Note 5. Allowance for Loan Losses and Credit Quality of Loans

Allowance for Loan Losses

The allowance for loan losses is maintained at a level estimated by management to provide adequately for risk of probable losses inherent in the current loan portfolio. The adequacy of the allowance for loan losses is continuously monitored. It is assessed for adequacy using a methodology designed to ensure the level of the allowance reasonably reflects the loan portfolio’s risk profile. It is evaluated to ensure that it is sufficient to absorb all reasonably estimable credit losses inherent in the current loan portfolio.

To develop and document a systematic methodology for determining the allowance for loan losses, the Company has divided the loan portfolio into three segments, each with different risk characteristics and methodologies for assessing risk. Those segments are further segregated between our loans accounted for under the amortized cost method (referred to as “originated” loans) and loans acquired in a business combination (referred to as “acquired” loans). Prior to 2013, separate disclosures for acquired loans were not significant and were included with originated loans in the Company’s asset quality disclosures. Each portfolio segment is broken down into class segments where appropriate. Class segments contain unique measurement attributes, risk characteristics and methods for monitoring and assessing risk that are necessary to develop the allowance for loan losses. Unique characteristics such as borrower type, loan type, collateral type, and risk characteristics define each class segment. The following table illustrates the portfolio and class segments for the Company’s loan portfolio:

Portfolio	Class
Commercial Loans	Commercial
	Commercial Real Estate
	Agricultural
	Agricultural Real Estate
	Business Banking

Consumer Loans	Indirect
	Home Equity
	Direct

Residential Real Estate Mortgages

Commercial Loans

The Company offers a variety of commercial loan products including commercial (non-real estate), commercial real estate, agricultural, agricultural real estate, and business banking loans. The Company’s underwriting analysis for commercial loans typically includes credit verification, independent appraisals, a review of the borrower’s financial condition, and a detailed analysis of the borrower’s underlying cash flows.

Commercial – The Company offers a variety of loan options to meet the specific needs of our commercial customers including term loans, time notes and lines of credit. Such loans are made available to businesses for working capital needs such as inventory and receivables, business expansion and equipment purchases. Generally, a collateral lien is placed on equipment or other assets owned by the borrower. These loans carry a higher risk than commercial real estate loans due to the nature of the underlying collateral, which can be business assets such as equipment and accounts receivable and is generally less liquid than real estate. To reduce the risk, management also attempts to secure real estate as collateral and obtain personal guarantees of the borrowers.

Commercial Real Estate – The Company offers commercial real estate loans to finance real estate purchases, refinancings, expansions and improvements to commercial properties. Commercial real estate loans are made to finance the purchases of real property which generally consists of real estate with completed structures. These commercial real estate loans are secured by first liens on the real estate, which may include apartments, commercial structures, housing businesses, healthcare facilities, and other non owner-occupied facilities. These loans are typically less risky than commercial loans, since they are secured by real estate and buildings, and are generally originated in amounts of no more than 80% of the appraised value of the property.

Agricultural – The Company offers a variety of agricultural loans to meet the needs of our agricultural customers including term loans, time notes, and lines of credit. These loans are made to purchase livestock, purchase and modernize equipment, and finance seasonal crop expenses. Generally, a collateral lien is placed on the livestock, equipment, produce inventories, and/or receivables owned by the borrower. These loans may carry a higher risk than commercial and agricultural real estate loans due to the industry price volatility, and in some cases, the perishable nature of the underlying collateral. To reduce these risks, management may attempt to secure these loans with additional real estate collateral, obtain personal guarantees of the borrowers, or obtain government loan guarantees to provide further support.

Agricultural Real Estate – The Company offers real estate loans to our agricultural customers to finance farm related real estate purchases, refinancings, expansions, and improvements to agricultural properties such as barns, production facilities, and land. The agricultural real estate loans are secured by first liens on the farm real estate. Because they are secured by land and buildings, these loans may be less risky than agricultural loans. These loans are typically originated in amounts of no more than 75% of the appraised value of the property. Government loan guarantees may be obtained to provide further support.

Business Banking - The Company offers a variety of loan options to meet the specific needs of our business banking customers including term loans, business banking mortgages and lines of credit. Such loans are generally less than $0.5 million and are made available to businesses for working capital such as inventory and receivables, business expansion, equipment purchases, and agricultural needs. Generally, a collateral lien is placed on equipment or other assets owned by the borrower such as inventory and/or receivables. These loans carry a higher risk than commercial loans due to the smaller size of the borrower and lower levels of capital. To reduce the risk, the Company obtains personal guarantees of the owners for a majority of the loans.

Consumer Loans

The Company offers a variety of consumer loan products including indirect, home equity, and direct loans.

Indirect – The Company maintains relationships with many dealers primarily in the communities that we serve. Through these relationships, the company finances the purchases of automobiles and recreational vehicles (such as campers, boats, etc.) indirectly through dealer relationships. Approximately 75% of the indirect relationships represent automobile financing. Most of these loans carry a fixed rate of interest with principal repayment terms typically ranging from three to six years, based upon the nature of the collateral and the size of the loan. The majority of indirect consumer loans are underwritten on a secured basis using the underlying collateral being financed.

Home Equity – The Company offers fixed home equity loans as well as home equity lines of credit to consumers to finance home improvements, debt consolidation, education and other uses. Consumers are able to borrow up to 85% of the equity in their homes. The Company originates home equity lines of credit and second mortgage loans (loans secured by a second junior lien position on one-to-four-family residential real estate). These loans carry a higher risk than first mortgage residential loans as they are in a second position with respect to collateral. Risk is reduced through underwriting criteria, which include credit verification, appraisals, a review of the borrower's financial condition, and personal cash flows. A security interest, with title insurance when necessary, is taken in the underlying real estate.

Direct – The Company offers a variety of consumer installment loans to finance vehicle purchases, mobile home purchases and personal expenditures. Most of these loans carry a fixed rate of interest with principal repayment terms typically ranging from one to ten years, based upon the nature of the collateral and the size of the loan. The majority of consumer loans are underwritten on a secured basis using the underlying collateral being financed or a customer's deposit account. In addition to installment loans, the Company also offers personal lines of credit and overdraft protection. A minimal amount of loans are unsecured, which carry a higher risk of loss.

Residential Real Estate Mortgages

Residential real estate loans consist primarily of loans secured by first or second deeds of trust on primary residences. We originate adjustable-rate and fixed-rate, one-to-four-family residential real estate loans for the construction, purchase or refinancing of a mortgage. These loans are collateralized by owner-occupied properties located in the Company’s market area. Loans on one-to-four-family residential real estate are generally originated in amounts of no more than 85% of the purchase price or appraised value (whichever is lower), or have private mortgage insurance. The Company’s underwriting analysis for residential mortgage loans typically includes credit verification, independent appraisals, and a review of the borrower’s financial condition. Mortgage title insurance and hazard insurance are normally required. Construction loans have a unique risk, because they are secured by an incomplete dwelling. This risk is reduced through periodic site inspections, including one at each loan draw period.

For purposes of evaluating the adequacy of the allowance, the Company considers a number of significant factors that affect the collectability of the portfolio. For individually analyzed loans, these include estimates of loss exposure, which reflect the facts and circumstances that affect the likelihood of repayment of such loans as of the evaluation date. For homogeneous pools of loans, estimates of the Company’s exposure to credit loss reflect a current assessment of a number of factors, which could affect collectability. These factors include: past loss experience; size, trend, composition, and nature of loans; changes in lending policies and procedures, including underwriting standards and collection, charge-offs and recoveries; trends experienced in nonperforming and delinquent loans; current economic conditions in the Company’s market; portfolio concentrations that may affect loss experienced across one or more components of the portfolio; the effect of external factors such as competition, legal and regulatory requirements; and the experience, ability, and depth of lending management and staff. In addition, various regulatory agencies, as an integral component of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to make loan grade changes as well as recognize additions to the allowance based on their examinations.

After a thorough consideration of the factors discussed above, any required additions or reductions to the allowance for loan losses are made periodically by charges or credits to the provision for loan losses. These charges or credits are necessary to maintain the allowance at a level which management believes is reasonably reflective of overall inherent risk of probable loss in the portfolio. While management uses available information to recognize losses on loans, additions and reductions of the allowance may fluctuate from one reporting period to another. These fluctuations are reflective of changes in risk associated with portfolio content and/or changes in management’s assessment of any or all of the determining factors discussed above.

The following tables illustrate the changes in the allowance for loan losses by our portfolio segments for the three and six months ended June 30, 2013 and 2012:

							Residential
Three months ended June 30	Commercial			Consumer			Real Estate
	Loans			Loans			Mortgages			Unallocated			Total
Balance as of March 31, 2013	$	35,358		$	26,285		$	6,708		$	383		$	68,734
Charge-offs		(1,198	)		(3,653	)		(302	)		-			(5,153	)
Recoveries		416			696			89			-			1,201
Provision		3,128			3,128			311			(165	)		6,402
Ending Balance as of June 30, 2013	$	37,704		$	26,456		$	6,806		$	218		$	71,184

Balance as of March 31, 2012	$	37,787		$	26,790		$	6,520		$	237		$	71,334
Charge-offs		(1,653	)		(3,735	)		(292	)		-			(5,680	)
Recoveries		303			667			7			-			977
Provision		1,058			3,513			(292	)		(176	)		4,103
Ending Balance as of June 30, 2012	$	37,495		$	27,235		$	5,943		$	61		$	70,734

							Residential
Six months ended June 30	Commercial			Consumer			Real Estate
	Loans			Loans			Mortgages			Unallocated			Total
Balance as of December 31, 2012	$	35,624		$	27,162		$	6,252		$	296		$	69,334
Charge-offs		(4,520	)		(7,376	)		(973	)		-			(12,869	)
Recoveries		883			1,673			103			-			2,659
Provision		5,717			4,997			1,424			(78	)		12,060
Ending Balance as of June 30, 2013	$	37,704		$	26,456		$	6,806		$	218		$	71,184

Balance as of December 31, 2011	$	38,831		$	26,049		$	6,249		$	205		$	71,334
Charge-offs		(2,783	)		(7,787	)		(650	)		-			(11,220	)
Recoveries		688			1,342			16			-			2,046
Provision		759			7,631			328			(144	)		8,574
Ending Balance as of June 30, 2012	$	37,495		$	27,235		$	5,943		$	61		$	70,734

For acquired loans, to the extent that we experience deterioration in borrower credit quality resulting in a decrease in our expected cash flows subsequent to acquisition of the loans, an allowance for loan losses would be established based on our estimate of future credit losses over the remaining life of the loans. As of June 30, 2013 and 2012, there was no allowance for loan losses for the acquired loan portfolio. Net charge-offs related to acquired loans totaled $0.2 million and $0.4 million during the three and six months ended June 30, 2013, respectively, and are included in the table above.

The following tables illustrate the allowance for loan losses and the recorded investment by portfolio segments as of June 30, 2013 and December 31, 2012:

Allowance for Loan Losses and Recorded Investment in Loans
(in thousands)

					Residential
	Commercial		Consumer		Real Estate
	Loans		Loans		Mortgages		Unallocated		Total
As of June 30, 2013
Allowance for loan losses	$	37,704	$	26,456	$	6,806	$	218	$	71,184

Allowance for loans individually evaluated for impairment	$	2,032	$	-	$	-			$	2,032

Allowance for loans collectively evaluated for impairment	$	35,672	$	26,456	$	6,806	$	218	$	69,152

Ending balance of loans	$	2,368,897	$	1,920,171	$	1,001,642			$	5,290,710

Ending balance of loans individually evaluated for impairment	$	12,887	$	-	$	-			$	12,887
Ending balance of acquired loans	$	460,995	$	269,151	$	338,750			$	1,068,896
Ending balance of loans collectively evaluated for impairment	$	1,895,015	$	1,651,020	$	662,892			$	4,208,927

As of December 31, 2012
Allowance for loan losses	$	35,624	$	27,162	$	6,252	$	296	$	69,334

Allowance for loans individually evaluated for impairment	$	2,848	$	-	$	-			$	2,848

Allowance for loans collectively evaluated for impairment	$	32,776	$	27,162	$	6,252	$	296	$	66,486


Ending balance of loans	$	2,003,371	$	1,623,138	$	651,107			$	4,277,616

Ending balance of loans individually evaluated for impairment	$	11,972	$	-	$	-			$	11,972

Ending balance of loans collectively evaluated for impairment	$	1,991,399	$	1,623,138	$	651,107			$	4,265,644

Credit Quality of Loans

Loans are placed on nonaccrual status when timely collection of principal and interest in accordance with contractual terms is doubtful. Loans are transferred to nonaccrual status generally when principal or interest payments become ninety days delinquent, unless the loan is well secured and in the process of collection, or sooner when management concludes or circumstances indicate that borrowers may be unable to meet contractual principal or interest payments. When a loan is transferred to a nonaccrual status, all interest previously accrued in the current period but not collected is reversed against interest income in that period. Interest accrued in a prior period and not collected is charged-off against the allowance for loan losses. The Company’s nonaccrual policies are the same for all classes of financing receivable.

If ultimate repayment of a nonaccrual loan is expected, any payments received are applied in accordance with contractual terms. If ultimate repayment of principal is not expected, any payment received on a nonaccrual loan is applied to principal until ultimate repayment becomes expected. Nonaccrual loans are returned to accrual status when they become current as to principal and interest and demonstrate a period of performance under the contractual terms and, in the opinion of management, are fully collectible as to principal and interest. When in the opinion of management the collection of principal appears unlikely, the loan balance is charged-off in total or in part. For loans in all portfolios, the principal amount is charged off in full or in part as soon as management determines, based on available facts, that the collection of principal in full is improbable. For commercial loans, management considers specific facts and circumstances relative to individual credits in making such a determination. For consumer and residential loan classes, management uses specific guidance and thresholds from the Federal Financial Institutions Examination Council’s Uniform Retail Credit Classification and Account Management Policy.

The following table illustrates the Company’s nonaccrual loans by loan class:

Loans on Nonaccrual Status as of:

(In thousands)	June 30, 2013		December 31, 2012
ORIGINATED
Commercial Loans
Commercial	$	2,622	$	4,985
Commercial Real Estate		10,716		7,977
Agricultural		595		699
Agricultural Real Estate		968		1,038
Business Banking		5,658		6,738
		20,559		21,437

Consumer Loans
Indirect		1,301		1,557
Home Equity		6,583		7,247
Direct		128		266
		8,012		9,070
Residential Real Estate Mortgages		6,414		9,169

	$	34,985	$	39,676

ACQUIRED
Commercial Loans
Commercial	$	446
Commercial Real Estate		-
Business Banking		1,593
		2,039

Consumer Loans
Indirect		139
Home Equity		425
Direct		74
		638

Residential Real Estate Mortgages		2,863

	$	5,540

Total nonaccrual loans	$	40,525	$	39,676

The following tables set forth information with regard to past due and nonperforming loans by loan class as of June 30, 2013 and December 31, 2012:

Age Analysis of Past Due Financing Receivables

As of June 30, 2013

(in thousands)

					Greater Than								Recorded
	31-60 Days		61-90 Days		90 Days		Total						Total
	Past Due		Past Due		Past Due		Past Due						Loans and
	Accruing		Accruing		Accruing		Accruing		Non-Accrual		Current		Leases
ORIGINATED
Commercial Loans
Commercial	$	195	$	20	$	-	$	215	$	2,622	$	583,101	$	585,938
Commercial Real Estate		1,692		-		-		1,692		10,716		875,555		887,963
Agricultural		154		20		-		174		595		63,834		64,603
Agricultural Real Estate		349		-		-		349		968		30,894		32,211
Business Banking		2,176		590		-		2,766		5,658		328,763		337,187
		4,566		630		-		5,196		20,559		1,882,147		1,907,902

Consumer Loans
Indirect		10,749		2,259		832		13,840		1,301		1,033,903		1,049,044
Home Equity		6,475		1,198		704		8,377		6,583		525,429		540,389
Direct		611		210		45		866		128		60,593		61,587
		17,835		3,667		1,581		23,083		8,012		1,619,925		1,651,020
Residential Real Estate Mortgages		487		1,085		358		1,930		6,414		654,548		662,892
	$	22,888	$	5,382	$	1,939	$	30,209	$	34,985	$	4,156,620	$	4,221,814

ACQUIRED
Commercial Loans
Commercial	$	473	$	5	$	-	$	478	$	446	$	137,215	$	138,139
Commercial Real Estate		-		-		-		-		-		242,322		242,322
Agricultural		-		-		-		-		-		25		25
Business Banking		74		-		-		74		1,593		78,842		80,509
		547		5		-		552		2,039		458,404		460,995

Consumer Loans
Indirect		751		162		23		936		139		164,267		165,342
Home Equity		307		754		38		1,099		425		93,370		94,894
Direct		38		30		4		72		74		8,769		8,915
		1,096		946		65		2,107		638		266,406		269,151
Residential Real Estate Mortgages		2,292		230		-		2,522		2,863		333,365		338,750
	$	3,935	$	1,181	$	65	$	5,181	$	5,540	$	1,058,175	$	1,068,896
Total Loans	$	26,823	$	6,563	$	2,004	$	35,390	$	40,525	$	5,214,795	$	5,290,710

As of December 31, 2012

(in thousands)

					Greater Than
	31-60 Days		61-90 Days		90 Days		Total						Recorded
	Past Due		Past Due		Past Due		Past Due						Total
	Accruing		Accruing		Accruing		Accruing		Non-Accrual		Current		Loans
Commercial Loans
Commercial	$	-	$	-	$	-	$	-	$	4,985	$	556,496	$	561,481
Commercial Real Estate		126		-		-		126		7,977		966,692		974,795
Agricultural		22		-		-		22		699		63,037		63,758
Agricultural Real Estate		108		-		103		211		1,038		36,128		37,377
Business Banking		3,019		708		45		3,772		6,738		355,450		365,960
		3,275		708		148		4,131		21,437		1,977,803		2,003,371

Consumer Loans
Indirect		10,956		2,477		1,205		14,638		1,557		964,802		980,997
Home Equity		6,065		1,223		681		7,969		7,247		560,066		575,282
Direct		717		144		84		945		266		65,648		66,859
		17,738		3,844		1,970		23,552		9,070		1,590,516		1,623,138
Residential Real Estate Mortgages		1,839		725		330		2,894		9,169		639,044		651,107
	$	22,852	$	5,277	$	2,448	$	30,577	$	39,676	$	4,207,363	$	4,277,616

There were no material commitments to extend further credit to borrowers with nonperforming loans.

Impaired Loans

The methodology used to establish the allowance for loan losses on impaired loans incorporates specific allocations on loans analyzed individually. Classified loans with outstanding balances of $0.5 million or more are evaluated for impairment through the Company’s quarterly status review process. In determining that we will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreements, we consider factors such as payment history and changes in the financial condition of individual borrowers, local economic conditions, historical loss experience and the conditions of the various markets in which the collateral may be liquidated. For loans that are impaired as defined by accounting standards, impairment is measured by one of three methods: 1) the fair value of collateral less cost to sell, 2) present value of expected future cash flows or 3) the loan’s observable market price. All impaired loans are reviewed on a quarterly basis for changes in the measurement of impairment. Any change to the previously recognized impairment loss is recognized as a change to the allowance account and recorded in the consolidated statement of income as a component of the provision for credit losses.

The following table provides information on impaired loans and specific reserve allocations as of June 30, 2013 and December 31, 2012:

	June 30, 2013						December 31, 2012
	Recorded		Unpaid				Recorded		Unpaid
	Investment		Principal				Investment		Principal
	Balance		Balance		Related		Balance		Balance		Related
(in thousands)	(Book)		(Legal)		Allowance		(Book)		(Legal)		Allowance
With no related allowance recorded:
Commercial Loans
Commercial	$	4,067	$	5,337			$	1,651	$	1,710
Commercial Real Estate		4,347		5,134				8,709		9,553
Agricultural		616		917				940		1,286
Agricultural Real Estate		1,634		1,955				1,713		2,026
Business Banking		7,534		10,213				7,048		9,579
Total Commercial Loans		18,198		23,556				20,061		24,154

Consumer Loans
Home Equity		2,971		3,156				2,553		2,657

Residential Real Estate Mortgages		2,018		2,360				2,011		2,308
	$	23,187	$	29,072			$	24,625	$	29,119

With an allowance recorded:
Commercial Loans
Commercial	$	-	$	-	$	-	$	4,335	$	4,340	$	2,241
Commercial Real Estate		7,302		8,924		2,032		4,068		5,689		607
Agricultural		-		-		-		-		-		-
Agricultural Real Estate		-		-		-		-		-		-
		7,302		8,924		2,032		8,403		10,029		2,848

Total:	$	30,489	$	37,996	$	2,032	$	33,028	$	39,148	$	2,848

The following tables summarize the average recorded investments on impaired loans and the interest income recognized for the three and six months ended June 30, 2013 and 2012:

	For the three months ended
	June 30, 2013				June 30, 2012
	Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income
(in thousands)	Investment		Recognized		Investment		Recognized
Commercial Loans
Commercial	$	2,822	$	15	$	1,128	$	46
Commercial Real Estate		8,616		11		7,140		-
Agricultural		770		-		2,876		5
Agricultural Real Estate		1,123		12		1,876		53
Business Banking		7,843		16		6,572		8
Consumer Loans
Home Equity		2,907		6		1,828		2
Residential Real Estate Mortgages		1,990		15		1,055		-
Total:	$	26,071	$	75	$	22,475	$	114

	For the six months ended
	June 30, 2013				June 30, 2012
	Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income
(in thousands)	Investment		Recognized		Investment		Recognized
Commercial Loans
Commercial	$	4,430	$	30	$	1,551	$	69
Commercial Real Estate		10,614		72		6,481		-
Agricultural		887		3		2,997		36
Agricultural Real Estate		1,482		24		1,926		53
Business Banking		8,016		30		7,151		12
Consumer Loans
Home Equity		2,775		12		1,869		3
Residential Real Estate Mortgages		1,989		27		1,043		-
Total:	$	30,193	$	198	$	23,018	$	173

Credit Quality Indicators

The Company has developed an internal loan grading system to evaluate and quantify the Bank’s loan portfolio with respect to quality and risk. The system focuses on, among other things, financial strength of borrowers, experience and depth of borrower’s management, primary and secondary sources of repayment, payment history, nature of the business, and outlook on particular industries. The internal grading system enables the Company to monitor the quality of the entire loan portfolio on a consistent basis and provide management with an early warning system, enabling recognition and response to problem loans and potential problem loans.

Commercial Grading System

For commercial and agricultural loans, the Company uses a grading system that relies on quantifiable and measurable characteristics when available. This would include comparison of financial strength to available industry averages, comparison of transaction factors (loan terms and conditions) to loan policy, and comparison of credit history to stated repayment terms and industry averages. Some grading factors are necessarily more subjective such as economic and industry factors, regulatory environment, and management. Classified commercial loans consist of loans graded substandard and below. The grading system for commercial and agricultural loans is as follows:

Doubtful

A doubtful loan has a high probability of total or substantial loss, but because of specific pending events that may strengthen the asset, its classification as a loss is deferred. Doubtful borrowers are usually in default, lack adequate liquidity or capital, and lack the resources necessary to remain an operating entity. Pending events can include mergers, acquisitions, liquidations, capital injections, the perfection of liens on additional collateral, the valuation of collateral, and refinancing. Generally, pending events should be resolved within a relatively short period and the ratings will be adjusted based on the new information. Nonaccrual treatment is required for doubtful assets because of the high probability of loss.

Substandard

Substandard loans have a high probability of payment default, or they have other well-defined weaknesses. They require more intensive supervision by bank management. Substandard loans are generally characterized by current or expected unprofitable operations, inadequate debt service coverage, inadequate liquidity, or marginal capitalization. Repayment may depend on collateral or other credit risk mitigants. For some Substandard loans, the likelihood of full collection of interest and principal may be in doubt and those loans should be placed on nonaccrual. Although Substandard assets in the aggregate will have a distinct potential for loss, an individual asset’s loss potential does not have to be distinct for the asset to be rated Substandard.

Special Mention

Special Mention loans have potential weaknesses that may, if not checked or corrected, weaken the asset or inadequately protect the Company’s position at some future date. These loans pose elevated risk, but their weakness does not yet justify a Substandard classification. Borrowers may be experiencing adverse operating trends (declining revenues or margins) or may be struggling with an ill-proportioned balance sheet (e.g., increasing inventory without an increase in sales, high leverage, tight liquidity). Adverse economic or market conditions, such as interest rate increases or the entry of a new competitor, may also support a Special Mention rating. Although a Special Mention loan has a higher probability of default than a pass asset, its default is not imminent.

Pass

Loans graded as Pass encompass all loans not graded as Doubtful, Substandard, or Special Mention. Pass loans are in compliance with loan covenants, and payments are generally made as agreed. Pass loans range from superior quality to fair quality.

Business Banking Grading System

Business banking loans are graded as either Classified or Non-classified:

Classified

Classified loans are inadequately protected by the current worth and paying capacity of the obligor or, if applicable, the collateral pledged. These loans have a well-defined weakness, or weaknesses, that jeopardize the liquidation of the debt, or in some cases make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Classified loans have a high probability of payment default, or a high probability of total or substantial loss. These loans require more intensive supervision by management and are generally characterized by current or expected unprofitable operations, inadequate debt service coverage, inadequate liquidity, or marginal capitalization. Repayment may depend on collateral or other credit risk mitigants. When the likelihood of full collection of interest and principal may be in doubt; classified loans are considered to have a nonaccrual status. In some cases, Classified loans are considered uncollectible and of such little value that their continuance as assets is not warranted.

Non-classified

Loans graded as Non-classified encompass all loans not graded as Classified. Non-classified loans are in compliance with loan covenants, and payments are generally made as agreed.

Consumer and Residential Mortgage Grading System

Consumer and Residential Mortgage loans are graded as either Performing or Nonperforming. Nonperforming loans are loans that are 1) over 90 days past due and interest is still accruing, 2) on nonaccrual status or 3) restructured. All loans not meeting any of these three criteria are considered Performing.

The following tables illustrate the Company’s credit quality by loan class as of June 30, 2013 and December 31, 2012:

Credit Quality Indicators

As of June 30, 2013

ORIGINATED
Commercial Credit Exposure			Commercial				Agricultural
By Internally Assigned Grade:	Commercial		Real Estate		Agricultural		Real Estate		Total
Pass	$	566,686	$	855,687	$	59,026	$	28,722	$	1,510,121
Special Mention		1,899		11,657		78		3		13,637
Substandard		16,850		19,856		5,476		3,486		45,668
Doubtful		503		763		23		-		1,289
Total	$	585,938	$	887,963	$	64,603	$	32,211	$	1,570,715

Business Banking Credit Exposure
By Internally Assigned Grade:	Small Business								Total
Non-classified	$	317,362							$	317,362
Classified		19,825								19,825
Total	$	337,187							$	337,187

Consumer Credit Exposure
By Payment Activity:	Indirect		Home Equity		Direct				Total
Performing	$	1,046,911	$	533,102	$	61,414			$	1,641,427
Nonperforming		2,133		7,287		173				9,593
Total	$	1,049,044	$	540,389	$	61,587			$	1,651,020

Residential Mortgage Credit Exposure	Residential
By Payment Activity:	Mortgage								Total
Performing	$	656,120							$	656,120
Nonperforming		6,772								6,772
Total	$	662,892							$	662,892

Credit Quality Indicators

As of June 30, 2013

ACQUIRED
Commercial Credit Exposure			Commercial
By Internally Assigned Grade:	Commercial		Real Estate		Agricultural		Total
Pass	$	121,901	$	220,131	$	25	$	342,057
Special Mention		8,323		8,822		-		17,145
Substandard		7,915		13,369		-		21,284
Doubtful		-		-		-		-
Total	$	138,139	$	242,322	$	25	$	380,486

Business Banking Credit Exposure
By Internally Assigned Grade:	Small Business						Total
Non-classified	$	75,418					$	75,418
Classified		5,091						5,091
Total	$	80,509					$	80,509

Consumer Credit Exposure
By Payment Activity:	Indirect		Home Equity		Direct		Total
Performing	$	165,180	$	94,006	$	8,763	$	267,949
Nonperforming		162		888		152		1,202
Total	$	165,342	$	94,894	$	8,915	$	269,151

Residential Mortgage Credit Exposure	Residential
By Payment Activity:	Mortgage						Total
Performing	$	335,887					$	335,887
Nonperforming		2,863						2,863
Total	$	338,750					$	338,750

Credit Quality Indicators

As of December 31, 2012

Commercial Credit Exposure			Commercial				Agricultural
By Internally Assigned Grade:	Commercial		Real Estate		Agricultural		Real Estate		Total
Pass	$	522,985	$	901,928	$	57,347	$	33,472	$	1,515,732
Special Mention		18,401		32,135		13		3		50,552
Substandard		17,351		40,732		6,362		3,902		68,347
Doubtful		2,744		-		36		-		2,780
Total	$	561,481	$	974,795	$	63,758	$	37,377	$	1,637,411

Business Banking. Credit Exposure
By Internally Assigned Grade:	Small Business								Total
Non-classified	$	342,528							$	342,528
Classified		23,432								23,432
Total	$	365,960							$	365,960

Consumer Credit Exposure
By Payment Activity:	Indirect		Home Equity		Direct				Total
Performing	$	978,235	$	567,354	$	66,509			$	1,612,098
Nonperforming		2,762		7,928		350				11,040
Total	$	980,997	$	575,282	$	66,859			$	1,623,138

Residential Mortgage Credit Exposure	Residential
By Payment Activity:	Mortgage								Total
Performing	$	641,608							$	641,608
Nonperforming		9,499								9,499
Total	$	651,107							$	651,107

Troubled Debt Restructured Loans

The Company’s loan portfolio includes certain loans that have been modified where economic concessions have been granted to borrowers who have experienced or are expected to experience financial difficulties. These concessions typically result from the Company’s loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Certain troubled debt restructured loans (“TDRs”) are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, generally six months.

When the Company modifies a loan, management evaluates any possible impairment based on the present value of the expected future cash flows, discounted at the contractual interest rate of the original loan agreement, except when the sole (remaining) source of repayment for the loan is the operation or liquidation of the collateral. In these cases, management uses the current fair value of the collateral, less selling costs, instead of discounted cash flows. If management determines that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized by segment or class of loan as applicable, through an allowance estimate or a charge-off to the allowance. Segment and class status is determined by the loan’s classification at origination.

TDRs that occurred during the three month period ending June 30, 2013 consisted of 10 home equity loans, one residential real estate mortgage, and one commercial real estate loan totaling $0.5 million, $0.1 million, and $0.9 million, respectively. For all such modifications, the pre and post outstanding recorded investment amount remained unchanged. During the three month period ending June 30, 2013 there were three defaults on home equity loans totaling $0.2 million.

TDRs that occurred during the three month period ending June 30, 2012 consisted of 1 commercial loan totaling $1.0 million. The pre and post outstanding recorded investment amount remained unchanged. During the three month period ending June 30, 2012 there was one default on a home equity loan and three defaults on residential real estate mortgages totaling $25,000 and $0.4 million, respectively, on previously modified loans.

TDRs that occurred during the six month period ending June 30, 2013 consisted of 14 home equity loans, one residential real estate mortgage, and one commercial real estate loan totaling $0.6 million, $0.1 million, and $0.9 million, respectively. For all such modifications, the pre and post outstanding recorded investment amount remained unchanged. During the six month period ending June 30, 2013 there were three defaults on home equity loans totaling $0.2 million.

TDRs that occurred during the six month period ending June 30, 2012 consisted of 1 commercial loan totaling $1.0 million and one residential real estate mortgage totaling $0.2 million. The pre and post outstanding recorded investment amount remained unchanged. During the six month period ending June 30, 2012 there was one default on a home equity loan totaling $25,000 that was previously modified.