FAIR VALUES OF FINANCIAL INSTRUMENTS

12 Months Ended

Dec. 31, 2012

Fair Value Disclosures [Abstract]

FAIR VALUE DISCLOSURES

NOTE 5 – FAIR VALUES OF FINANCIAL INSTRUMENTS

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

Level 1 Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2 Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3 Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Securities: Securities available for sale are valued primarily by a third party pricing service. The fair values of securities available for sale are determined on a recurring basis by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or pricing models which untilize significant observable inputs such as matrix pricing. This is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). These models utilize the market approach with standard inputs that include, but are not limited to benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data. For certain non-agency residential mortgage-backed securities where observable inputs about the specific issuer are not available, fair values are estimated using observable data from other non-agency residential mortgage-backed securities presumed to be similar or other market data on other non-agency residential mortgage-backed securities (Level 3 inputs). For certain municipal securities that are not rated and observable inputs about the specific issuer are not available, fair values are estimated using observable data from other municipal securities presumed to be similar or other market data on other non-rated municipal securities (Level 3 inputs). There were no transfers between Level 1and Level 2 during 2012 and 2011.

Mortgage banking derivative: The fair values of derivatives are based on observable market data as of the measurement date (Level 2).

Impaired loans: Impaired loans with specific allocations of the allowance for loan losses are generally based on the fair value of the underlying collateral if repayment is expected solely from the collateral. Fair value is determined using several methods. Generally, the fair value of real estate is based on appraisals by qualified third party appraisers. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and result in a Level 3 classification of the inputs for determining fair value. In addition, the Company’s management routinely applies internal discount factors to the value of appraisals used in the fair value evaluation of impaired loans. The deductions to the appraisals take into account changing business factors and market conditions, as well as value impairment in cases where the appraisal date predates a likely change in market conditions. Commercial real estate is generally discounted from its appraised value by 0-50% with the higher discounts applied to real estate that is determined to have a thin trading market or to be specialized collateral. In addition to real estate, the Company’s management evaluates other types of collateral as follows: (a) Raw and finished inventory is discounted from its cost or book value by 35-65%, depending on the marketability of the goods. (b) Finished goods are generally discounted by 30-60%, depending on the ease of marketability, cost of transportation or scope of use of the finished good. (c) Work in process inventory is typically discounted by 50-100%, depending on the length of manufacturing time, types of components used in the completion process, and the breadth of the user base. (d) Equipment is valued at a percentage of depreciated book value or recent appraised value, if available, and is typically discounted at 30-70% after various considerations including age and condition of the equipment, marketability, breadth of use, and whether the equipment includes unique components or add-ons. (e) Marketable securities are discounted by 10-30%, depending on the type of investment, age of valuation report and general market conditions. This methodology is based on a market approach and typically results in a Level 3 classification of the inputs for determining fair value.

Mortgage servicing rights: As of December 31, 2012, the fair value of the Company’s Level 3 servicing assets for residential mortgage loans was $2.2 million, some of which are not currently impaired and therefore carried at amortized cost. These residential mortgage loans have a weighted average interest rate of 4.44%, a weighted average maturity of 19 years and are secured by homes generally within the Company’s market area of Northern Indiana. A valuation model is used to estimate fair value, which is based on an income approach. The inputs used include estimates of prepayment speeds, discount rate, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, late fees, and float income. The most significant assumption used to value MSRs is prepayment rate. Prepayment rates are estimated based on published industry consensus prepayment rates. At December 31, 2012, the constant prepayment speed (“PSA”) used was 392 and the discount rate used was 9.2%. At December 31, 2011, the PSA used was 387 and the discount rate used was 9.2%.

Other real estate owned: Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property and are reviewed by the Company’s internal appraisal officer. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales. Such adjustments are usually significant and result in a Level 3 classification. In addition, the Company’s management may apply discount factors to the appraisals to take into account changing business factors and market conditions, as well as value impairment in cases where the appraisal date predates a likely change in market conditions. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

The table below presents the balances of assets and liabilities measured at fair value on a recurring basis:

	December 31, 2012
	Fair Value Measurements Using						Assets
	Level 1		Level 2		Level 3		at Fair Value
			(in thousands)
Assets
U.S. Treasury securities	$	1,037	$	0	$	0	$	1,037
U.S. Government sponsored agencies		0		5,304		0		5,304
Mortgage-backed securities		0		365,644		0		365,644
Non-agency residential mortgage-backed securities		0		3,594		2,859		6,453
State and municipal securities		0		87,595		988		88,583
Total Securities		1,037		462,137		3,847		467,021
Mortgage banking derivative		0		739		0		739
Total assets	$	1,037	$	462,876	$	3,847	$	467,760
Liabilities
Mortgage banking derivative	$	0	$	12	$	0	$	12

	December 31, 2011
	Fair Value Measurements Using						Assets
	Level 1		Level 2		Level 3		at Fair Value
			(in thousands)
Assets
U.S. Treasury securities	$	1,055	$	0	$	0	$	1,055
U.S. Government sponsored agencies		0		5,277		0		5,277
Mortgage-backed securities		0		350,102		0		350,102
Non-agency residential mortgage-backed securities		0		32,207		0		32,207
State and municipal securities		0		78,064		686		78,750
Total Securities		1,055		465,650		686		467,391
Mortgage banking derivative		0		406		0		406
Total assets	$	1,055	$	466,056	$	686	$	467,797
Liabilities
Mortgage banking derivative	$	0	$	81	$	0	$	81

There were no transfers between Level 1and Level 2 during 2012 and 2011.

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the years ended December 31, 2012 and 2011:

	Non-Agency Residential
	Mortgage-Backed Securities				State and Municipal Securities
	2012		2011		2012			2011
	(in thousands)				(in thousands)
Balance of recurring Level 3 assets at January 1	$	0	$	0	$	686		$	0
Transfers into Level 3		2,859		0		351			686
Changes in fair value of securities		0		0		(4	)		0
Principal payments		0		0		(45	)		0
Balance of recurring Level 3 assets at December 31	$	2,859	$	0	$	988		$	686

The fair value of three non-agency residential mortgage-backed securities with a fair value of $2.9 million and two state and municipal securities with a fair value of $351,000 as of December 31, 2012 were transferred out of Level 2 and into Level 3 because of a lack of observable market data for these investments. The Company’s policy is to recognize transfers as of the end of the reporting period. As a result, the fair value for these non-agency residential mortgage-backed securities and state and municipal securities was transferred on December 31, 2012.

The fair value of three state and municipal securities with a fair value of $686,000 as of December 31, 2011 were transferred out of Level 2 and into Level 3 because of a lack of observable market data for these investments. The Company’s policy is to recognize transfers as of the end of the reporting period. As a result, the fair value for these state and municipal securities was transferred on December 31, 2011.

The state and municipal securities measured at fair value included below are nonrated Indiana municipal revenue bonds and are not actively traded.

Quantitative Information about Level 3 Fair Value Measurements
	Fair Value at				Range of Inputs
	12/31/2012		Valuation Technique	Unobservable Input	(Average)
	(in thousands)
Non-agency residential mortgage-backed securities	$	2,859	Discounted cash flow	Constant prepayment rate	5.00-9.00
					(6.00)
				Average life	0.20-2.86
					(2.70)
				Swap/EDSF spread	297-339
					(328)
State and municipal securities	$	988	Price to type, par, call	Discount to benchmark index	1-11%
					(4%)

The Company’s Controlling Department, which is responsible for all accounting and SEC compliance and the Company’s Treasury Department, which is responsible for investment portfolio management and asset/liability modeling, are the two areas that decide the Company’s valuation policies and procedures. Both of these areas report directly to the President and Chief Financial Officer of the Company. For assets or liabilities that may be considered for Level 3 fair value measurement on a recurring basis, these two departments and the President and Chief Financial Officer determine the appropriate level of the assets or liabilities under consideration. If there are assets or liabilities that are determined to be Level 3 by this group, the Risk Management Committee of the Company and the Audit Committee of the Board of Directors are made aware of such assets at their next scheduled meeting.

Securities pricing is obtained from a third party pricing service and is tested at least annually against prices from another third party provider and reviewed with a market value tolerance variance of 3%. If any securities fall above this tolerance threshold, they are reviewed in more detail to determine why the variance exists. Changes in market value are reviewed monthly in aggregate yield by security type and any material differences are reviewed to determine why they exist. At least annually, the pricing methodology of the pricing service is received and reviewed to support the fair value levels used by the Company. A detailed pricing evaluation is requested and reviewed on any security determined to be fair valued using unobservable inputs by the pricing service.

The significant unobservable inputs used in the fair value measurement of the Company’s non-agency residential mortgage-backed securities classified as Level 3 are constant prepayment rates, average life, and a Swap/EDSF spread. Significant increases/(decreases) in any of those inputs in isolation would result in a significantly lower/(higher) fair value measurement.

The primary methodology used in the fair value measurement of the Company’s state and municipal securities classified as Level 3 is a discount to the AAA municipal benchmark index. Significant increases or (decreases) in this index as well as the degree to which the security differs in ratings, coupon, call and duration will result in a higher or (lower) fair value measurement for those securities that are not callable. For those securities that are continuously callable, a slight premium to par is used.

The table below presents the balances of assets measured at fair value on a nonrecurring basis:

	December 31, 2012
	Fair Value Measurements Using						Assets
	Level 1		Level 2		Level 3		at Fair Value
			(in thousands)
Assets
Impaired loans:
Commercial and industrial loans:
Working capital lines of credit loans	$	0	$	0	$	990	$	990
Non-working capital loans		0		0		2,990		2,990
Commercial real estate and multi-family residential loans:
Construction and land development loans		0		0		2,026		2,026
Owner occupied loans		0		0		3,892		3,892
Nonowner occupied loans		0		0		18,642		18,642
Multifamily loans		0		0		0		0
Agri-business and agricultural loans:
Loans secured by farmland		0		0		268		268
Loans for agricultural production		0		0		0		0
Other commercial loans		0		0		0		0
Consumer 1-4 family mortgage loans:
Closed end first mortgage loans		0		0		352		352
Open end and junior lien loans		0		0		158		158
Residential construction loans		0		0		0		0
Other consumer loans		0		0		46		46
Total impaired loans	$	0	$	0	$	29,364	$	29,364
Mortgage servicing rights		0		0		1,906		1,906
Other real estate owned		0		0		75		75
Total assets	$	0	$	0	$	31,345	$	31,345

	Level 1		Level 2		Level 3		at Fair Value
			(in thousands)
Assets
Impaired loans:
Commercial and industrial loans:
Working capital lines of credit loans	$	0	$	0	$	2,762	$	2,762
Non-working capital loans		0		0		11,885		11,885
Commercial real estate and multi-family residential loans:
Construction and land development loans		0		0		303		303
Owner occupied loans		0		0		3,515		3,515
Nonowner occupied loans		0		0		23,591		23,591
Multifamily loans		0		0		0		0
Agri-business and agricultural loans:
Loans secured by farmland		0		0		433		433
Loans for agricultural production		0		0		207		207
Other commercial loans		0		0		0		0
Consumer 1-4 family mortgage loans:
Closed end first mortgage loans		0		0		878		878
Open end and junior lien loans		0		0		406		406
Residential construction loans		0		0		0		0
Other consumer loans		0		0		0		0
Total impaired loans	$	0	$	0	$	43,980	$	43,980
Mortgage servicing rights		0		0		1,734		1,734
Other real estate owned		0		0		730		730
Total assets	$	0	$	0	$	46,444	$	46,444

The following table presents the valuation methodology and unobservable inputs for Level 3 assets measured at fair value on a non-recurring basis at December 31, 2012:

	Fair Value		Valuation Methodology	Unobservable Inputs	Average			Range of Inputs
Impaired Loans:
Commercial and industrial:	$	3,980	Collateral based	Discount to reflect		35	%	(10% - 99%)
			measurements	current market conditions
				and ultimate collectability
Impaired loans:
Commercial real estate:		24,560	Collateral based	Discount to reflect		23	%	(4% - 57%)
			measurements	current market conditions
				and ultimate collectability
Impaired loans:
Agri-business and agricultural:		268	Collateral based	Discount to reflect		19	%
			measurements	current market conditions
				and ultimate collectability
Impaired loans:
Consumer 1-4 family mortgage		510	Collateral based	Discount to reflect		39	%	(8% - 100%)
			measurements	current market conditions
				and ultimate collectability
Impaired loans:
Other consumer		46	Collateral based	Discount to reflect		40	%	(29% - 100%)
			measurements	current market conditions
				and ultimate collectability
Mortgage servicing rights		1,906	Discounted cash flows	Discount rate		9.20	%	(9.10% - 9.50%)
Other real estate owned		75	Appraisals	Discount to reflect		49	%
				current market conditions

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $39.4 million, with a valuation allowance of $10.0 million at December 31, 2012, resulting in a net reduction in provision for loan losses of $8.2 million for the year ended December 31, 2012. At December 31, 2011, impaired loans had a carrying amount of $62.2 million, with a valuation allowance of $18.2 million, resulting in an additional provision for loans losses of $6.9 million for the year ending December 31, 2011.

MSRs, which are carried at the lower of cost or fair value, included a portion carried at their fair value of $1.9 million, which is made up of the outstanding balance of $1.9 million, net of a valuation allowance of $42,000 at December 31, 2012, resulting in a net decrease in impairment of $66,000 for the year ended December 31, 2012. At December 31, 2011, MSRs included a portion carried at their fair value of $1.7 million, which is made up of the outstanding balance of $1.8 million, net of a valuation allowance of $108,000 at December 31, 2011, resulting in a net increase in impairment of $86,000 for the year ended December 31, 2011.

Other real estate owned measured at fair value less costs to sell, had a net carrying amount of $75,000, which is made up of the outstanding balance of $147,000, net of a valuation allowance of $72,000 at December 31, 2012, which was all written down during 2012 and at December 31, 2011 had a net carrying amount of $730,000, which is made up of the outstanding balance of $1.1 million, net of a valuation allowance of $340,000, which was all written down during 2011.

The following table contains the estimated fair values and the related carrying values of the Company’s financial instruments at December 31, 2012 and 2011. Items which are not financial instruments are not included.

	December 31, 2012
	Carrying			Estimated Fair Value
	Value			Level 1			Level 2			Level 3			Total
Financial Assets:
Cash and cash equivalents	$	232,237		$	232,237		$	0		$	0		$	232,237
Securities available for sale		467,021			1,037			462,137			3,847			467,021
Real estate mortgages held for sale		9,452			0			9,663			0			9,663
Loans, net		2,206,075			0			0			2,230,993			2,230,993
Federal Home Loan Bank stock		7,313			N/A			N/A			N/A			N/A
Federal Reserve Bank stock		3,420			N/A			N/A			N/A			N/A
Accrued interest receivable		8,485			6			2,215			6,264			8,485
Financial Liabilities:
Certificates of deposit		(907,505	)		0			(922,397	)		0			(922,397	)
All other deposits		(1,674,251	)		(1,674,251	)		0			0			(1,674,251	)
Securities sold under agreements to repurchase		(121,883	)		0			(121,883	)		0			(121,883	)
Long-term borrowings		(15,038	)		0			(15,607	)		0			(15,607	)
Subordinated debentures		(30,928	)		0			0			(31,223	)		(31,223	)
Standby letters of credit		(262	)		0			0			(262	)		(262	)
Accrued interest payable		(4,757	)		(298	)		(4,456	)		(3	)		(4,757	)

	December 31, 2011
	Carrying			Estimated
	Value			Fair Value
Financial Assets:
Cash and cash equivalents	$	104,584		$	104,584
Securities available for sale		467,391			467,391
Real estate mortgages held for sale		2,953			2,998
Loans, net		2,180,309			2,141,459
Federal Home Loan Bank stock		7,313			N/A
Federal Reserve Bank stock		3,420			N/A
Accrued interest receivable		9,604			9,604
Financial Liabilities:
Certificates of deposit		(910,381	)		(925,619	)
All other deposits		(1,502,315	)		(1,502,315	)
Securities sold under agreements to repurchase		(131,990	)		(131,990	)
Other short-term borrowings		(10,000	)		(10,000	)
Long-term borrowings		(15,040	)		(16,079	)
Subordinated debentures		(30,928	)		(31,240	)
Standby letters of credit		(247	)		(247	)
Accrued interest payable		(5,574	)		(5,574	)

The methods and assumptions, not previously presented, used to estimate fair values are described as follows:

Cash and cash equivalents - The carrying amount of cash and cash equivalents approximate fair value and are classified as Level 1.

Loans, net – Fair values of loans, excluding loans held for sale, are estimated as follows: For variable rate loans, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using current market rates applied to the estimated life resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

FHLB and Federal Reserve Bank stock– It is not practical to determine the fair value of FHLB stock and Federal Reserve Bank stock due to restrictions placed on its transferability.

Certificates of deposit - Fair values of certificates of deposit are estimated using discounted cash flow analyses using current market rates applied to the estimated life resulting in a Level 2 classification.

All other deposits- The fair values for all other deposits other than certificates of deposit are equal to the amount payable on demand (the carrying value) resulting in a Level 1 classification.

Securities sold under agreements to repurchase – The carrying amount of borrowings under repurchase agreements approximate their fair values resulting in a Level 2 classification.

Long-term borrowings – The fair value of long-term borrowings is estimated using discounted cash flow analyses based on current borrowing rates resulting in a Level 2 classification.

Subordinated debentures- The fair value of subordinated debentures is based on the rates currently available to the Company with similar term and remaining maturity and credit spread resulting in a Level 3 classification.

Standby letters of credit – The fair value of off-balance sheet items is based on the current fees and costs that would be charged to enter into or terminate such arrangements resulting in a Level 3 classification.

Accrued interest receivable/payable – The carrying amounts of accrued interest approximate fair value resulting in a Level 1, Level 2 or Level 3 classification which is consistent with its associated asset/liability.