3.	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 loan agreements 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 March 31, 2012, the Company had nine loans on which partial charge-offs of $543,000 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 March 31, 2012:


	Residential Real Estate		Land		Construction			Commercial Real Estate			Commercial Business			Home Equity & 2nd Mtg		Other Consumer		Total
	(In thousands)
Recorded Investment in Loans:
Principal loan balance	$	113,427	$	9,987	$	6,315		$	58,143		$	20,795		$	37,831	$	29,539	$	276,037

Accrued interest receivable		418		46		14			154			65			143		144		984

Net deferred loan origination fees and costs		71		1		(1	)		(6	)		(10	)		75		0		130


Recorded investment in loans	$	113,916	$	10,034	$	6,328		$	58,291		$	20,850		$	38,049	$	29,683	$	277,151


Recorded Investment in Loans as Evaluated for Impairment:
Individually evaluated for impairment	$	2,068	$	41	$	266		$	2,761		$	1,927		$	273	$	0	$	7,336
Collectively evaluated for impairment		111,848		9,993		6,062			55,530			18,923			37,776		29,683		269,815
Acquired with deteriorated credit quality		0		0		0			0			0			0		0		0


Ending balance	$	113,916	$	10,034	$	6,328		$	58,291		$	20,850		$	38,049	$	29,683	$	277,151

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


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


Recorded Investment in Loans as Evaluated for Impairment:
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
Acquired with deteriorated credit quality		0		0		0		0		0			0		0		0


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

An analysis of the allowance for loan losses as of March 31, 2012 is as follows:


	Residential						Commercial		Commercial		Home Equity &		Other
	Real Estate		Land		Construction		Real Estate		Business		2nd Mtg		Consumer		Total
							(In thousands)
Ending allowance balance attributable to loans:

Individually evaluated for impairment	$	140	$	0	$	0	$	422	$	936	$	168	$	0	$	1,666
Collectively evaluated for impairment		920		99		35		502		239		483		284		2,562
Acquired with deteriorated credit quality		0		0		0		0		0		0		0		0


Ending balance	$	1,060	$	99	$	35	$	924	$	1,175	$	651	$	284	$	4,228

An analysis of the allowance for loan losses as of December 31, 2011 is as follows:


	Residential						Commercial		Commercial		Home Equity &		Other
	Real Estate		Land		Construction		Real Estate		Business		2nd Mtg		Consumer		Total
							(In thousands)
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
Acquired with deteriorated credit quality		0		0		0		0		0		0		0		0


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

An analysis of the changes in the allowance for loan losses for the three months ended March 31, 2012 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:

Beginning balance	$	828		$	93		$	33	$	1,269		$	1,160	$	400		$	399		$	4,182
Provisions for loan losses		498			10			2		(345	)		12		361			(63	)		475
Charge-offs		(276	)		(4	)		0		0			0		(114	)		(91	)		(485	)
Recoveries		10			0			0		0			3		4			39			56


Ending balance	$	1,060		$	99		$	35	$	924		$	1,175	$	651		$	284		$	4,228

An analysis of the changes in the allowance for loan losses for the three months ended March 31, 2011 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:

Beginning balance	$	1,024		$	55	$	21	$	1,051	$	1,251		$	606		$	465		$	4,473
Provisions for loan losses		232			24		18		197		(42	)		87			(16	)		500
Charge-offs		(265	)		0		0		0		0			(157	)		(64	)		(486	)
Recoveries		1			0		0		0		2			26			61			90


Ending balance	$	992		$	79	$	39	$	1,248	$	1,211		$	562		$	446		$	4,577

At March 31, 2012 and December 31, 2011, 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 March 31, 2012 and December 31, 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 March 31, 2012 and December 31, 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 March 31, 2012 and December 31, 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, management assigned a risk factor of 1.20 for this component at March 31, 2012 and December 31, 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 March 31, 2012 and December 31, 2011. The effect of the overall qualitative factor was to increase the estimated allowance for loan losses by $322,000 and $317,000 at March 31, 2012 and December 31, 2011, respectively.

The following table summarizes the Company’s impaired loans by class of loans as of March 31, 2012 and for the three months ended March 31, 2012 and 2011:


	At March 31, 2012						Three Months Ended March 31, 2012						Three Months Ended March 31, 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	$	1,359	$	1,792	$	0	$	1,254	$	1	$	1	$	1,173	$	4	$	2
Land		41		41		0		23		0		0		3		0		0
Construction		266		270		0		257		0		0		155		0		0
Commercial real estate		1,251		1,530		0		1,233		0		0		436		0		0
Commercial business		0		0		0		0		0		0		15		0		0
Home Equity/2nd mortgage		85		91		0		86		1		0		30		0		0
Other consumer		0		0		0		0		0		0		17		0		0


		3,002		3,724		0		2,853		2		1		1,829		4		2


Loans with an allowance recorded:
Residential		709		782		140		921		0		0		2,040		0		0
Land		0		0		0		0		0		0		0		0		0
Construction		0		0		0		0		0		0		140		0		0
Commercial real estate		1,510		1,595		422		1,574		0		0		1,198		0		0
Commercial business		1,927		2,023		936		1,928		0		0		2,146		0		0
Home Equity/2nd mortgage		188		188		168		94		0		1		439		0		0
Other consumer		0		0		0		0		0		0		12		0		0


		4,334		4,588		1,666		4,517		0		1		5,975		0		0


Total:
Residential		2,068		2,574		140		2,175		1		1		3,213		4		2
Land		41		41		0		23		0		0		3		0		0
Construction		266		270		0		257		0		0		295		0		0
Commercial real estate		2,761		3,125		422		2,807		0		0		1,634		0		0
Commercial business		1,927		2,023		936		1,928		0		0		2,161		0		0
Home Equity/2nd mortgage		273		279		168		180		1		1		469		0		0
Other consumer		0		0		0		0		0		0		29		0		0


	$	7,336	$	8,312	$	1,666	$	7,370	$	2	$	2	$	7,804	$	4	$	2

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


	Recorded Investment		Unpaid Principal Balance		Related Allowance
	(In thousands)
Loans with no related allowance recorded:
Residential	$	1,149	$	1,507	$	0
Land		5		6		0
Construction		247		249		0
Commercial real estate		1,215		1,280		0
Commercial business		0		0		0
HE/2nd mortgage		87		94		0
Other consumer		0		0		0


		2,703		3,136		0


Loans with an allowance recorded:
Residential		1,132		1,233		183
Land		0		0		0
Construction		0		0		0
Commercial real estate		1,638		1,933		539
Commercial business		1,928		2,023		936
HE/2nd mortgage		0		0		0
Other consumer		0		0		0


		4,698		5,189		1,658


Total:
Residential		2,281		2,740		183
Land		5		6		0
Construction		247		249		0
Commercial real estate		2,853		3,213		539
Commercial business		1,928		2,023		936
Home Equity/2nd mortgage		87		94		0
Other consumer		0		0		0


	$	7,401	$	8,325	$	1,658

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 March 31, 2012 and December 31, 2011:


	March 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	$	2,068	$	66	$	2,134	$	2,281	$	143	$	2,424
Land		41		0		41		5		38		43
Construction		266		0		266		247		0		247
Commercial real estate		2,761		3		2,764		2,853		0		2,853
Commercial business		1,927		0		1,927		1,928		0		1,928
Home Equity/2nd mortgage		273		42		315		87		159		246
Other consumer		0		12		12		0		23		23


Total	$	7,336	$	123	$	7,459	$	7,401	$	363	$	7,764

The following table presents the aging of the recorded investment loans by class of loans at March 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	$	3,956	$	1,215	$	865	$	6,036	$	107,880	$	113,916
Land		102		42		41		185		9,849		10,034
Construction		0		0		266		266		6,062		6,328
Commercial real estate		585		175		1,254		2,014		56,277		58,291
Commercial business		58		10		0		68		20,782		20,850
Home Equity/2nd mortgage		353		141		167		661		37,388		38,049
Other consumer		179		10		12		201		29,482		29,683


Total	$	5,233	$	1,593	$	2,605	$	9,431	$	267,720	$	277,151

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	$	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/2nd 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 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 and class of loans as of the date indicated:


	Residential Real Estate		Land		Construction		Commercial Real Estate		Commercial Business		Home Equity & 2nd Mtg		Other Consumer		Total
							(In thousands)
March 31, 2012
Pass	$	109,374	$	7,578	$	5,552	$	47,532	$	16,913	$	37,457	$	29,588	$	253,994
Special Mention		859		253		257		5,368		1,622		30		37		8,426
Substandard		1,615		2,162		253		2,630		388		289		58		7,395
Doubtful		2,068		41		266		2,761		1,927		273		0		7,336
Loss		0		0		0		0		0		0		0		0


Ending balance	$	113,916	$	10,034	$	6,328	$	58,291	$	20,850	$	38,049	$	29,683	$	277,151


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


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

The following table summarizes the Company’s troubled debt restructurings (TDRs) by class of loan and accrual status as of March 31, 2012 and December 31, 2011:


	March 31, 2012								December 31, 2011
	Accruing		Nonaccrual		Total		Related Allowance for Loan Losses		Accruing		Nonaccrual		Total		Related Allowance for Loan Losses
							(In thousands)
Troubled debt restructurings:
Residential real estate	$	319	$	344	$	663	$	5	$	112	$	516	$	628	$	11
Land		136		0		136		0		135		0		135		0
Construction		252		266		518		0		207		247		454		0
Commercial real estate		0		1,593		1,593		107		0		1,603		1,603		211
Commercial business		0		1,843		1,843		914		0		1,843		1,843		914
Home equity and 2nd mortgage		8		25		33		25		8		0		8		0
Consumer		0		0		0		0		0		0		0		0


Total	$	715	$	4,071	$	4,786	$	1,051	$	462	$	4,209	$	4,671	$	1,136

At March 31, 2012 and December 31, 2011, commitments to lend additional funds to debtors whose loan terms have been modified in a TDR (both accruing and nonaccruing) totaled $145,000 and $192,000, respectively. These commitments represent the undisbursed portion of construction loans to borrowers that have outstanding loans classified as TDRs.

The following table summarizes information in regard to TDRs that were restructured during the three months ended March 31, 2012:


	Number of Contracts		Pre-Modification Outstanding Balance		Post-Modification Outstanding Balance
	(Dollars in thousands)

Troubled debt restructurings:
Residential real estate		1	$	88	$	88
Home equity & 2nd mortgage		1		25		25
Construction		0		0		0
Commercial real estate		0		0		0
Commercial business		0		0		0
Construction		0		0		0
Consumer		0		0		0


Total		2	$	113	$	113

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 the three months ended March 31, 2012.

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 three months ended March 31, 2012. 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.