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 September 30, 2011, the Company had one loan on which a partial charge-off of $36,000 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.

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


	Residential Real Estate		Land		Construction		Commercial Real Estate		Commercial Business			Home Equity & 2nd Mtg		Other Consumer		Total
	(In thousands)
September 30, 2011

Principal loan balance	$	121,379	$	7,711	$	6,997	$	59,541	$	24,460		$	39,751	$	30,120	$	289,959

Accrued interest receivable		455		45		16		147		76			153		187		1,079

Net deferred loan origination fees		77		1		0		3		(11	)		94		0		164


Recorded investment in loans	$	121,911	$	7,757	$	7,013	$	59,691	$	24,525		$	39,998	$	30,307	$	291,202


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 September 30, 2011, and for the three- and nine-month periods then ended is as follows:


	Residential Real Estate			Land		Construction		Commercial Real Estate			Commercial Business			Home Equity & 2nd Mtg			Other Consumer			Total
	(In thousands)
Allowance for loan losses:
Changes in Allowance for Loan Losses for the three-months ended September 30, 2011:
Beginning balance	$	1,217		$	59	$	26	$	1,271		$	1,020		$	562		$	406		$	4,561
Provisions for loan losses		146			2		2		114			130			3			3			400
Charge-offs		(80	)		0		0		0			0			(250	)		(73	)		(403	)
Recoveries		5			0		3		0			36			16			45			105


Ending balance	$	1,288		$	61	$	31	$	1,385		$	1,186		$	331		$	381		$	4,663


Changes in Allowance for Loan Losses for the nine-months ended September 30, 2011:
Beginning balance	$	1,024		$	55	$	21	$	1,051		$	1,251		$	606		$	465		$	4,473
Provisions for loan losses		601			6		7		402			199			136			(26	)		1,325
Charge-offs		(346	)		0		0		(68	)		(305	)		(458	)		(211	)		(1,388	)
Recoveries		9			0		3		0			41			47			153			253


Ending balance	$	1,288		$	61	$	31	$	1,385		$	1,186		$	331		$	381		$	4,663


Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	606		$	0	$	0	$	592		$	937		$	34		$	0		$	2,169
Collectively evaluated for impairment		682			61		31		793			249			297			381			2,494
Acquired with deteriorated credit quality		0			0		0		0			0			0			0			0


Ending balance	$	1,288		$	61	$	31	$	1,385		$	1,186		$	331		$	381		$	4,663


Recorded investment in loans:
Individually evaluated for impairment	$	3,292		$	6	$	176	$	1,082		$	2,012		$	82		$	5		$	6,655
Collectively evaluated for impairment		118,619			7,751		6,837		58,609			22,513			39,916			30,302			284,547
Acquired with deteriorated credit quality		0			0		0		0			0			0			0			0


Ending balance	$	121,911		$	7,757	$	7,013	$	59,691		$	24,525		$	39,998		$	30,307		$	291,202

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


	Residential Real Estate		Land		Construction		Commercial Real Estate		Commercial Business		Home Equity & 2nd Mtg		Other 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 September 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 September 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 September 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 September 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 credit 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 September 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 September 30, 2011 and December 31, 2010. The effect of the overall qualitative factor was to increase the estimated allowance for loan losses by $291,000 and $258,000 at September 30, 2011 and December 31, 2010, respectively.

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


	At September 30, 2011						Three Months Ended September 30, 2011						Nine Months Ended September 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	$	811	$	809	$	0	$	820	$	3	$	2	$	936	$	13	$	5
Land		6		6		0		6		1		3		5		1		3
Construction		176		176		0		331		0		0		264		0		0
Commercial real estate		81		81		0		241		9		9		339		9		9
Commercial business		49		49		0		25		0		0		17		0		0
Home Equity/2nd mortgage		15		14		0		16		2		1		18		4		2
Other consumer		5		5		0		3		2		0		6		3		1


		1,143		1,140		0		1,442		17		15		1,585		30		20


Loans with an allowance recorded:
Residential		2,481		2,478		606		2,481		5		0		2,260		0		36
Land		0		0		0		0		0		0		0		0		0
Construction		0		0		0		0		0		0		70		0		0
Commercial real estate		1,001		1,001		592		1,004		0		0		1,101		0		0
Commercial business		1,963		1,963		937		1,981		0		0		2,063		0		0
Home Equity/2nd mortgage		67		67		34		265		0		0		352		0		0
Other consumer		0		0		0		0		0		0		6		0		0


		5,512		5,509		2,169		5,731		5		0		5,852		0		36


Total:
Residential		3,292		3,287		606		3,301		8		2		3,196		13		41
Land		6		6		0		6		1		3		5		1		3
Construction		176		176		0		331		0		0		334		0		0
Commercial real estate		1,082		1,082		592		1,245		9		9		1,440		9		9
Commercial business		2,012		2,012		937		2,006		0		0		2,080		0		0
Home Equity/2nd mortgage		82		81		34		281		2		1		370		4		2
Other consumer		5		5		0		3		2		0		12		3		1


	$	6,655	$	6,649	$	2,169	$	7,173	$	22	$	15	$	7,437	$	30	$	56

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
Home Equity/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
Home Equity/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
Home Equity/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 September 30, 2011 and December 31, 2010:


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

Residential	$	3,292	$	187	$	3,479	$	2,951	$	334	$	3,285
Land		6		82		88		0		0		0
Construction		176		0		176		279		0		279
Commercial real estate		1,082		1,171		2,253		1,780		0		1,780
Commercial business		2,012		0		2,012		2,148		20		2,168
Home Equity/2nd mortgage		82		167		249		390		8		398
Other consumer		5		115		120		0		17		17


Total	$	6,655	$	1,722	$	8,377	$	7,548	$	379	$	7,927

The following table presents the aging of the recorded investment in loans by class of loans at September 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	$	4,197	$	1,027	$	1,922	$	7,146	$	114,765	$	121,911
Land		280		4		88		372		7,385		7,757
Construction		88		176		0		264		6,749		7,013
Commercial real estate		0		0		1,627		1,627		58,064		59,691
Commercial business		0		0		49		49		24,476		24,525
Home Equity/2nd mortgage		382		112		227		721		39,277		39,998
Other consumer		304		39		115		458		29,849		30,307


Total	$	5,251	$	1,358	$	4,028	$	10,637	$	280,565	$	291,202

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
Home Equity/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)
September 30, 2011
Pass	$	113,894	$	7,219	$	6,276	$	49,594	$	20,694	$	39,225	$	30,091	$	266,993
Special Mention		1,772		289		404		5,529		1,265		325		158		9,742
Substandard		2,953		243		157		3,486		554		366		53		7,812
Doubtful		3,292		6		176		1,082		2,012		82		5		6,655
Loss		0		0		0		0		0		0		0		0


Ending balance	$	121,911	$	7,757	$	7,013	$	59,691	$	24,525	$	39,998	$	30,307	$	291,202


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

Modification of a loan is considered to be a troubled debt restructuring (TDR) if the debtor is experiencing financial difficulties and the Company grants a concession to the debtor that it would not otherwise consider. By granting the concession, the Company expects to obtain more cash or other value from the debtor, or to increase the probability of receipt, than would be expected by not granting the concession. The concession may include, but is not limited to, reduction of the stated interest rate of the loan, reduction of accrued interest, extension of the maturity date or reduction of the face amount or maturity amount of the debt. A concession will be granted when, as a result of the restructuring, the Company does not expect to collect all amounts due, including interest at the original stated rate. A concession may also be granted if the debtor is not able to access funds elsewhere at a market rate for debt with similar risk characteristics as the restructured debt. The Company’s determination of whether a loan modification is a TDR considers the individual facts and circumstances surrounding each modification.

Loans modified in a TDR 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.

The following table summarizes the Company’s TDRs by class of loan and accrual status at September 30, 2011 and December 31, 2010:


	September 30, 2011								December 31, 2010
	Accruing		Nonaccrual		Total		Related Allowance for Loan Losses		Accruing		Nonaccrual		Total		Related Allowance for Loan Losses
	(In thousands)
Troubled debt restructurings:
Residential real estate	$	112	$	701	$	813	$	89	$	0	$	623	$	623	$	71
Construction		157		176		333		0		0		279		279		0
Commercial real estate		1,168		683		1,851		428		0		1,057		1,057		444
Commercial business		0		1,876		1,876		914		0		1,909		1,909		914
Consumer		8		0		8		0		0		75		75		75


Total	$	1,445	$	3,436	$	4,881	$	1,431	$	0	$	3,943	$	3,943	$	1,504

The following table summarizes information in regard to TDRs that occurred during the three- and nine-month periods ended September 30, 2011:


	Three Months Ended September 30, 2011						Nine Months Ended September 30, 2011
	Number of Contracts		Pre-Modification Outstanding Balance		Post-Modification Outstanding Balance		Number of Contracts		Pre-Modification Outstanding Balance		Post-Modification Outstanding Balance
	(Dollars in thousands)
Troubled debt restructurings:
Residential real estate		2	$	211	$	211		2	$	211	$	211
Construction		2		333		333		2		333		333
Commercial real estate		2		1,168		1,168		2		1,168		1,168
Commercial business		0		0		0		0		0		0
Consumer		1		8		8		1		8		8


Total		7	$	1,720	$	1,720		7	$	1,720	$	1,720

For the TDRs listed above, the terms of modification included temporary interest-only payment periods, reduction of the stated interest rate and the deferral of past due principal and interest until maturity, or the consolidation of outstanding loans at a reduced interest rate.

There were no TDRs modified within the previous twelve months for which there was a payment default (defined as more than 90 days past due) during the three or nine months ended September 30, 2011.