Allowance for Loan Losses and Credit Quality of Loans

9 Months Ended

Sep. 30, 2013

Allowance for Loan Losses and Credit Quality of Loans [Abstract]

Allowance for Loan Losses and Credit Quality of Loans

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 nine months ended September 30, 2013 and 2012:

							Residential
Three months ended September 30	Commercial			Consumer			Real Estate
	Loans			Loans			Mortgages			Unallocated			Total
Balance as of June 30, 2013	$	37,704		$	26,456		$	6,806		$	218		$	71,184
Charge-offs		(3,489	)		(3,746	)		(374	)		-			(7,609	)
Recoveries		602			733			76			-			1,411
Provision		980			3,744			402			72			5,198
Ending Balance as of September 30, 2013	$	35,797		$	27,187		$	6,910		$	290		$	70,184
Balance as of June 30, 2012	$	37,495		$	27,235		$	5,943		$	61		$	70,734
Charge-offs		(1,904	)		(3,446	)		(480	)		-			(5,830	)
Recoveries		492			574			9			-			1,075
Provision		1,734			2,213			809			(1	)		4,755
Ending Balance as of September 30, 2012	$	37,817		$	26,576		$	6,281		$	60		$	70,734
							Residential
Nine months ended September 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		(8,009	)		(11,122	)		(1,347	)		-			(20,478	)
Recoveries		1,485			2,363			179			43			4,070
Provision		6,697			8,784			1,826			(49	)		17,258
Ending Balance as of September 30, 2013	$	35,797		$	27,187		$	6,910		$	290		$	70,184
Balance as of December 31, 2011	$	38,831		$	26,049		$	6,249		$	205		$	71,334
Charge-offs		(4,685	)		(11,237	)		(1,130	)		-			(17,052	)
Recoveries		1,180			1,918			25			-			3,123
Provision		2,491			9,846			1,137			(145	)		13,329
Ending Balance as of September 30, 2012	$	37,817		$	26,576		$	6,281		$	60		$	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 September 30, 2013 and 2012, there was no allowance for loan losses for the acquired loan portfolio. Net charge-offs related to acquired loans totaled approximately $47,000 and $0.3 million during the three and nine months ended September 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 September 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 September 30, 2013
Allowance for loan losses	$	35,797	$	27,187	$	6,910	$	290	$	70,184
Allowance for loans individually evaluated for impairment	$	1,100	$	-	$	-			$	1,100
Allowance for loans collectively evaluated for impairment	$	34,697	$	27,187	$	6,910	$	290	$	69,084
Ending balance of loans	$	2,378,848	$	1,960,225	$	1,028,158			$	5,367,231
Ending balance of loans individually evaluated for impairment	$	15,323	$	-	$	-			$	15,323
Ending balance of acquired loans	$	432,806	$	243,469	$	325,491			$	1,001,766
Ending balance of loans collectively evaluated for impairment	$	1,930,719	$	1,716,756	$	702,667			$	4,350,142
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)	September 30, 2013		December 31, 2012
ORIGINATED
Commercial Loans
Commercial	$	4,409	$	4,985
Commercial Real Estate		8,642		7,977
Agricultural		1,076		699
Agricultural Real Estate		868		1,038
Business Banking		4,949		6,738
		19,944		21,437
Consumer Loans
Indirect		1,440		1,557
Home Equity		5,965		7,247
Direct		92		266
		7,497		9,070
Residential Real Estate Mortgages		6,666		9,169
	$	34,107	$	39,676
ACQUIRED
Commercial Loans
Commercial	$	102
Commercial Real Estate		1,329
Business Banking		1,338
		2,769
Consumer Loans
Indirect		258
Home Equity		353
Direct		71
		682
Residential Real Estate Mortgages		3,860
	$	7,311
Total nonaccrual loans	$	41,418	$	39,676

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

Age Analysis of Past Due Financing Receivables
As of September 30, 2013
(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
ORIGINATED
Commercial Loans
Commercial	$	76	$	1,031	$	-	$	1,107	$	4,409	$	589,008	$	594,524
Commercial Real Estate		478		-		-		478		8,642		910,134		919,254
Agricultural		140		-		-		140		1,076		63,576		64,792
Agricultural Real Estate		-		-		-		-		868		34,071		34,939
Business Banking		1,900		675		-		2,575		4,949		325,009		332,533
		2,594		1,706		-		4,300		19,944		1,921,798		1,946,042
Consumer Loans
Indirect		10,530		2,331		1,229		14,090		1,440		1,098,286		1,113,816
Home Equity		6,513		1,648		768		8,929		5,965		527,428		542,322
Direct		625		156		107		888		92		59,638		60,618
		17,668		4,135		2,104		23,907		7,497		1,685,352		1,716,756
Residential Real Estate Mortgages		2,955		172		994		4,121		6,666		691,880		702,667
	$	23,217	$	6,013	$	3,098	$	32,328	$	34,107	$	4,299,030	$	4,365,465
ACQUIRED
Commercial Loans
Commercial	$	70	$	-	$	-	$	70	$	102	$	114,202	$	114,374
Commercial Real Estate		232		-		-		232		1,329		243,233		244,794
Business Banking		246		-		-		246		1,338		72,054		73,638
		548		-		-		548		2,769		429,489		432,806
Consumer Loans
Indirect		526		116		32		674		258		143,588		144,520
Home Equity		750		-		154		904		353		89,443		90,700
Direct		113		16		2		131		71		8,047		8,249
		1,389		132		188		1,709		682		241,078		243,469
Residential Real Estate Mortgages		2,479		317		-		2,796		3,860		318,835		325,491
	$	4,416	$	449	$	188	$	5,053	$	7,311	$	989,402	$	1,001,766
Total Loans	$	27,633	$	6,462	$	3,286	$	37,381	$	41,418	$	5,288,432	$	5,367,231

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 September 30, 2013 and December 31, 2012:

	September 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	$	5,507	$	5,549			$	1,651	$	1,710
Commercial Real Estate		5,427		5,431				8,709		9,553
Agricultural		1,097		1,460				940		1,286
Agricultural Real Estate		1,529		1,936				1,713		2,026
Business Banking		6,533		8,927				7,048		9,579
Total Commercial Loans		20,093		23,303				20,061		24,154
Consumer Loans
Home Equity		3,304		3,496				2,553		2,657
Residential Real Estate Mortgages		2,234		2,626				2,011		2,308
	$	25,631	$	29,425			$	24,625	$	29,119
With an allowance recorded:
Commercial Loans
Commercial	$	-	$	-	$	-	$	4,335	$	4,340	$	2,241
Commercial Real Estate		6,216		7,838		1,100		4,068		5,689		607
Agricultural		-		-		-		-		-		-
Agricultural Real Estate		-		-		-		-		-		-
		6,216		7,838		1,100		8,403		10,029		2,848
Total:	$	31,847	$	37,263	$	1,100	$	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 nine months ended September 30, 2013 and 2012:

	For the three months ended
	September 30, 2013				September 30, 2012
	Average		Interest		Average		Interest Income
	Recorded		Income		Recorded		Recognized
(in thousands)	Investment		Recognized		Investment		Accrual
Commercial Loans
Commercial	$	3,348	$	15	$	1,128	$	32
Commercial Real Estate		10,751		-		7,140		-
Agricultural		1,526		-		2,876		4
Agricultural Real Estate		897		12		1,876		12
Business Banking		6,581		13		6,572		-
Consumer Loans
Home Equity		3,064		8		1,828		5
Residential Real Estate Mortgages		2,066		15		1,055		1
Total:	$	28,233	$	63	$	22,475	$	54
	For the nine months ended
	September 30, 2013				September 30, 2012
	Average		Interest		Average		Interest Income
	Recorded		Income		Recorded		Recognized
(in thousands)	Investment		Recognized		Investment		Accrual
Commercial Loans
Commercial	$	4,069	$	45	$	1,551	$	101
Commercial Real Estate		10,660		51		6,481		-
Agricultural		1,100		1		2,997		40
Agricultural Real Estate		1,287		36		1,926		65
Business Banking		7,538		43		7,151		-
Consumer Loans
Home Equity		2,871		20		1,869		17
Residential Real Estate Mortgages		2,015		42		1,043		4
Total:	$	29,540	$	238	$	23,018	$	227

Credit Quality Indicators

The Company has developed an internal loan grading system to evaluate and quantify the Company’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 September 30, 2013 and December 31, 2012:

Credit Quality Indicators
As of September 30, 2013
ORIGINATED
			Commercial				Agricultural
Commercial Credit Exposure	Commercial		Real Estate		Agricultural		Real Estate		Total
By Internally Assigned Grade:
Pass	$	574,229	$	903,073	$	59,797	$	31,418	$	1,568,517
Special Mention		10,098		50		389		43		10,580
Substandard		10,197		16,131		4,594		3,478		34,400
Doubtful		-		-		12		-		12
Total	$	594,524	$	919,254	$	64,792	$	34,939	$	1,613,509
Business Banking Credit Exposure	Small Business								Total
By Internally Assigned Grade:
Non-classified	$	313,250							$	313,250
Classified		19,283								19,283
Total	$	332,533							$	332,533
Consumer Credit Exposure
By Payment Activity:	Indirect		Home Equity		Direct				Total
Performing	$	1,111,147	$	535,589	$	60,419			$	1,707,155
Nonperforming		2,669		6,733		199				9,601
Total	$	1,113,816	$	542,322	$	60,618			$	1,716,756
	Residential
Residential Mortgage Credit Exposure	Mortgage								Total
By Payment Activity:
Performing	$	695,007							$	695,007
Nonperforming		7,660								7,660
Total	$	702,667							$	702,667

Credit Quality Indicators
As of September 30, 2013
ACQUIRED
Commercial Credit Exposure			Commercial
By Internally Assigned Grade:	Commercial		Real Estate		Agricultural		Total
Pass	$	98,128	$	221,777	$	-	$	319,905
Special Mention		1,602		4,762		-		6,364
Substandard		14,644		18,255		-		32,899
Doubtful		-		-		-		-
Total	$	114,374	$	244,794	$	-	$	359,168
Business Banking Credit Exposure
By Internally Assigned Grade:	Small Business						Total
Non-classified	$	68,917					$	68,917
Classified		4,721						4,721
Total	$	73,638					$	73,638
Consumer Credit Exposure
By Payment Activity:	Indirect		Home Equity		Direct		Total
Performing	$	144,230	$	90,193	$	8,176	$	242,599
Nonperforming		290		507		73		870
Total	$	144,520	$	90,700	$	8,249	$	243,469
Residential Mortgage Credit Exposure	Residential
By Payment Activity:	Mortgage						Total
Performing	$	321,631					$	321,631
Nonperforming		3,860						3,860
Total	$	325,491					$	325,491

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.  Substantially all of these modifications included one or a combination of the following: an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; temporary reduction in the interest rate; or change in scheduled payment amount.

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 September 30, 2013 consisted of 9 home equity loans, five residential real estate mortgage, and three commercial loans totaling $0.4 million, $0.3 million, and $6.1 million, respectively.  For all such modifications, the pre and post outstanding recorded investment amount remained unchanged. During the three month period ending September 30, 2013 there was one default on a home equity loan totaling $0.1 million.

There were no TDRs that occurred during the three month period ending September 30, 2012.  During the three month period ending September 30, 2012 there were no defaults on previously modified loans.

TDRs that occurred during the nine month period ending September 30, 2013 consisted of 20 home equity loans, six residential real estate mortgage, and four commercial loans totaling $1.0 million, $0.5 million, and $7.0 million, respectively.  For all such modifications, the pre and post outstanding recorded investment amount remained unchanged.  During the nine month period ending September 30, 2013 there were seven defaults on home equity loans totaling $0.5 million.

TDRs that occurred during the nine month period ending September 30, 2012 consisted of one 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 nine month period ending September 30, 2012 there was one default on a home equity loan totaling $25,000 and three residential real estate mortgages totaling $0.4 million that were previously modified.