4.	Loans and Allowance for Loan Losses

The Company’s loan and allowance for loan loss policies are as follows:

Loans are stated at unpaid principal balances, less net deferred loan fees and the allowance for loan losses. The Company grants real estate mortgage, commercial business and consumer loans. A substantial portion of the loan portfolio is represented by mortgage loans to customers in southern Indiana. The ability of the Company’s customers to honor their contracts is dependent upon the real estate and general economic conditions in this area.

Loan origination and commitment fees, as well as certain direct costs of underwriting and closing loans, are deferred and amortized as a yield adjustment to interest income over the lives of the related loans using the interest method. Amortization of net deferred loan fees is discontinued when a loan is placed on nonaccrual status.

The recognition of income on a loan is discontinued and previously accrued interest is reversed, when interest or principal payments become ninety (90) days past due unless, in the opinion of management, the outstanding interest remains collectible. Past due status is determined based on contractual terms. Generally, by applying the cash receipts method, interest income is subsequently recognized only as received until the loan is returned to accrual status. The cash receipts method is used when the likelihood of further loss on the loan is remote. Otherwise, the Company applies the cost recovery method and applies all payments as a reduction of the unpaid principal balance until the loan qualifies for return to accrual status. Interest income on impaired loans is recognized using the cost recovery method, unless the likelihood of further loss on the loan is remote.

A loan is restored to accrual status when all principal and interest payments are brought current and the borrower has demonstrated the ability to make future payments of principal and interest as scheduled, which generally requires that the borrower demonstrate a period of performance of at least six consecutive months.

The Company’s practice is to charge-off any loan or portion of a loan when the loan is determined by management to be uncollectible due to the borrower’s failure to meet repayment terms, the borrower’s deteriorating or deteriorated financial condition, the depreciation of the underlying collateral, the loan’s classification as a loss by regulatory examiners, or for other reasons. A partial charge-off is recorded on a loan when the uncollectibility of a portion of the loan has been confirmed, such as when a loan is discharged in bankruptcy, the collateral is liquidated, a loan is restructured at a reduced principal balance, or other identifiable events that lead management to determine the full principal balance of the loan will not be repaid. A specific reserve is recognized as a component of the allowance for estimated losses on loans individually evaluated for impairment. Partial charge-offs on nonperforming and impaired loans are included in the Company’s historical loss experience used to estimate the general component of the allowance for loan losses as discussed below. Specific reserves are not considered charge-offs in management’s analysis of the allowance for loan losses because they are estimates and the outcome of the loan relationship is undetermined. At June 30, 2011 and December 31, 2010, the Company had no loans outstanding on which a partial charge-off had been recorded.

Installment loans are typically charged off at 90 days past due, or earlier if deemed uncollectible, unless the loans are in the process of collection. Overdrafts are charged off after 45 days past due. Charge-offs are typically recorded on loans secured by real estate when the property is foreclosed upon.

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific and general components. The specific component relates to loans that are classified as doubtful, substandard, or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors, as discussed below.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Values for collateral dependent loans are generally based on appraisals obtained from independent licensed real estate appraisers, with adjustments applied for estimated costs to sell the property, costs to complete unfinished or repair damaged property and other known defects. New appraisals are generally obtained for all significant properties when a loan is identified as impaired. Generally, a property is considered significant if the value of the property is estimated to exceed $200,000. Subsequent appraisals are obtained as needed or if management believes there has been a significant change in the market value of the property. In instances where it is not deemed necessary to obtain a new appraisal, management would base its impairment and allowance for loan loss analysis on the original appraisal with adjustments for current conditions based on management’s assessment of market factors and management’s inspection of the property.

Loans modified in a troubled debt restructuring are placed on nonaccrual status until the Company determines 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 of at least six consecutive months. At June 30, 2011, troubled debt restructurings totaled $3.7 million and the related allowance for loan losses on troubled debt restructurings was $1.4 million. At December 31, 2010, troubled debt restructurings totaled $3.9 million and the related allowance for loan losses on troubled debt restructurings was $1.5 million. All troubled debt restructurings were on nonaccrual status at June 30, 2011 and December 31, 2010.

The following table provides the components of the Company’s recorded investment in loans for each portfolio segment at June 30, 2011 and December 31, 2010:


	Residential						Commercial		Commercial		Home Equity &		Other
	Real Estate		Land		Construction		Real Estate		Business		2nd Mtg		Consumer		Total
	(In thousands)
June 30, 2011
Principal loan balance	$	123,361	$	9,110	$	6,029	$	58,143	$	26,734	$	40,849	$	29,587	$	293,813
Accrued interest receivable		467		34		14		149		78		154		164		1,060
Net deferred loan origination fees		79		1		0		3		1		101		0		185

Recorded investment in loans	$	123,907	$	9,145	$	6,043	$	58,295	$	26,813	$	41,104	$	29,751	$	295,058


December 31, 2010
Principal loan balance	$	130,143	$	9,534	$	5,032	$	59,901	$	21,911	$	43,046	$	29,234	$	298,801
Accrued interest receivable		480		54		16		174		68		171		199		1,162
Net deferred loan origination fees		91		1		0		10		0		120		0		222

Recorded investment in loans	$	130,714	$	9,589	$	5,048	$	60,085	$	21,979	$	43,337	$	29,433	$	300,185

An analysis of the allowance for loan losses and recorded investment in loans as of June 30, 2011, and for the three- and six-month periods then ended is as follows:


	Residential									Commercial			Commercial			Home Equity &			Other
	Real Estate			Land			Construction			Real Estate			Business			2nd Mtg			Consumer			Total
	(In thousands)
Allowance for loan losses:
Changes in Allowance for Loan Losses for the three-months ended June 30, 2011:
Beginning balance	$	992		$	79		$	39		$	1,248		$	1,211		$	562		$	446		$	4,577
Provisions for loan losses		223			(20	)		(13	)		91			112			46			(14	)		425
Charge-offs		(1	)		0			0			(68	)		(305	)		(51	)		(73	)		(498	)
Recoveries		3			0			0			0			2			5			47			57

Ending balance	$	1,217		$	59		$	26		$	1,271		$	1,020		$	562		$	406		$	4,561

Changes in Allowance for Loan Losses for the six-months ended June 30, 2011:
Beginning balance	$	1,024		$	55		$	21		$	1,051		$	1,251		$	606		$	465		$	4,473
Provisions for loan losses		454			4			5			288			70			133			(29	)		925
Charge-offs		(265	)		0			0			(68	)		(305	)		(208	)		(138	)		(984	)
Recoveries		4			0			0			0			4			31			108			147

Ending balance	$	1,217		$	59		$	26		$	1,271		$	1,020		$	562		$	406		$	4,561

Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	534		$	0		$	0		$	598		$	940		$	253		$	0		$	2,325
Collectively evaluated for impairment		683			59			26			673			80			309			406			2,236
Acquired with deteriorated credit quality		0			0			0			0			0			0			0			0

Ending balance	$	1,217		$	59		$	26		$	1,271		$	1,020		$	562		$	406		$	4,561

Recorded investment in loans:
Individually evaluated for impairment	$	3,309		$	6		$	485		$	1,408		$	1,999		$	480		$	0		$	7,687
Collectively evaluated for impairment		120,598			9,139			5,558			56,887			24,814			40,624			29,751			287,371
Acquired with deteriorated credit quality		0			0			0			0			0			0			0			0

Ending balance	$	123,907		$	9,145		$	6,043		$	58,295		$	26,813		$	41,104		$	29,751		$	295,058

An analysis of the Company’s allowance for loan losses and recorded investment in loans as of December 31, 2010 is as follows:


	Residential						Commercial		Commercial		Home Equity &		Other
	Real Estate		Land		Construction		Real Estate		Business		2nd Mtg		Consumer		Total
	(In thousands)
Allowance for loan losses:
Individually evaluated for impairment	$	458	$	0	$	0	$	607	$	1,089	$	338	$	0	$	2,492
Collectively evaluated for impairment		566		55		21		444		162		268		465		1,981
Acquired with deteriorated credit quality		0		0		0		0		0		0		0		0

Ending balance	$	1,024	$	55	$	21	$	1,051	$	1,251	$	606	$	465	$	4,473


Recorded investment in loans:
Individually evaluated for impairment	$	3,285	$	0	$	279	$	1,780	$	2,168	$	398	$	17	$	7,927
Collectively evaluated for impairment		127,429		9,589		4,769		58,305		19,811		42,939		29,416		292,258
Acquired with deteriorated credit quality		0		0		0		0		0		0		0		0

Ending balance	$	130,714	$	9,589	$	5,048	$	60,085	$	21,979	$	43,337	$	29,433	$	300,185

At June 30, 2011 and December 31, 2010, for each loan portfolio segment management applied an overall qualitative factor of 1.15 to the Company’s historical loss factors based on the most recent calendar quarters. The overall qualitative factor is derived from management’s analysis of changes and trends in the following qualitative factors:

•

Underwriting Standards – Management reviews the findings of periodic internal audit loan reviews, independent outsourced loan reviews and loan reviews performed by the banking regulators to evaluate the risk associated with changes in underwriting standards. At June 30, 2011 and December 31, 2010, management assessed the risk associated with this component as neutral, requiring no adjustment to the historical loss factors.

•

Economic Conditions – Management analyzes trends in housing and unemployment data in the Harrison, Floyd and Clark counties of Indiana, the Company’s primary market area, to evaluate the risk associated with economic conditions. Due to a decrease in new home construction and an increase in unemployment in the Company’s primary market area, management assigned a risk factor of 1.20 for the component at June 30, 2011 and December 31, 2010.

•

Past Due Loans – Management analyzes trends in past due loans for the Company to evaluate the risk associated with delinquent loans. In general, past due loan ratios have remained at elevated levels compared to historical amounts since 2007, and management assigned a risk factor of 1.20 for the component at June 30, 2011 and December 31, 2010.

•

Other Internal and External Factors – This component includes management’s consideration of other qualitative factors such as loan portfolio composition. The Company has focused on origination of commercial business and real estate loans in an effort to convert the Company’s balance sheet from that of a traditional thrift institution to a commercial bank. In addition, the Company has increased its investment in mortgage loans in which it does not hold a first lien position. Commercial loans and second mortgage loans generally entail greater risk than residential mortgage loans secured by a first lien. As a result of changes in the loan portfolio composition, management assigned a risk factor of 1.20 for this component at June 30, 2011 and December 31, 2010.

Each of the four factors above was assigned an equal weight to arrive at an average for the overall qualitative factor of 1.15 at June 30, 2011 and December 31, 2010. The effect of the overall qualitative factor was to increase the estimated allowance for loan losses by $297,000 and $258,000 at June 30, 2011 and December 31, 2010, respectively.

The Company’s impaired loans by class of loans as of June 30, 2011 and for the three- and six-month periods then ended is as follows:


	At June 30, 2011						Three Months Ended June 30, 2011						Six Months Ended June 30, 2011
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized		Interest Recognized - Cash Method		Average Recorded Investment		Interest Income Recognized		Interest Recognized - Cash Method
	(In thousands)
Loans with no related allowance recorded:
Residential	$	828	$	827	$	0	$	947	$	6	$	2	$	977	$	10	$	4
Land		6		6		0		6		0		0		4		0		0
Construction		485		485		0		441		0		0		294		0		0
Commercial real estate		401		401		0		438		0		0		424		0		0
Commercial business		0		0		0		0		0		0		7		0		0
HE/2nd mortgage		17		17		0		17		2		0		19		2		0
Other consumer		0		0		0		0		1		1		6		1		1


		1,737		1,736		0		1,849		9		3		1,731		13		5


Loans with an allowance recorded:
Residential		2,481		2,479		534		2,156		0		34		2,187		0		34
Land		0		0		0		0		0		0		0		0		0
Construction		0		0		0		0		0		0		93		0		0
Commercial real estate		1,007		1,006		598		1,011		0		0		1,134		0		0
Commercial business		1,999		1,999		940		2,071		0		0		2,097		0		0
HE/2nd mortgage		463		463		253		484		0		0		447		0		0
Other consumer		0		0		0		12		0		0		8		0		0


		5,950		5,947		2,325		5,734		0		34		5,966		0		34


Total:
Residential		3,309		3,306		534		3,103		6		36		3,164		10		38
Land		6		6		0		6		0		0		4		0		0
Construction		485		485		0		441		0		0		387		0		0
Commercial real estate		1,408		1,407		598		1,449		0		0		1,558		0		0
Commercial business		1,999		1,999		940		2,071		0		0		2,104		0		0
HE/2nd mortgage		480		480		253		501		2		0		466		2		0
Other consumer		0		0		0		12		1		1		14		1		1


	$	7,687	$	7,683	$	2,325	$	7,583	$	9	$	37	$	7,697	$	13	$	39

The following table summarizes the Company’s impaired loans by class of loans as of December 31, 2010:


	Recorded Investment		Unpaid Principal Balance		Related Allowance
	(In thousands)
Loans with no related allowance recorded:
Residential	$	1,037	$	1,026	$	0
Land		0		0		0
Construction		0		0		0
Commercial real estate		398		398		0
Commercial business		20		20		0
HE/2nd mortgage		25		25		0
Other consumer		17		17		0


		1,497		1,486		0


Loans with an allowance recorded:
Residential		2,248		2,244		458
Land		0		0		0
Construction		279		279		0
Commercial real estate		1,382		1,382		607
Commercial business		2,148		2,148		1,089
HE/2nd mortgage		373		373		338
Other consumer		0		0		0


		6,430		6,426		2,492


Total:
Residential		3,285		3,270		458
Land		0		0		0
Construction		279		279		0
Commercial real estate		1,780		1,780		607
Commercial business		2,168		2,168		1,089
HE/2nd mortgage		398		398		338
Other consumer		17		17		0


	$	7,927	$	7,912	$	2,492

Nonperforming loans consists of nonaccrual loans and loans over 90 days past due and still accruing interest. The following table presents the recorded investment in nonperforming loans by class of loans at June 30, 2011 and December 31, 2010:


	June 30, 2011						December 31, 2010
			Loans 90+ Days		Total				Loans 90+ Days		Total
	Nonaccrual		Past Due		Nonperforming		Nonaccrual		Past Due		Nonperforming
	Loans		Still Accruing		Loans		Loans		Still Accruing		Loans
	(In thousands)

Residential	$	3,309	$	380	$	3,689	$	2,951	$	334	$	3,285
Land		6		0		6		0		0		0
Construction		485		0		485		279		0		279
Commercial real estate		1,408		0		1,408		1,780		0		1,780
Commercial business		1,999		0		1,999		2,148		20		2,168
HE/2nd mortgage		480		131		611		390		8		398
Other consumer		0		34		34		0		17		17


Total	$	7,687	$	545	$	8,232	$	7,548	$	379	$	7,927

The following table presents the aging of the recorded investment in loans by class of loans at June 30, 2011:


	30-59 Days Past Due		60-89 Days Past Due		Over 90 Days Past Due		Total Past Due		Current		Total Loans
	(In thousands)

Residential	$	4,587	$	1,422	$	1,698	$	7,707	$	116,200	$	123,907
Land		158		84		6		248		8,897		9,145
Construction		249		485		0		734		5,309		6,043
Commercial real estate		111		1,929		642		2,682		55,613		58,295
Commercial business		184		19		0		203		26,610		26,813
HE/2nd mortgage		431		207		398		1,036		40,068		41,104
Other consumer		289		33		34		356		29,395		29,751


Total	$	6,009	$	4,179	$	2,778	$	12,966	$	282,092	$	295,058

The following table presents the aging of the recorded investment in loans by class of loans at December 31, 2010:


	30-59 Days Past Due		60-89 Days Past Due		Over 90 Days Past Due		Total Past Due		Current		Total Loans
	(In thousands)

Residential	$	5,652	$	581	$	1,590	$	7,823	$	122,891	$	130,714
Land		143		6		0		149		9,440		9,589
Construction		135		0		279		414		4,634		5,048
Commercial real estate		788		337		678		1,803		58,282		60,085
Commercial business		143		0		2,001		2,144		19,835		21,979
HE/2nd mortgage		596		352		298		1,246		42,091		43,337
Other consumer		362		93		17		472		28,961		29,433


Total	$	7,819	$	1,369	$	4,863	$	14,051	$	286,134	$	300,185

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, public information, historical payment experience, credit documentation, and current economic trends, among other factors. The Company classifies loans based on credit risk at least quarterly. The Company uses the following regulatory definitions for risk ratings:

Special Mention: Loans classified as special mention 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.

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.

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

Loss: Loans classified as loss are considered uncollectible and of such little value that their continuance on the institution’s books as an asset, without establishment of a specific valuation allowance or charge-off, is not warranted.

Loans not meeting the criteria above that are analyzed individually as part of the described process are considered to be pass rated loans.

The following table presents the recorded investment in loans by risk category as of the date indicated:


	Residential Real Estate		Land		Construction		Commercial Real Estate		Commercial Business		Home Equity & 2nd Mtg		Other Consumer		Total
	(In thousands)

June 30, 2011
Pass	$	115,792	$	8,636	$	5,008	$	47,722	$	23,341	$	39,947	$	29,651	$	270,097
Special Mention		1,803		258		340		5,700		989		443		87		9,620
Substandard		3,003		245		210		3,465		484		234		13		7,654
Doubtful		3,309		6		485		1,408		1,999		480		0		7,687
Loss		0		0		0		0		0		0		0		0


Ending balance	$	123,907	$	9,145	$	6,043	$	58,295	$	26,813	$	41,104	$	29,751	$	295,058


December 31, 2010
Pass	$	121,604	$	9,172	$	4,588	$	50,742	$	18,568	$	42,014	$	29,275	$	275,963
Special Mention		2,691		308		0		4,937		765		695		158		9,554
Substandard		3,468		109		181		2,626		498		238		0		7,120
Doubtful		2,951		0		279		1,780		2,148		390		0		7,548
Loss		0		0		0		0		0		0		0		0


Ending balance	$	130,714	$	9,589	$	5,048	$	60,085	$	21,979	$	43,337	$	29,433	$	300,185