The following discussion is an analysis of our results of operations for the three and nine months ended September 30, 2009 and 2008, and financial condition as of September 30, 2009, compared to September 30, 2008, and December 31, 2008. 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.
In June 2009, the FASB issued Statement No. 168 - The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles (FASB ASC 105-10, Generally Accepted Accounting Principles). SFAS No. 168 replaces SFAS No. 162 and establishes the FASB Accounting Standards Codification as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with generally accepted accounting principles ("GAAP"). Rules and interpretative releases of the Securities and Exchange Commission under federal securities laws are also sources of authoritative GAAP for SEC registrants. The FASB Accounting Standards Codification will be effective for financial statements that cover interim and annual periods ending after September 15, 2009. Other than resolving certain minor inconsistencies in current GAAP, the FASB Accounting Standards Codification is not intended to change GAAP, but rather to make it easier to review and research GAAP applicable to a particular transaction or accounting issue. Technical references to generally accepted accounting principles included in this Form 10-Q are provided under the new FASB ASC structure with the prior terminology included parenthetically.
EXECUTIVE SUMMARY
During the third quarter we significantly strengthened our capital position with a successful stock offering. Net proceeds from the issuance of 20.7 million shares were approximately $196.4 million. Our tier one and total risk-based regulatory capital ratios improved from 10.2% and 12.6% at June 30, 2009, to 14.1% and 16.5% at September 30, 2009.
Although non-performing, problem and special mention loan categories showed improvement during the third quarter, the overall credit environment remains challenging and we expect it to remain that way for the near term. We recorded provision expense of $12.2 million during the third quarter. As a percent of total loans, the allowance was 1.72% at September 30, 2009, compared to 1.41% and 1.36% at December 31, 2008 and September 30, 2008, respectively. Annualized net charge-offs were 1.17% of average loans in the third quarter of 2009 compared to 1.14% in the fourth quarter of 2008, and 0.46% year-over-year. Nonperforming loans totaled 1.80% of total loans at September 30, 2009, compared to 1.34% at December 31, 2008 and 1.46% a year ago.
Third quarter results include the sale of a $258 million municipal lease portfolio, securities gains of $5.1 million, other-than-temporary impairment of securities of $5.1 million, elevated credit costs and net interest margin compression as a result of soft loan demand, the sale of the aforementioned municipal lease portfolio and reduced earnings from our investment portfolio. Net income for the third quarter of 2009 is $4.0 million, compared to $6.6 million and $17.0 million for the quarters ended December 31, 2008 and September 30, 2008, respectively. Net interest margin in the third quarter of 2009 was 3.53% compared to 3.59% during the second quarter of 2009, and 3.79% year-over-year.
We believe the economy is in a very deep and long lasting recession and the effects on our industry will be felt for an extended period of time. We believe that Old National is well positioned to not only withstand, but to capitalize on the industry challenges based on a number of the strategic actions we have taken. While loan demand remains soft as evidenced by the decrease in our loan portfolio it is management's intent to focus on streamlining current processes and gain efficiency improvements.

RESULTS OF OPERATIONS
The following table sets forth certain income statement information of Old
National for the three and nine months ended September 30, 2009 and 2008:

                             Three Months Ended                         Nine Months Ended
                               September 30,               %              September 30,               %
(dollars in thousands)       2009           2008        Change         2009           2008         Change
Income Statement
Summary:
Net interest income       $   56,411      $ 59,596        (5.3) %    $ 176,376      $ 180,730        (2.4) %
Provision for loan
losses                        12,191         6,842         78.2         41,459         34,447         20.4
Noninterest income            39,003        38,995          0.0        126,844        129,384         (2.0 )
Noninterest expense           83,966        72,463         15.9        248,181        218,233         13.7
Other Data:
Return on average
common equity                   2.53 %       10.50 %                      4.00 %        11.20 %
Efficiency ratio               83.39         70.03                       77.58          67.36
Tier 1 leverage ratio          10.03          8.29                       10.03           8.29
Net charge-offs to
average loans                   1.17          0.46                        1.14           0.78

Net Interest Income
Net interest income is our most significant component of earnings, comprising over 58% of revenues at September 30, 2009. 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 prepayment risk on mortgage and investment-related assets and the composition and maturity of earning assets and interest-bearing liabilities. Loans typically generate more interest income than investment securities with similar maturities. In the current market, wholesale funding sources cost less than client deposits; however, ordinarily funding from client deposits costs less than wholesale funding sources. Factors such as general economic activity, Federal Reserve Board monetary policy and price volatility of competing alternative investments, can also exert significant influence on our ability to optimize our mix of assets and funding and our net interest income and margin.
Net interest income and net interest margin in the following discussion are presented on a fully taxable equivalent basis, which adjusts tax-exempt or nontaxable interest income to an amount that would be comparable to interest subject to income taxes using the federal statutory tax rate of 35% in effect for all periods. Net income is unaffected by these taxable equivalent adjustments as the offsetting increase of the same amount is made to income tax expense. Net interest income includes taxable equivalent adjustments of $5.3 million and $4.9 million for the three months ended September 30, 2009 and 2008, respectively. Taxable equivalent adjustments for the nine months ended September 30, 2009 and 2008 were $16.7 million and $13.9 million, respectively. Taxable equivalent net interest income was $61.7 million and $193.1 million for the three and nine months ended September 30, 2009, down from the $64.5 million and $194.6 million reported for the three and nine months ended September 30, 2008. The net interest margin was 3.53% and 3.58% for the three and nine months ended September 30, 2009, compared to 3.79% and 3.77% for the three and nine months ended September 30, 2008. The decrease in both net interest income and net interest margin is primarily due to the decrease in the yield on interest earning assets being greater than the decrease in the cost of interest-bearing liabilities, combined with a change in the mix of interest earning assets and interest-bearing liabilities. The yield on average earning assets decreased 84 basis points from 5.89% to 5.05% while the cost of interest-bearing liabilities decreased 64 basis points from 2.45% to 1.81% in the quarterly year-over-year comparison. In the year-to-date comparison, the yield on average assets decreased 89 basis points from 6.04% to 5.15% while the cost of interest-bearing liabilities decreased 78 basis points from 2.63% to 1.85%.

Average earning assets were $6.995 billion for the three months ended September 30, 2009, compared to $6.804 billion for the three months ended September 30, 2008, an increase of 2.8%, or $190.5 million. Average earning assets were $7.189 billion for the nine months ended September 30, 2009, compared to $6.878 billion for the nine months ended September 30, 2008, an increase of 4.5%, or $311.5 million. Significantly affecting average earning assets at September 30, 2009 compared to September 30, 2008, was the increase in the size of the investment portfolio combined with the reduction of the size of the loan portfolio. During the nine months ended September 30, 2009, $1.842 billion of investment securities were purchased and $915.8 million of investment securities were called by the issuers or sold. During the third quarter of 2009, approximately $258.0 million of leases held for sale were sold. In addition, commercial and commercial real estate loans have been affected by continued weak loan demand in our markets, more stringent loan underwriting standards and our desire to lower future potential credit risk by being cautious towards the real estate market. Year over year, the investment portfolio, which generally has an average yield lower than the loan portfolio, has increased as a percent of interest earning assets.
Also affecting margin was an increase in noninterest-bearing demand deposits and time deposits. Included in deposits at September 30, 2009 are $88.8 million of noninterest-bearing deposits and $126.2 million of time deposits from the Citizens Financial branch acquisition. In the fourth quarter of 2008, $19.3 million of high cost brokered certificates of deposit were called or matured. In addition, $25.0 million of FHLB advances matured in the fourth quarter of 2008 and a revolving credit facility with $55 million outstanding was paid off in the fourth quarter of 2008. During the first nine months of 2009, $81.0 million of high cost brokered certificates of deposit were called and $67.1 million of retail certificates of deposit were called. In addition, $25.0 million of FHLB advances were prepaid in the first nine months of 2009. Year over year, brokered certificates of deposit, which have an average interest rate higher than other types of deposits, have decreased as a percent of interest-bearing liabilities. Year over year, noninterest-bearing demand deposits have increased as a percent of total funding. Funding from client deposits generally cost less than wholesale funding, but not in the current market.
Provision for Loan Losses
The provision for loan losses was $12.2 million for the three months ended September 30, 2009, compared to $6.8 million for the three months ended September 30, 2008. The provision for loan losses was $41.5 million for the nine months ended September 30, 2009, compared to $34.4 million for the nine months ended September 30, 2008. Included in the 2008 provision is $17.7 million associated with the misconduct of a former loan officer in the Indianapolis market and subsequent deterioration of these credits. The higher provision in 2009 is attributable to an increase in net charge-offs combined with an increase in nonaccrual loans. Included in 2009 net charge-offs is a $3.1 million insurance recovery associated with the misconduct of a former loan officer in 2008 as discussed above.
Noninterest Income
We generate revenues in the form of noninterest income through client fees and sales commissions from our core banking franchise and other related businesses, such as wealth management, investment consulting, investment products and insurance. Noninterest income was $39.0 million for both the three months ended September 30, 2009 and the three months ended September 30, 2008. For the nine months ended September 30, 2009, noninterest income was $126.8 million, a decrease of $2.6 million, or 2.0%, from the $129.4 million reported for the nine months ended September 30, 2008.
Net securities gains were $40 thousand and $5.7 million for the three and nine months ended September 30, 2009, compared to net securities gains of $45 thousand and $6.6 million for the three and nine months ended September 30, 2008. Included in the third quarter and first nine months of 2009 is $5.1 million and $15.3 million, respectively, in charges for other-than-temporary-impairment on six pooled trust preferred securities and two non-agency mortgage-backed securities. The 2008 net securities gains were primarily the result of securities which were called by the issuers. Wealth management fees were $3.9 million and $11.9 million for the three and nine months ended September 30, 2009 as compared to $4.2 million and $13.6 million for the three and nine months ended September 30, 2008. Trust fee income has declined as a result of lower market values of managed assets. Service charges on deposit accounts were $15.1 million and $41.4 million for the three and nine months ended September 30, 2009, compared to $11.8 million and $33.4 million for the three and nine months ended September 30, 2008. The increase in revenue is primarily attributable to the acquisition of the retail branch banking network of Citizens Financial Group in March 2009.
ATM fees were $5.4 million and $15.0 million for the three and nine months ended September 30, 2009, compared to $4.5 million and $13.0 million for the three and nine months ended September 30, 2008. The increase in debit card usage is primarily attributable to the Citizens Financial branch acquisition.

Revenue from company-owned life insurance was $0.5 million and $1.6 million for the three and nine months ended September 30, 2009, compared to $2.9 million and $8.4 million for the three and nine months ended September 30, 2008. During the third quarter of 2008, the crediting rate formula for the 1997 company-owned life insurance policy was amended to adopt a more conservative position and improve the overall market to book value ratio. This change resulted in lower revenues in the first nine months of 2009 and while we expect revenues to increase in 2010 and future years, we also anticipate revenue will remain below 2008 levels.
Fluctuations in the value of our derivatives resulted in losses on derivatives of $0.7 million for the three months ended September 30, 2009 and gains of $0.3 million for the nine months ended September 30, 2009 as compared to losses on derivatives of $0.2 million and $1.2 million for the three and nine months ended September 30, 2008.
Other income decreased $1.1 million and $3.9 million for the three and nine months ended September 30, 2009 as compared to the three and nine months ended September 30, 2008. Included in third quarter 2009 is a $1.4 million loss from the sale of approximately $258.0 million of leases held for sale, net of transaction fees. The first quarter of 2008 included a $1.5 million gain associated with the redemption of class B VISA shares. Customer derivative fee revenue has also decreased in the year-over-year comparison. Noninterest Expense
Noninterest expense for the three months ended September 30, 2009, totaled $84.0 million, an increase of $11.5 million, or 15.9%, from the $72.5 million recorded for the three months ended September 30, 2008. For the nine months ended September 30, 2009, noninterest expense was $248.2 million, an increase of $30.0 million, or 13.7%, from the $218.2 million recorded for the nine months ended September 30, 2008. The increased expenses in 2009 relate primarily to costs associated with the 65 Citizens Financial branches acquired during March 2009, as well as an increase in FDIC insurance expense.
Salaries and benefits is the largest component of noninterest expense. For the three months ended September 30, 2009, salaries and benefits were $46.5 million compared to $40.5 million for the three months ended September 30, 2008. For the nine months ended September 30, 2009, salaries and benefits were $134.4 million compared to $126.0 million for the nine months ended September 30, 2008. Included in the third quarter of 2009 is approximately $4.7 million of personnel expense associated with the acquisition of the Indiana retail branch banking network of Citizens Financial Group. Included in the first nine months of 2009 is approximately $10.0 million of personnel expense associated with the acquisition of the Indiana retail branch banking network of Citizens Financial Group and $2.0 million for higher medical insurance expense. Partially offsetting these increases was a $2.0 million decrease in performance-based incentive compensation expense during the nine months ended September 30, 2009. Occupancy expense increased $2.2 million and $5.6 million for the three and nine months ended September 30, 2009, compared to the three and nine months ended September 30, 2008, primarily as a result of increases in rent expense and the amortization of leasehold improvements. Utilities expense and real estate taxes also increased for the three and nine months ended September 30, 2009 as compared to the three and nine months ended September 30, 2008. The increase in rent expense is related to the sale leaseback transactions discussed in Note 16 to the consolidated financial statements and the additional 65 branches acquired from Citizens Financial in the first quarter of 2009. The increase in amortization expense is also related to the acquisition of the branches from Citizens Financial.
Professional fees increased $1.5 million for the nine months ended September 30, 2009 as compared to the nine months ended September 30, 2008. The increase is primarily attributable to legal and other professional fees associated with the acquisition of the Citizens Financial branch network.
FDIC assessment expense was $1.8 million for the three months ended September 30, 2009, compared to $0.3 million for the three months ended September 30, 2008. For the nine months ended September 30, 2009, FDIC assessment expense was $10.2 million compared to $0.9 million for the nine months ended September 30, 2008. The increase is primarily due to the increase in the rates banks pay for deposit insurance and the expiration of our one-time assessment credit at the end of 2008. The FDIC implemented a special assessment during the second quarter of 2009 which resulted in approximately $4.0 million of additional expense during the quarter. We continue to monitor the FDIC's restoration plan and believe it is possible that the FDIC will impose another special assessment later in the year or require us to prepay our 2010, 2011 and 2012 assessments in the current year.

The increase in the expense for amortization of intangibles for both the quarterly and year-to-date comparisons is primarily due to the core deposit intangible associated with the acquisition of the retail branch banking network of Citizens Financial Group and subsequent amortization of this asset. Other expense for the nine months ended September 30, 2009, totaled $12.7 million, an increase of $2.0 million compared to the nine months ended September 30, 2008. The provision for unfunded commitments increased $1.1 million for the nine months ended September 30, 2009 as compared to the nine months ended September 30, 2008. Included in the nine months ended September 30, 2009 is approximately $1.1 million of conversion expenses related to the acquisition of the retail branch banking network of Citizens Financial Group.
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 interest on tax-exempt securities and loans. The provision for income taxes, as a percentage of pre-tax income, was a benefit of 640.6% for the three months ended September 30, 2009, compared to expense of 11.8% for the three months ended September 30, 2008. The provision for income taxes, as a percentage of pre-tax income, was a benefit of 69.8% for the nine months ended September 30, 2009, compared to expense of 2.8% for the nine months ended September 30, 2008. The decrease in the effective tax rate for the three months ended September 30, 2009, is the result of tax-exempt income being a higher percentage of pre-tax income in 2009 than in the prior year and the pre-tax income being lower than prior periods. Management intends to gradually reduce the current level of tax-exempt income and sold $258 million of tax-exempt municipal leases during the third quarter of 2009. The average balance of municipal bonds also declined during the quarter. The decrease in the effective tax rate for the nine months ended September 30, 2009, is the result of tax-exempt income being a higher percentage of pre-tax income in 2009 than in the prior year. See Note 14 to the consolidated financial statements for additional information.
FINANCIAL CONDITION
Overview
At September 30, 2009, our assets were $7.973 billion, a 5.4% increase compared to September 30, 2008 assets of $7.568 billion, and an annualized increase of 1.7% compared to December 31, 2008 assets of $7.874 billion. On March 20, 2009, Old National completed its acquisition of the Indiana retail branch banking network of Citizens Financial Group, which increased assets by approximately $424.7 million and deposits by $424.5 million. In September 2009, Old National sold $258.0 million of finance leases and raised approximately $196.4 million from a public offering of common stock.
Earning Assets
Our earning assets are comprised of investment securities, loans and loans and leases held for sale, and money market investments. Earning assets were $7.095 billion at September 30, 2009, an increase of 4.5% from September 30, 2008, and an annualized increase of 0.4% since December 31, 2008. 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 do have $73.4 million of 15- and 20-year fixed-rate mortgage pass-through securities in our held-to-maturity investment portfolio and during the second quarter of 2009 approximately $230.1 million of U.S. government-sponsored entity and agency securities were added to our held-to-maturity investment portfolio.
At September 30, 2009, the total investment securities portfolio was $2.960 billion compared to $2.070 billion at September 30, 2008, an increase of $890.3 million or 43.0%. Investment securities increased $694.7 million compared to December 31, 2008, an annualized increase of 40.9%. Investment securities represented 41.7% of earning assets at September 30, 2009, compared to 30.5% at September 30, 2008, and 32.0% at December 31, 2008. Funds received in the Citizens Financial branch acquisition, the sale of the finance leases and from the public offering of common stock have been invested primarily in investment securities. Stronger commercial loan demand in the future and management's efforts to deleverage the balance sheet could result in a reduction in the securities portfolio. As of September 30, 2009, management does not intend to sell any securities with an unrealized loss position.

The investment securities available-for-sale portfolio had net unrealized losses of $7.3 million at September 30, 2009, a decrease of $66.9 million compared to net unrealized losses of $74.2 million at September 30, 2008, and a decrease of $57.3 million compared to net unrealized losses of $64.6 million at December 31, 2008. A $15.3 million charge was recorded during the first nine months of 2009 related to other-than-temporary-impairment on six pooled trust preferred securities and two non-agency mortgage-backed securities. Contributing to the volatility in net unrealized losses over the past twelve months are changes in interest rates and the financial crisis affecting the banking system and financial markets.
The investment portfolio had an average duration of 4.41 years at September 30, 2009, compared to 4.76 years at September 30, 2008, and 3.87 years at December 31, 2008. The annualized average yields on investment securities, on a taxable equivalent basis, were 4.98% for the three months ended September 30, 2009, compared to 5.38% for the three months ended September 30, 2008, and 5.62% for the three months ended December 31, 2008. Average yields on investment securities, on a taxable equivalent basis, were 5.20%, 5.25% and 5.34% for the nine months ended September 30, 2009 and 2008, and for the year ended December 31, 2008, respectively.
Residential Loans Held for Sale
Residential loans held for sale were $11.4 million at September 30, 2009, compared to $11.1 million at September 30, 2008, and $17.2 million at December 31, 2008. Residential loans held for sale are loans that are closed, but not yet purchased by investors. The amount of residential loans held for sale on the balance sheet varies depending on the amount of originations and timing of loan sales to the secondary market.
We elected the fair value option under FASB ASC 825-10 (SFAS No. 159) prospectively for residential loans held for sale. The election was effective for loans originated after January 1, 2008. The aggregate fair value exceeded the unpaid principal balances by $0.4 million, $0.6 million and $0.2 million as of September 30, 2009, December 31, 2008 and September 30, 2008, respectively. Finance Leases Held for Sale
At September 30, 2009, Old National had finance leases held for sale of $58.4 million. In the second quarter of 2009, $370.2 million of leases were transferred from the commercial loan category at cost utilizing the lower of cost or fair value method. During the third quarter of 2009, approximately $258.0 million of leases held for sale were sold at a price above par; however the transaction resulted in a loss of $1.4 million after transaction fees. Approximately $46.0 million of leases were transferred from held for sale back to the loan portfolio at the lower of cost or market and at September 30, 2009. After scheduled principal payments and prepayments, $58.4 million of finance leases remained available for sale. The leases held for sale at September 30, 2009 have maturities ranging from 1 to 18 years and interest rates ranging from 3.76% to 9.73%. All of the leases held for sale are to municipalities, with various types of equipment securing the leases, and all of the leases are current.
Commercial and Commercial Real Estate Loans Commercial and commercial real estate loans are the second largest classification within earning assets, representing 35.1% of earning assets at September 30, 2009, a decrease from 43.7% at September 30, 2008, and a decrease from 43.2% at December 31, 2008. At September 30, 2009, commercial and commercial real estate loans were $2.488 billion, a decrease of $482.0 million since September 30, 2008, and a decrease of $564.4 million since December 31, 2008. The majority of the decrease relates to the finance leases which were moved to held for sale status or sold in the third quarter of 2009. In addition, . . .