD is defined as credit loss incurred when an obligor of the bank defaults. The sum of all net charge-offs for a particular portfolio segment are divided by all loans that have defaulted over a given period of time. The expected loss derived from the model considers the PD, LGD, and exposure at default. Additionally, qualitative factors, such as changes in lending policies or procedures, and economic business conditions are also considered.

We use historic loss ratios adjusted for economic conditions to determine the appropriate level of allowance for residential real estate and consumer loans.

 

    Effect if Actual Results Differ From Assumptions. The allowance represents management’s best estimate, but significant downturns in circumstances relating to loan quality and economic conditions could result in a requirement for additional allowance. Likewise, an upturn in loan quality and improved economic conditions may allow a reduction in the required allowance. In either instance, unanticipated changes could have a significant impact on results of operations.

Management’s analysis of probable losses in the portfolio at June 30, 2018 resulted in a range for allowance for loan losses of $15.6 million. The range pertains to general (FASB ASC 450, Contingencies) reserves for both retail and performing commercial loans. Specific (FASB ASC 310, Receivables) reserves do not have a range of probable loss. Due to the risks and uncertainty associated with the economy and our projection of loss rates inherent in the portfolio, we establish a range of probable outcomes (a high-end estimate and a low-end estimate) and evaluate our position within this range. The potential effect to net income based on our position in the range relative to the high and low endpoints is a decrease of $1.8 million and an increase of $10.0 million, respectively, after taking into account the tax effects. These sensitivities are hypothetical and may not represent actual results.

Derivative Financial Instruments

 

    Description. As part of our overall interest rate risk management, we use derivative instruments to reduce exposure to changes in interest rates and market prices for financial instruments. The application of the hedge accounting policy requires judgment in the assessment of hedge effectiveness, identification of similar hedged item groupings and measurement of changes in the fair value of derivative financial instruments and hedged items. To the extent hedging relationships are found to be effective, as determined by FASB ASC 815, Derivatives and Hedging (“ASC Topic 815”), changes in fair value of the derivatives are offset by changes in the fair value of the related hedged item or recorded to other comprehensive income. Management believes hedge effectiveness is evaluated properly in preparation of the financial statements. All of the derivative financial instruments we use have an active market and indications of fair value can be readily obtained. We are not using the “short-cut” method of accounting for any fair value derivatives.

 

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    Judgments and Uncertainties. The application of the hedge accounting policy requires judgment in the assessment of hedge effectiveness, identification of similar hedged item groupings and measurement of changes in the fair value of derivative financial instruments and hedged items.

 

    Effect if Actual Results Differ From Assumptions. To the extent hedging relationships are found to be effective, as determined by ASC Topic 815, changes in fair value of the derivatives are offset by changes in the fair value of the related hedged item or recorded to other comprehensive income. However, if in the future the derivative financial instruments used by us no longer qualify for hedge accounting treatment, all changes in fair value of the derivative would flow through the consolidated statements of income in other noninterest income, resulting in greater volatility in our earnings.

Income Taxes

 

    Description. We are subject to the income tax laws of the U.S., its states, and the municipalities in which we operate. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant government taxing authorities. We review income tax expense and the carrying value of deferred tax assets quarterly; and as new information becomes available, the balances are adjusted as appropriate. FASB ASC 740-10 (FIN 48) prescribes a recognition threshold of more-likely-than-not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those tax positions to be recognized in the financial statements. See Note 20 to the consolidated financial statements for a further description of our provision and related income tax assets and liabilities.

 

    Judgments and Uncertainties. In establishing a provision for income tax expense, we must make judgments and interpretations about the application of these inherently complex tax laws. We must also make estimates about when in the future certain items will affect taxable income in the various tax jurisdictions. Disputes over interpretations of the tax laws may be subject to review/adjudication by the court systems of the various tax jurisdictions or may be settled with the taxing authority upon examination or audit.

 

    Effect if Actual Results Differ From Assumptions. Although management believes that the judgments and estimates used are reasonable, actual results could differ and we may be exposed to losses or gains that could be material. To the extent we prevail in matters for which reserves have been established, or are required to pay amounts in excess of our reserves, our effective income tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement would result in an increase in our effective income tax rate in the period of resolution. A favorable tax settlement would result in a reduction in our effective income tax rate in the period of resolution.

Management has discussed the development and selection of these critical accounting estimates with the Audit Committee and the Audit Committee has reviewed our disclosure relating to it in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

FORWARD-LOOKING STATEMENTS

In this report, we have made various statements regarding current expectations or forecasts of future events, which speak only as of the date the statements are made. These statements are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are also made from time-to-time in press releases and in oral statements made by the officers of Old National Bancorp (“Old National” or the “Company”). Forward-looking statements can be identified by the use of the words “expect,” “may,” “could,” “intend,” “project,” “estimate,” “believe,” “anticipate,” and other words of similar meaning. Forward-looking statements also include, but are not limited to, statements regarding estimated cost savings, plans and objectives for future operations, the Company’s business and growth strategies, including future acquisitions of banks, regulatory developments, and expectations about performance as well as economic and market conditions and trends.

 

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Such forward-looking statements are based on assumptions and estimates, which although believed to be reasonable, may turn out to be incorrect. Therefore, undue reliance should not be placed upon these estimates and statements. We cannot assure that any of these statements, estimates, or beliefs will be realized and actual results may differ from those contemplated in these “forward-looking statements.” We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events, or otherwise. You are advised to consult further disclosures we may make on related subjects in our filings with the SEC. In addition to other factors discussed in this report, some of the important factors that could cause actual results to differ materially from those discussed in the forward-looking statements include the following:

 

    economic, market, operational, liquidity, credit, and interest rate risks associated with our business;

 

    economic conditions generally and in the financial services industry;

 

    expected cost savings in connection with the consolidation of recent acquisitions may not be fully realized or realized within the expected time frames, and deposit attrition, customer loss, and revenue loss following completed acquisitions may be greater than expected;

 

    failure to properly understand risk characteristics of newly entered markets;

 

    increased competition in the financial services industry either nationally or regionally, resulting in, among other things, credit quality deterioration;

 

    our ability to achieve loan and deposit growth;

 

    volatility and direction of market interest rates;

 

    governmental legislation and regulation, including changes in accounting regulation or standards;

 

    our ability to execute our business plan;

 

    a weakening of the economy which could materially impact credit quality trends and the ability to generate loans;

 

    changes in the securities markets; and

 

    changes in fiscal, monetary, and tax policies.

Investors should consider these risks, uncertainties, and other factors in addition to risk factors included in our other filings with the SEC.

 

ITEM 3. QUANTITIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

See Management’s Discussion and Analysis of Financial Condition and Results of Operations – Market Risk and Liquidity Risk.

 

ITEM 4. CONTROLS AND PROCEDURES

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

Evaluation of disclosure controls and procedures. Old National’s principal executive officer and principal financial officer have concluded that Old National’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended), based on their evaluation of these controls and procedures as of the end of the period covered by this quarterly report on Form 10-Q, are effective at the reasonable assurance level as discussed below to ensure that information required to be disclosed by Old National in the reports it files under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission and that such information is accumulated and communicated to Old National’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Limitations on the Effectiveness of Controls. Management, including the principal executive officer and principal financial officer, does not expect that Old National’s disclosure controls and internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls.

 

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The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be only reasonable assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, control may become inadequate because of changes in conditions or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

Changes in Internal Control over Financial Reporting. There were no changes in Old National’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, Old National’s internal control over financial reporting.

PART II

OTHER INFORMATION

 

ITEM 1A. RISK FACTORS

There have been no material changes from the risk factors previously disclosed in the “Risk Factors” section of the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

 

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

 

  (c) ISSUER PURCHASES OF EQUITY SECURITIES

 

                   Total Number         
                   of Shares         
     Total      Average      Purchased as      Maximum Number of  
     Number      Price      Part of Publicly      Shares that May Yet  
     of Shares      Paid Per      Announced Plans      Be Purchased Under  

Period

   Purchased      Share      or Programs      the Plans or Programs  

04/01/18 - 04/30/18

     1,196      $ 16.95        —          —    

05/01/18 - 05/31/18

     29,352        17.40        —          —    

06/01/18 - 06/30/18

     400        18.34        —          —    
  

 

 

    

 

 

    

 

 

    

 

 

 

Quarter-to-date 6/30/18

     30,948      $ 17.40        —          —    
  

 

 

    

 

 

    

 

 

    

 

 

 

The Board of Directors did not authorize a stock repurchase plan for 2018. During the three months ended June 30, 2018, Old National repurchased a limited number of shares associated with employee share-based incentive programs.

 

ITEM 5. OTHER INFORMATION

 

(a) None

 

(b) There have been no material changes in the procedure by which security holders recommend nominees to the Company’s board of directors.

 

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ITEM 6. EXHIBITS

 

Exhibit

    No.    

  

Description

    2.1    Agreement and Plan of Merger dated as of August 7, 2017 by and between Old National Bancorp and Anchor Bancorp, Inc. (the schedules and exhibits have been omitted pursuant to Item 601(b)(2) of Regulation S-K) (incorporated by reference to Exhibit 2.1 of Old National’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 8, 2017).
    2.2    Agreement and Plan of Merger dated as of June 20, 2018 by and between Old National Bancorp and Klein Financial, Inc. (the schedules and exhibits have been omitted pursuant to Item 601(b)(2) of Regulation S-K) (incorporated by reference to Exhibit 2.1 of Old National’s Current Report on Form 8-K filed with the Securities and Exchange Commission on June 21, 2018).
    3.1    Fourth Amended and Restated Articles of Incorporation of Old National, amended May 13, 2016 (incorporated by reference to Exhibit 3.1 of Old National’s Current Report on Form 8-K filed with the Securities and Exchange Commission on May 16, 2016).
    3.2    Amended and Restated By-Laws of Old National, amended July 28, 2016 (incorporated by reference to Exhibit 3.1 of Old National’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 1, 2016).
    4.1    Senior Indenture between Old National and The Bank of New York Trust Company (as successor to J.P. Morgan Trust Company, National Association (as successor to Bank One, N.A.)), as trustee, dated as of July 23, 1997 (incorporated by reference to Exhibit 4.3 to Old National’s Registration Statement on Form S-3, Registration No. 333-118374, filed with the Securities and Exchange Commission on December 2, 2004).
    4.2    Second Indenture Supplement, dated as of August 15, 2014, between Old National and The Bank of New York Mellon Trust Company, N.A., as trustee, providing for the issuance of its 4.125% Senior Notes due 2024 (incorporated by reference to Exhibit 4.1 of Old National’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 15, 2014).
  31.1    Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
  31.2    Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
  32.1    Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
  32.2    Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101    The following materials from Old National’s Form 10-Q Report for the quarterly period ended June 30, 2018, formatted in XBRL: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) the Consolidated Statements of Changes in Shareholders’ Equity, (v) the Consolidated Statements of Cash Flows, and (vi) the Notes to Consolidated Financial Statements.

 

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

OLD NATIONAL BANCORP

(Registrant)

 

By:  

/s/ James C. Ryan, III

 

James C. Ryan, III

Senior Executive Vice President and Chief Financial Officer

Duly Authorized Officer and Principal Financial Officer

  Date: August 1, 2018

 

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