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 utilize 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).

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 determine 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 price tolerance variance of +/-3%, an individual security market value tolerance of +/-$50,000 and an aggregate market value tolerance of +/-$500,000 for all securities. If any securities fall outside any of these tolerance thresholds, 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.

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

Interest rate swap derivatives: The Company records all interest rate swap derivatives on the balance sheet at fair value. The accounting for changes in the fair value of these derivatives depends on the intended use of the derivative, whether the Company has elected to designate such derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Currently, none of the Company’s derivatives are designated in qualifying hedging relationships, as the derivatives are not used to manage risks within the Company’s assets or liabilities. As such, all changes in fair value of the Company’s derivatives are recognized directly in earnings. The fair value of interest rate swap derivatives is determined by pricing or valuation models using 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; and (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, 2013, the fair value of the Company’s Level 3 servicing assets for residential mortgage loans (“MSRs”) was $3.3 million, none of which are currently impaired and therefore are carried at amortized cost. These residential mortgage loans have a weighted average interest rate of 4.11%, 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 by stratifying the portfolios on the basis of certain risk characteristics, including loan type and interest rate. Impairment is estimated 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, 2013, the constant prepayment speed (“PSA”) used was 185 and discount rate used was 9.4%. At December 31, 2012, the PSA used was 392 and the discount rate used was 9.2%.

At December 31, 2013, the sensitivity of the current fair value of MSRs to an immediate 10% and 20% adverse change in the PSA and discount rate was ($129,000) and ($250,000) respectively for the PSA and was ($103,000) and ($199,000) respectively for the discount rate. These sensitivities are hypothetical and should not be relied upon. As the figures indicate, changes in value based on a 10% and 20% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in value may not be linear. Also, in this example, the effect of a variation in a particular assumption on the value of the MSR is calculated without changing any other assumption; however, in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments), which might magnify or counteract the sensitivities.

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 properties used to determine value. 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, 2013
	Fair Value Measurements Using						Assets
(dollars in thousands)	Level 1		Level 2		Level 3		at Fair Value
Assets
U.S. Treasury securities	$	1,017	$	0	$	0	$	1,017
Mortgage-backed securities		0		371,977		0		371,977
State and municipal securities		0		94,998		975		95,973
Total Securities		1,017		466,975		975		468,967
Mortgage banking derivative		0		142		0		142
Interest rate swap derivative		0		627		0		627
Total assets	$	1,017	$	467,744	$	975	$	469,736

Liabilities
Mortgage banking derivative		0		2		0		2
Interest rate swap derivative		0		592		0		592
Total liabilities	$	0	$	594	$	0	$	594

	December 31, 2012
	Fair Value Measurements Using						Assets
(dollars in thousands)	Level 1		Level 2		Level 3		at Fair Value
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

There were no transfers between Level 1and Level 2 during 2013 and 2012.

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, 2013 and 2012:

	Non-Agency Residential Mortgage-Backed Securities					State and Municipal Securities
(dollars in thousands)	2013			2012		2013			2012
Balance of recurring Level 3 assets at January 1	$	2,859		$	0	$	988		$	686
Transfers into Level 3		3,334			2,859		0			351
Changes in fair value of securities		(158	)		0		(13	)		(4	)
Principal payments		(2,183	)		0		0			(45	)
Sales		(3,852	)		0		0			0
Balance of recurring Level 3 assets at December 31	$	0		$	2,859	$	975		$	988

The fair value of two non-agency residential mortgage-backed securities with a fair value of $3.3 million as of March 31, 2013 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 was transferred on March 31, 2013.

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 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

Range of

Fair Value at

Inputs

(dollars in thousands)

12/31/2013

Valuation Technique

Unobservable Input

(Average)

State and municipal securities

975

Price to type, par, call

Discount to benchmark index

0-6%

(2.21

Quantitative Information about Level 3 Fair Value Measurements
					Range of
	Fair Value at				Inputs
(dollars in thousands)	12/31/2012		Valuation Technique	Unobservable Input	(Average)

Non-agency residential	$	2,859	Discounted cash flow	Constant prepayment rate		5.00-9.00
mortgage-backed securities						(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 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, 2013
	Fair Value Measurements Using						Assets
(dollars in thousands)	Level 1		Level 2		Level 3		at Fair Value
Assets
Impaired loans:
Commercial and industrial loans:
Working capital lines of credit loans	$	0	$	0	$	920	$	920
Non-working capital loans		0		0		3,097		3,097
Commercial real estate and multi-family residential loans:
Construction and land development loans		0		0		2,210		2,210
Owner occupied loans		0		0		3,958		3,958
Nonowner occupied loans		0		0		8,938		8,938
Agri-business and agricultural loans:
Loans secured by farmland		0		0		472		472
Consumer 1-4 family mortgage loans:
Closed end first mortgage loans		0		0		409		409
Open end and junior lien loans		0		0		174		174
Other consumer loans		0		0		50		50
Total impaired loans	$	0	$	0	$	20,228	$	20,228
Other real estate owned		0		0		75		75
Total assets	$	0	$	0	$	20,303	$	20,303

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

	December 31, 2012
	Fair Value Measurements Using						Assets
(dollars in thousands)	Level 1		Level 2		Level 3		at Fair Value
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
Agri-business and agricultural loans:
Loans secured by farmland		0		0		268		268
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
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

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, 2013:

(dollars in thousands)	Fair Value		Valuation Methodology	Unobservable Inputs	Average			Range of Inputs
Impaired loans:

Commercial and industrial	$	4,017	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability		29	%	(3% - 93%)

Impaired loans:

Commercial real estate		15,106	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability		22	%	(3% - 45%)

Impaired loans:

Agri-business and agricultural		472	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability		8	%	(4% - 12%)

Impaired loans:

Consumer 1-4 family mortgage		583	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability		33	%	(6% - 77%)

Impaired loans:

Other consumer		50	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability		53	%	(28% - 98%)

Other real estate owned		75	Appraisals	Discount to reflect current market conditions		49	%

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:

(dollars in thousands)	Fair Value		Valuation Methodology	Unobservable Inputs	Average			Range of Inputs

Impaired Loans:

Commercial and industrial:	$	3,980	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability		35	%	(10% - 99%)

Impaired loans:
Commercial real estate:		24,560	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability		23	%	(4% - 57%)

Impaired loans:
Agri-business and agricultural:		268	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability		19	%

Impaired loans:
Consumer 1-4 family mortgage		510	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability		39	%	(8% - 100%)
Impaired loans:
Other consumer		46	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability		40	%	(29% - 100%)

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 current market conditions		49	%

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $26.5 million, with a valuation allowance of $6.3 million at December 31, 2013, resulting in a net reduction in provision for loan losses of $3.7 million for the year ended December 31, 2013. At December 31, 2012, impaired loans had a gross carrying amount of $39.4 million, with a valuation allowance of $10.0 million, resulting in a net reduction in provision for loans losses of $8.2 million for the year ending December 31, 2012.

At December 31, 2012, MSRs 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.

Other real estate owned measured at fair value less costs to sell, at December 31, 2013 and 2012 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, which was all written down during 2012.

The following table contains the estimated fair values and the related carrying values of the Company’s financial instruments at December 31, 2013. Items which are not financial instruments are not included.

	December 31, 2013
	Carrying			Estimated Fair Value
(dollars in thousands)	Value			Level 1			Level 2			Level 3			Total
Financial Assets:
Cash and cash equivalents	$	63,105		$	63,105		$	0		$	0		$	63,105
Securities available for sale		468,967			1,017			466,975			975			468,967
Real estate mortgages held for sale		1,778			0			1,800			0			1,800
Loans, net		2,486,301			0			0			2,490,593			2,490,593
Federal Home Loan Bank stock		7,312			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		8,577			0			2,297			6,280			8,577
Financial Liabilities:
Certificates of deposit		(727,809	)		0			(736,088	)		0			(736,088	)
All other deposits		(1,818,259	)		(1,818,259	)		0			0			(1,818,259	)
Securities sold under agreements
to repurchase		(104,876	)		0			(104,876	)		0			(104,876	)
Federal funds purchased		(11,000	)		0			(11,000	)		0			(11,000	)
Other short-term borrowings		(146,000	)		0			(146,002	)		0			(146,002	)
Long-term borrowings		(37	)		0			(43	)		0			(43	)
Subordinated debentures		(30,928	)		0			0			(31,217	)		(31,217	)
Standby letters of credit		(312	)		0			0			(312	)		(312	)
Accrued interest payable		(2,918	)		(125	)		(2,790	)		(3	)		(2,918	)

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

	December 31, 2012
	Carrying			Estimated Fair Value
(dollars in thousands)	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		7,312			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	)

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 analysis, 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 analysis 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.

Federal funds purchased – The carrying amount of federal funds purchased approximate fair value resulting in a Level 2 classification.

Other short-term borrowings – The fair value of other short-term borrowings is estimated using discounted cash flow analysis based on current borrowing rates 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 terms 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 depending on its associated asset/liability.