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June 29, 2007
VIA EDGAR
Securities and Exchange Commission
Division of Corporation Finance
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention: Rebekah Moore and Kevin W. Vaughn
Mail Stop-4561
Re: First Merchants Corporation
Form 10-K for Fiscal Year Ended December 31, 2006
Filed March 16, 2007
File No. 000-17071
Ladies and Gentlemen:
This correspondence is First Merchants Corporation's response to comments
received from the Securities and Exchange Commission on June 18, 2007, regarding
document revisions for future filings of First Merchants Corporation's Form
10-K.
Note 1 Nature of Operations and Summary of Significant Accounting Policies,
page 25
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In response to comments made regarding First Merchants Reinsurance Company's
total insurance exposure and inter-company accounting policy, we will revise
page 4 of the 10-K to read as follows.
1. SEC Comment: We note that you have proposed to disclose your self-insurance
risk on a per policy basis. Please revise to disclose the total exposure
related to self-insurance for all policies outstanding.
First Merchants Corporation response: In future filings, we
propose to change the disclosure on page 4 to read as follows:
The Corporation operates First Merchants Insurance Services,
Inc. a full-service property, casualty, personal lines, and
employee benefit insurance agency headquartered in Muncie,
Indiana. The Corporation is also the majority owner of Indiana
Title Insurance Company, LLC which is a full-service title
insurance agency. The Corporation operates First Merchants
Reinsurance Co. Ltd., a small life reinsurance company whose
primary business includes underwriting short-duration
contracts of credit life and accidental and health insurance
policies and debt cancellation contracts. Such policies and
contracts are purchased by customers of the Corporation's bank
customers to cover the amount of debt incurred by the insured.
No policies are issued for loans other than those originated
by the subsidiary banks. First Merchants Reinsurance Co. Ltd.
limits its self-insurance risk to the first $15,000 of
exposure under each credit life policy and $350 per month on
each accident and health policy. The company maintains the
same standard for its debt cancellation contracts. The total
self-insurance exposure as of December 31, 2006 totaled $20.5
million. All intercompany transactions are eliminated during
the preparation of consolidated financial statements.
2. SEC Comment: Please revise to disclose how you account for the intercompany
transactions related to self-insurance that First Merchant's Reinsurance
Company provides to its parent or other related entities.
First Merchants Corporation Response: See response under item 1.
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Note 22 Derivative Instruments and Hedging Activities, page 52
3. SEC Comment: Please revise to disclose the methods and significant
assumptions used to determine the fair value of your derivative
instruments.
First Merchants Corporation Response: In future filings, we
propose to change Note 22 to read substantially as follows:
Statement of Financial Accounting Standards No. 133,
Accounting for Derivative Instruments and Hedging Activities
(SFAS 133), as amended and interpreted, establishes accounting
and reporting standards for derivative instruments, including
certain derivative instruments embedded in other contracts,
and for hedging activities. As required by SFAS 133, the
Corporation records all derivatives on the balance sheet at
fair value. The accounting for changes in the fair value of
derivatives depends on the intended use of the derivative and
the resulting designation. Derivatives used to hedge the
exposure to changes in the fair value of an asset, liability,
or firm commitment attributable to a particular risk, such as
interest rate risk, are considered fair value hedges.
Derivatives used to hedge the exposure to variability in
expected future cash flows, or other types of forecasted
transactions, are considered cash flow hedges. Hedge
ineffectiveness, if any, is measured periodically throughout
the life of the hedging relationship.
The Corporation's objective in using derivatives is to add
stability to interest income and to manage its exposure to
changes in interest rates. To accomplish this objective, the
Corporation uses interest rate floors to protect the
Corporation against movements in interest rates below the
instruments' strike rates, over the lives of the agreements.
The interest rate floors have notional amounts of $50,000,000,
$100,000,000, and $100,000,000 with corresponding strike rates
of 6.0%, 7.0% and 7.5%, respectively. All of the floors have
maturity dates of August 1, 2009. During 2006, the floors were
used to hedge the variable cash flows associated with existing
variable-rate loan asset pools that are based on the prime
rate (Prime). For accounting purposes, the floors are
designated as cash flow hedges of the overall changes in cash
flows on the first Prime-based interest payments received by
the Corporation each calendar month during the terms of the
hedges that, in aggregate for each period, are interest
payments on principal from specified portfolios equal to the
notional amounts of the floors.
For derivatives designated as cash flow hedges, the effective
portion of changes in the fair value of the derivative is
initially reported in other comprehensive income (outside of
earnings) and subsequently reclassified to earnings ("interest
income on loans") when the hedged transaction affects
earnings. Ineffectiveness resulting from the hedging
relationship, if any, is recorded as a gain or loss in
earnings as part of non-interest income. Based on the
Corporation's assessments both at inception and throughout the
life of the hedging relationship, it is probable that
sufficient Prime-based interest receipts will exist through
the maturity dates of the floors. The Corporation uses the
"Hypothetical Derivative Method" described in SFAS 133
Implementation Issue No. G20, "Cash Flow Hedges: Assessing and
Measuring the Effectiveness of a Purchased Option Used in a
Cash Flow Hedge," for its quarterly prospective and
retrospective assessments of hedge effectiveness, as well as
for measurements of hedge ineffectiveness. The Corporation
also monitors the risk of counterparty default on an ongoing
basis.
Prepayments in hedged loan portfolios are treated in a manner
consistent with the guidance in SFAS 133 Implementation Issue
No. G25, "Cash Flow hedges: Using the First-Payments-Received
Technique in Hedging the Variable Interest Payments on a Group
of Non-Benchmark-Rate-Based Loans," which allows the
designated forecasted transactions to be the variable,
Prime-rate-based interest payments on a rolling portfolio of
prepayable interest-bearing loans using the
first-payments-received technique, thereby allowing interest
payments from loans that prepay to be replaced with interest
payments from new loan originations.
As of December 31, 2006, no derivatives were designated as
fair value hedges or hedges of net investments in foreign
operations. Additionally, the Corporation does not use
derivatives for trading or speculative purposes and currently
does not have any derivatives that are not designated as
hedges.
At December 31, 2006, interest rate floors with a fair value
of $428,000 were included in other assets. For the year ended
December 31, 2006, the change in net unrealized losses of
$125,000 for derivatives designated as cash flow hedges is
separately disclosed in the statement of changes in
shareholders' equity and comprehensive income. No hedge
ineffectiveness on cash flow hedges was recognized during the
year ended December 31, 2006.
Amounts reported in accumulated other comprehensive income
related to derivatives will be reclassified to interest income
as interest payments are received on the Corporation's
variable-rate loan assets. For the year ended December 31,
2006, the change in net unrealized losses on cash flow hedges
reflects a reclassification of $38 of net unrealized losses
from accumulated other comprehensive income to interest
income. For the year ended December 31, 2007, the Corporation
estimates that an additional $50,000 will be reclassified from
accumulated other comprehensive income to interest income.
Interest rate floors are valued using market standard
methodologies that incorporate implied forward interest rates
and implied volatility as inputs. The fair value of each floor
is obtained by summing the values of each individual floorlet
- which are monthly European-style options on the
daily-weighted-average Prime rate. The fair value of each
floorlet is calculated using the Black-Scholes Model.
4. SEC Comment: We note in your response that your interest rate floors have
strike rates that range from 6.0% to 7.5%. Please revise to disclose the
total notional amounts associated with each strike rate.
First Merchants Corporation Response: See response under item 3 paragraph 2.
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In closing, First Merchants Corporation acknowledges that:
o the Corporation is responsible for the adequacy and accuracy of the
disclosure in the filing;
o staff comments or changes to disclosure in response to staff comments do
not foreclose the Commission from taking any action with respect to the
filing; and
o the Corporation may not assert staff comments as a defense in any
proceeding initiated by the Commission or any person under the federal
securities laws of the United States.
Sincerely,
Mark Hardwick
Executive Vice President
Chief Financial Officer
First Merchants Corporation