(4)	LOANS AND ALLOWANCE FOR LOAN LOSSES

Loans at December 31, 2012 and 2011 consisted of the following:


(In thousands)	2012			2011
Real estate mortgage loans:
Residential	$	108,097		$	116,338
Land		9,607			9,910
Residential construction		12,753			10,988
Commercial real estate		68,731			57,680
Commercial real estate construction		3,299			743
Commercial business loans		18,612			20,722
Consumer loans:
Home equity and second mortgage loans		36,962			38,641
Automobile loans		21,922			20,627
Loans secured by savings accounts		770			767
Unsecured loans		3,191			3,126
Other consumer loans		5,303			5,312

Gross loans		289,247			284,854

Deferred loan origination fees, net		202			143
Undisbursed portion of loans in process		(4,306	)		(4,768	)
Allowance for loan losses		(4,736	)		(4,182	)

Loans, net	$	280,407		$	276,047

At December 31, 2012, residential mortgage loans secured by residential properties without private mortgage insurance or government guarantee and with loan-to-value ratios exceeding 90% amounted to approximately $4.5 million.

Mortgage loans serviced for the benefit of others amounted to $210,000 and $269,000 at December 31, 2012 and 2011, respectively.

The Bank has entered into loan transactions with certain directors, officers and their affiliates (i.e., related parties). In the opinion of management, such indebtedness was incurred in the ordinary course of business on substantially the same terms, including interest rate and collateral, as those prevailing at the time for comparable transactions with unrelated persons.

The following table represents the aggregate activity for related party loans during the year ended December 31, 2012. The beginning balance has been adjusted to reflect new directors and officers, as well as directors and officers that are no longer with the Company.


(In thousands)
Beginning balance, as adjusted	$	5,627
New loans		9,174
Payments		(8,717	)

Ending balance	$	6,084

A director of the Bank is a shareholder of a farm implement dealership that contracts with the Bank to provide sales financing to the dealership’s customers. In the opinion of management, these transactions were made in the ordinary course of business on substantially the same terms, including interest rate and collateral, as those prevailing at the time for comparable transactions with unrelated parties. During the year ended December 31, 2012, the Bank purchased approximately $473,000 of loans to customers of the corporation and the aggregate outstanding balance of all loans purchased from the corporation was approximately $1.0 million and $1.2 million at December 31, 2012 and 2011, respectively.

The following table provides the components of the Company’s recorded investment in loans for each portfolio segment at December 31, 2012 and 2011:


	Residential Real Estate		Land		Construction			Commercial Real Estate			Commercial Business			Home Equity and Second Mortgage		Other Consumer		Total
	(In thousands)
December 31, 2012:
Principal loan balance	$	108,097	$	9,607	$	11,746		$	68,731		$	18,612		$	36,962	$	31,186	$	284,941
Accrued interest receivable		444		48		29			188			53			147		184		1,093
Net deferred loan origination fees and costs		62		2		(12	)		(17	)		(10	)		177		0		202

Recorded investment in loans	$	108,603	$	9,657	$	11,763		$	68,902		$	18,655		$	37,286	$	31,370	$	286,236

December 31, 2011:
Principal loan balance	$	116,338	$	9,910	$	6,963		$	57,680		$	20,722		$	38,641	$	29,832	$	280,086
Accrued interest receivable		463		60		16			160			64			162		202		1,127
Net deferred loan origination fees and costs		67		2		0			0			(10	)		84		0		143

Recorded investment in loans	$	116,868	$	9,972	$	6,979		$	57,840		$	20,776		$	38,887	$	30,034	$	281,356

An analysis of the allowance for loan losses and recorded investment in loans as of and for the year ended December 31, 2012 is as follows:


	Residential Real Estate			Land			Construction			Commercial Real Estate			Commercial Business			Home Equity and Second Mortgage			Other Consumer			Total
	(In thousands)
Allowance for Loan Losses:
Beginning balance	$	828		$	93		$	33		$	1,269		$	1,160		$	400		$	399		$	4,182
Provisions		496			(19	)		(33	)		145			70			834			32			1,525
Charge-offs		(418	)		(4	)		0			(104	)		(17	)		(342	)		(313	)		(1,198	)
Recoveries		16			1			0			0			10			27			173			227

Ending balance	$	922		$	71		$	0		$	1,310		$	1,223		$	919		$	291		$	4,736

Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	213		$	0		$	0		$	275		$	1,098		$	66		$	0		$	1,652
Collectively evaluated for impairment		709			71			0			1,035			125			853			291			3,084

Ending balance	$	922		$	71		$	0		$	1,310		$	1,223		$	919		$	291		$	4,736

Recorded Investment in Loans:
Individually evaluated for impairment	$	2,370		$	125		$	403		$	2,836		$	1,776		$	73		$	0		$	7,583
Collectively evaluated for impairment		106,233			9,532			11,360			66,066			16,879			37,213			31,370			278,653

Ending balance	$	108,603		$	9,657		$	11,763		$	68,902		$	18,655		$	37,286		$	31,370		$	286,236

An analysis of the allowance for loan losses and recorded investment in loans as of and for the year ended December 31, 2011 is as follows:


	Residential Real Estate			Land		Construction		Commercial Real Estate			Commercial Business			Home Equity and Second Mortgage			Other Consumer			Total
	(In thousands)
Allowance for Loan Losses:
Beginning balance	$	1,024		$	55	$	21	$	1,051		$	1,251		$	606		$	465		$	4,473
Provisions		609			38		8		614			197			322			37			1,825
Charge-offs		(819	)		0		0		(396	)		(333	)		(577	)		(302	)		(2,427	)
Recoveries		14			0		4		0			45			49			199			311

Ending balance	$	828		$	93	$	33	$	1,269		$	1,160		$	400		$	399		$	4,182

Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	183		$	0	$	0	$	539		$	936		$	0		$	0		$	1,658
Collectively evaluated for impairment		645			93		33		730			224			400			399			2,524

Ending balance	$	828		$	93	$	33	$	1,269		$	1,160		$	400		$	399		$	4,182

Recorded Investment in Loans:
Individually evaluated for impairment	$	2,281		$	5	$	247	$	2,853		$	1,928		$	87		$	0		$	7,401
Collectively evaluated for impairment		114,587			9,967		6,732		54,987			18,848			38,800			30,034			273,955

Ending balance	$	116,868		$	9,972	$	6,979	$	57,840		$	20,776		$	38,887		$	30,034		$	281,356

At December 31, 2011, the historical loss experience used to estimate the allowance for loan losses was for the most recent eight calendar quarters. Effective as of December 31, 2012, the Company began using the most recent twelve calendar quarters as the basis for developing the historical loss factors, which increased the estimated allowance for loan losses by approximately $575,000. Also at December 31, 2012, management adjusted the qualitative factors for the home equity and second mortgage portfolio segment which increased the estimated allowance for loan losses related to that portfolio segment by approximately $511,000. These qualitative factors applied to the home equity and second mortgage loan portfolio considered risks associated with loan to value ratios, delinquency history and whether the Bank does not hold the first lien position on the collateral. These changes were made to better reflect management’s analysis of inherent losses in the loan portfolio at December 31, 2012.

At December 31, 2012 and 2011, for each loan portfolio segment management applied an overall qualitative factor of 1.15 to the Company’s historical loss factors. 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 December 31, 2012 and 2011, 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 this component at December 31, 2012 and 2011.

•

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 this component at December 31, 2012 and 2011.

•

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 the 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 and other factors, management assigned a risk factor of 1.20 for this component at December 31, 2012 and 2011.

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 December 31, 2012 and 2011. The effect of the overall qualitative factor was to increase the estimated allowance for loan losses by $419,000 and $317,000 at December 31, 2012 and 2011, respectively.

Management also adjusts the historical loss factors for loans classified as watch, special mention and substandard that are not individually evaluated for impairment. The adjustments consider the increased likelihood of loss on classified loans based on the Company’s separate historical experience for classified loans. The effect of the adjustments for classified loans was to increase the estimated allowance for loan losses by $664,000 and $172,000 at December 31, 2012 and 2011, respectively.

The following table summarizes the Company’s impaired loans by class of loans as of and for the year ended December 31, 2012:


	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized		Interest Recognized – Cash Method
	(In thousands)
Loans with no related allowance recorded:
Residential real estate	$	1,427	$	1,760	$	0	$	1,248	$	6	$	4
Land		125		126		0		43		0		2
Construction		403		413		0		315		0		0
Commercial real estate		1,535		1,944		0		1,292		0		1
Commercial business		0		0		0		0		0		0
Home equity and second mortgage		0		0		0		51		2		2
Other consumer		0		0		0		0		1		0

		3,490		4,243		0		2,949		9		9

Loans with an allowance recorded:
Residential real estate		943		1,020		213		1,110		0		0
Land		0		0		0		0		0		0
Construction		0		0		0		0		0		0
Commercial real estate		1,301		1,394		275		1,542		0		0
Commercial business		1,776		1,909		1,098		1,857		0		0
Home equity and second mortgage		73		73		66		103		0		0
Other consumer		0		0		0		0		0		0

		4,093		4,396		1,652		4,612		0		0

Total:
Residential real estate		2,370		2,780		213		2,358		6		4
Land		125		126		0		43		0		2
Construction		403		413		0		315		0		0
Commercial real estate		2,836		3,338		275		2,834		0		1
Commercial business		1,776		1,909		1,098		1,857		0		0
Home equity and second mortgage		73		73		66		154		2		2
Other consumer		0		0		0		0		1		0

	$	7,583	$	8,639	$	1,652	$	7,561	$	9	$	9

The following table summarizes the Company’s impaired loans by class of loans as of and for the year ended December 31, 2011:


	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized		Interest Recognized – Cash Method
	(In thousands)
Loans with no related allowance recorded:
Residential real estate	$	1,149	$	1,507	$	0	$	978	$	0	$	29
Land		5		6		0		5		0		0
Construction		247		249		0		261		0		0
Commercial real estate		1,215		1,280		0		514		0		9
Commercial business		0		0		0		14		0		0
Home equity and second mortgage		87		94		0		32		0		1
Other consumer		0		0		0		4		0		0

		2,703		3,136		0		1,808		0		39

Loans with an allowance recorded:
Residential real estate		1,132		1,233		183		2,035		0		9
Land		0		0		0		0		0		0
Construction		0		0		0		56		0		0
Commercial real estate		1,638		1,933		539		1,208		0		0
Commercial business		1,928		2,023		936		2,036		0		0
Home equity and second mortgage		0		0		0		282		0		0
Other consumer		0		0		0		5		0		0

		4,698		5,189		1,658		5,622		0		9

Total:
Residential real estate		2,281		2,740		183		3,013		0		38
Land		5		6		0		5		0		0
Construction		247		249		0		317		0		0
Commercial real estate		2,853		3,213		539		1,722		0		9
Commercial business		1,928		2,023		936		2,050		0		0
Home equity and second mortgage		87		94		0		314		0		1
Other consumer		0		0		0		9		0		0

	$	7,401	$	8,325	$	1,658	$	7,430	$	0	$	48

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 December 31, 2012 and 2011:


	December 31, 2012						December 31, 2011
	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 real estate	$	2,370	$	215	$	2,585	$	2,281	$	143	$	2,424
Land		125		0		125		5		38		43
Construction		403		0		403		247		0		247
Commercial real estate		2,836		0		2,836		2,853		0		2,853
Commercial business		1,776		0		1,776		1,928		0		1,928
Home equity and second mortgage		73		56		129		87		159		246
Other consumer		0		18		18		0		23		23

Total	$	7,583	$	289	$	7,872	$	7,401	$	363	$	7,764

The following table presents the aging of the recorded investment loans by class of loans at December 31, 2012:


	30-59 Days Past Due		60-89 Days Past Due		Over 90 Days Past Due		Total Past Due		Current		Total Loans
	(In thousands)
Residential real estate	$	4,085	$	871	$	1,644	$	6,600	$	102,003	$	108,603
Land		343		0		119		462		9,195		9,657
Construction		171		0		113		284		11,479		11,763
Commercial real estate		360		0		335		695		68,207		68,902
Commercial business		36		0		0		36		18,619		18,655
Home equity and second mortgage		1,206		102		97		1,405		35,881		37,286
Other consumer		510		30		18		558		30,812		31,370

Total	$	6,711	$	1,003	$	2,326	$	10,040	$	276,196	$	286,236

The following table presents the aging of the recorded investment in loans by class of loans at December 31, 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 real estate	$	5,205	$	1,068	$	1,035	$	7,308	$	109,560	$	116,868
Land		442		43		43		528		9,444		9,972
Construction		0		0		247		247		6,732		6,979
Commercial real estate		676		0		1,258		1,934		55,906		57,840
Commercial business		256		0		0		256		20,520		20,776
Home equity and second mortgage		558		72		246		876		38,011		38,887
Other consumer		306		37		23		366		29,668		30,034

Total	$	7,443	$	1,220	$	2,852	$	11,515	$	269,841	$	281,356

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 Company’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 Company 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 Company’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 above described process are considered to be pass rated loans.

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


	Residential Real Estate		Land		Construction		Commercial Real Estate		Commercial Business		Home Equity and Second Mortgage		Other Consumer		Total
	(In thousands)
December 31, 2012:
Pass	$	102,618	$	7,220	$	11,244	$	63,095	$	15,026	$	36,035	$	31,302	$	266,540
Special mention		958		17		116		1,018		1,354		553		25		4,041
Substandard		2,657		2,295		0		1,953		499		625		43		8,072
Doubtful		2,370		125		403		2,836		1,776		73		0		7,583
Loss		0		0		0		0		0		0		0		0

Total	$	108,603	$	9,657	$	11,763	$	68,902	$	18,655	$	37,286	$	31,370	$	286,236

December 31, 2011:
Pass	$	113,037	$	7,578	$	6,217	$	46,544	$	16,961	$	38,513	$	29,976	$	258,826
Special mention		862		255		307		5,392		1,462		63		44		8,385
Substandard		688		2,134		208		3,051		425		224		14		6,744
Doubtful		2,281		5		247		2,853		1,928		87		0		7,401
Loss		0		0		0		0		0		0		0		0

Total	$	116,868	$	9,972	$	6,979	$	57,840	$	20,776	$	38,887	$	30,034	$	281,356

The following table summarizes the Company’s TDRs by class of loan and accrual status as of December 31, 2012 and 2011:


	December 31, 2012								December 31, 2011
	Accruing		Nonaccrual		Total		Related Allowance for Loan Losses		Accruing		Nonaccrual		Total		Related Allowance for Loan Losses
	(In thousands)
Residential real estate	$	180	$	588	$	768	$	87	$	112	$	516	$	628	$	11
Land		0		0		0		0		135		0		135		0
Construction		0		170		170		0		207		247		454		0
Commercial real estate		0		1,534		1,534		83		0		1,603		1,603		211
Commercial business		0		1,776		1,776		1,098		0		1,843		1,843		914
Home equity and second mortgage		41		31		72		25		8		0		8		0
Other consumer		0		0		0		0		0		0		0		0

Total	$	221	$	4,099	$	4,320	$	1,293	$	462	$	4,209	$	4,671	$	1,136

At December 31, 2012 and 2011, commitments to lend additional funds to debtors whose loan terms have been modified in a TDR (both accruing and nonaccruing) totaled $0 and $192,000, respectively. These commitments represented the undisbursed portion of construction loans to borrowers that had outstanding loans classified as TDRs.

The following table summarizes information in regard to TDRs that were restructured during the year ended December 31, 2012:


	Number of Contracts		Pre- Modification Outstanding Balance		Post- Modification Outstanding Balance
	(In thousands)
Residential real estate		3	$	270	$	270
Home equity and second mortgage		2		65		65

Total		5	$	335	$	335

For the TDRs listed above, the terms of modification included reduction of the stated interest rate, a decrease in the monthly payment amount and the extension of the maturity date. There were no principal charge-offs recorded as a result of TDRs during 2012 and the specific allowance for loan losses related to TDRs modified during 2012 was $73,000 at December 31, 2012.

The following table summarizes information in regard to TDRs that were restructured during the year ended December 31, 2011:


	Number of Contracts		Pre- Modification Outstanding Balance		Post- Modification Outstanding Balance
	(In thousands)
Residential real estate		4	$	331	$	331
Land		1		135		135
Construction		2		454		454
Commercial real estate		2		1,139		1,139
Home equity and second mortgage		1		8		8

Total		10	$	2,067	$	2,067

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 principal charge-offs recorded as a result of TDRs during 2011 and the specific allowance for loan losses related to TDRs modified during 2011 was $6,000 at December 31, 2011.

There were no TDRs modified within the previous 12 months for which there was a subsequent payment default (defined as the loan becoming more than 90 days past due, being moved to nonaccrual status, or the collateral being foreclosed upon) during the years ended December 31, 2012 and 2011. In the event that a TDR subsequently defaults, the Company evaluates the restructuring for possible impairment. As a result, the related allowance for loan losses may be increased or charge-offs may be taken to reduce the carrying amount of the loan.