LOANS AND LEASES

Loans and leases as of March 31, 2013, and December 31, 2012, were as follows, in thousands:



	March 31, 2013			December 31, 2012
Loans and leases receivable held to maturity:
Commercial	$	693,235		$	712,308
Commercial real estate	1,297,583			1,289,184
Agricultural and agricultural real estate	314,606			328,311
Residential real estate	240,453			249,689
Consumer	246,996			245,678
Gross loans and leases receivable held to maturity	2,792,873			2,825,170
Unearned discount	(479		)	(676		)
Deferred loan fees	(2,501		)	(2,945		)
Total net loans and leases receivable held to maturity	2,789,893			2,821,549
Loans covered under loss share agreements:
Commercial and commercial real estate	2,738			3,074
Agricultural and agricultural real estate	453			748
Residential real estate	2,722			2,645
Consumer	828			786
Total loans covered under loss share agreements	6,741			7,253
Allowance for loan and lease losses	(37,528		)	(38,715		)
Loans and leases receivable, net	$	2,759,106		$	2,790,087

Heartland has certain lending policies and procedures in place that are designed to provide for an acceptable level of credit risk. The board of directors reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management and the board with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming loans and potential problem loans. Diversification in the loan portfolio is also a means of managing risk associated with fluctuations in economic conditions.

The commercial and commercial real estate loan portfolio includes a wide range of business loans, including lines of credit for working capital and operational purposes and term loans for the acquisition of equipment and real estate. Although most loans are made on a secured basis, loans may be made on an unsecured basis where warranted by the overall financial condition of the borrower. Terms of commercial business loans generally range from one to five years. Commercial loans and leases are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. The collateral for most of these loans and leases is based upon a discount from its market value. The primary repayment risks of commercial loans and leases are that the cash flow of the borrowers may be unpredictable, and the collateral securing these loans may fluctuate in value. Heartland seeks to minimize these risks in a variety of ways. The underwriting analysis includes credit verification, analysis of global cash flows, appraisals and a review of the financial condition of the borrower. Personal guarantees are frequently required as a tertiary form of repayment. In addition, when underwriting loans for commercial real estate, careful consideration is given to the property's operating history, future operating projections, current and projected occupancy, location and physical condition. Heartland also utilizes government guaranteed lending through the U.S. Small Business Administration and the USDA Rural Development Business and Industry Program to assist customers with longer-term funding and to reduce risk.

Agricultural loans, many of which are secured by crops, machinery and real estate, are provided to finance capital improvements and farm operations as well as acquisitions of livestock and machinery. Agricultural loans present unique credit risks relating to adverse weather conditions, loss of livestock due to disease or other factors, declines in market prices for agricultural products and the impact of government regulations. The ultimate repayment of agricultural loans is dependent upon the profitable operation or management of the agricultural entity. In underwriting agricultural loans, lending personnel work closely with their customers to review budgets and cash flow projections for the ensuing crop year. These budgets and cash flow projections are monitored closely during the year and reviewed with the customers at least annually. Lending personnel also work closely with governmental agencies, including the Farm Service Agency, to help agricultural customers obtain credit enhancement products such as loan guarantees or interest assistance.

Heartland originates first-lien, adjustable-rate and fixed-rate, one-to-four-family residential real estate loans for the construction, purchase or refinancing of a single family residential property. These loans are principally collateralized by owner-occupied properties and are amortized over 10 to 30 years. Heartland typically sells longer-term, low-rate, residential mortgage loans in the secondary market with servicing rights retained. This practice allows Heartland to better manage interest rate risk and liquidity risk. The Heartland bank subsidiaries participate in lending programs sponsored by U.S. government agencies such as Veterans Administration and Federal Home Administration when justified by market conditions.

Consumer lending includes motor vehicle, home improvement, home equity and small personal credit lines. Consumer loans typically have shorter terms, lower balances, higher yields and higher risks of default than one- to four-family residential mortgage loans. Consumer loan collections are dependent on the borrower's continuing financial stability, and are therefore more likely to be affected by adverse personal circumstances. 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. Heartland's consumer finance subsidiary, Citizens Finance Co., typically lends to borrowers with past credit problems or limited credit histories, which comprise approximately 27% of Heartland's total consumer loan portfolio.

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Heartland’s policy is to discontinue the accrual of interest income on any loan or lease when, in the opinion of management, there is a reasonable doubt as to the timely collection of the interest and principal, normally when a loan or lease is 90 days past due. When interest accruals are deemed uncollectible, interest credited to income in the current year is reversed and interest accrued in prior years is charged to the allowance for loan and lease losses. Nonaccrual loans and leases are returned to an accrual status when, in the opinion of management, the financial position of the borrower indicates that there is no longer any reasonable doubt as to the timely payment of interest and principal.

Under Heartland’s credit practices, a loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loan impairment is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except where more practical, at the observable market price of the loan or the fair value of the collateral if the loan is collateral dependent.

The following table shows the balance in the allowance for loan and lease losses at March 31, 2013, and December 31, 2012, and the related loan balances, disaggregated on the basis of impairment methodology, in thousands. Loans evaluated under ASC 310-10-35 include loans on nonaccrual status and troubled debt restructurings, which are individually evaluated for impairment, and other impaired loans deemed to have similar risk characteristics. All other loans are collectively evaluated for impairment under ASC 450-20. Heartland has made no changes to the accounting for the allowance for loan and lease losses policy during 2013.



	Allowance For Loan and Lease Losses						Gross Loans and Leases Receivable Held to Maturity
	Ending Balance Under ASC 310-10-35		Ending Balance Under ASC 450-20		Total		Ending Balance Evaluated for Impairment Under ASC 310-10-35		Ending Balance Evaluated for Impairment Under ASC 450-20		Total
March 31, 2013
Commercial	$	1,026	$	8,273	$	9,299	$	8,457	$	684,778	$	693,235
Commercial real estate	964		14,226		15,190		37,194		1,260,389		1,297,583
Agricultural and agricultural real estate	176		2,019		2,195		13,222		301,384		314,606
Residential real estate	796		2,470		3,266		7,305		233,148		240,453
Consumer	1,530		6,048		7,578		5,055		241,941		246,996
Total	$	4,492	$	33,036	$	37,528	$	71,233	$	2,721,640	$	2,792,873
December 31, 2012
Commercial	$	1,350	$	10,038	$	11,388	$	9,031	$	703,277	$	712,308
Commercial real estate	1,112		13,361		14,473		45,583		1,243,601		1,289,184
Agricultural and agricultural real estate	109		2,029		2,138		16,128		312,183		328,311
Residential real estate	783		2,760		3,543		7,443		242,246		249,689
Consumer	1,270		5,903		7,173		5,391		240,287		245,678
Total	$	4,624	$	34,091	$	38,715	$	83,576	$	2,741,594	$	2,825,170

The following table presents nonaccrual loans, accruing loans past due 90 days or more and troubled debt restructured loans not covered under loss share agreements at March 31, 2013, and December 31, 2012, in thousands. There were no nonaccrual leases, accruing leases past due 90 days or more or restructured leases at March 31, 2013, and December 31, 2012.



	March 31, 2013		December 31, 2012
Nonaccrual loans	$	30,282	$	38,675
Nonaccrual troubled debt restructured loans	2,074		4,481
Total nonaccrual loans	$	32,356	$	43,156
Accruing loans past due 90 days or more	454		—
Performing troubled debt restructured loans	$	24,473	$	21,121

Heartland had $26.5 million of troubled debt restructured loans at March 31, 2013, of which $2.1 million were classified as nonaccrual and $24.5 million were accruing according to the restructured terms. Heartland had $25.6 million of troubled debt restructured loans at December 31, 2012, of which $4.5 million were classified as nonaccrual and $21.1 million were accruing according to the restructured terms.

The following tables provide information on troubled debt restructured loans that were modified during the three months ended March 31, 2013, and March 31, 2012, in thousands:



	Three Months Ended March 31, 2013					Three Months Ended March 31, 2012
	Number of Loans	Pre- Modification Recorded Investment		Post- Modification Recorded Investment		Number of Loans	Pre- Modification Recorded Investment		Post- Modification Recorded Investment
Commercial	2	$	4,670	$	4,670	—	$	—	$	—
Commercial real estate	—	—		—		—	—		—
Total commercial and commercial real estate	2	4,670		4,670		—	—		—
Agricultural and agricultural real estate	3	2,576		2,576		—	—		—
Residential real estate	2	646		646		1	19		19
Consumer	—	—		—		—	—		—
Total	7	$	7,892	$	7,892	1	$	19	$	19

The pre-modification and post-modification recorded investment represents amounts as of the date of loan modification. Since the modifications on these loans have been only interest rate concessions and term extensions, not principal reductions, the pre-modification and post-modification recorded investment amounts are the same.

The following tables provide information on troubled debt restructured loans for which there was a payment default during the three months ended March 31, 2013, and March 31, 2012, in thousands, that had been modified during the twelve-month period prior to the default:



	With Payment Defaults During the Following Periods
	Three Months Ended March 31, 2013			Three Months Ended March 31, 2012
	Number of Loans	Recorded Investment		Number of Loans	Recorded Investment
Commercial	—	$	—	—	$	—
Commercial real estate	—	—		1	640
Total commercial and commercial real estate	—	—		1	640
Agricultural and agricultural real estate	—	—		—	—
Residential real estate	—	—		—	—
Consumer	—	—		—	—
Total	—	$	—	1	$	640

Heartland's internal rating system is a series of grades reflecting management's risk assessment, based on its analysis of the borrower's financial condition. The "pass" category consists of all loans that are not in the "nonpass" category, categorized into a range of loan grades that reflect increasing, though still acceptable, risk. Movement of risk through the various grade levels in the pass category is monitored for early identification of credit deterioration. The "nonpass" category consists of special mention, substandard, doubtful and loss loans. The "special mention" rating is attached to loans where the borrower exhibits negative financial trends due to borrower specific or systemic conditions that, if left uncorrected, threaten its capacity to meet its debt obligations. The borrower is believed to have sufficient financial flexibility to react to and resolve its negative financial situation. These credits are closely monitored for improvement or deterioration. The "substandard" rating is assigned to loans that are inadequately protected by the current sound net worth and paying capacity of the borrower and may be further at risk due to deterioration in the value of collateral pledged. Well-defined weaknesses jeopardize liquidation of the debt. These loans are still considered collectible, however, a distinct possibility exists that Heartland will sustain some loss if deficiencies are not corrected. Substandard loans may exhibit some or all of the following weaknesses: deteriorating trends, lack of earnings, inadequate debt service capacity, excessive debt and/or lack of liquidity. The "doubtful" rating is assigned to loans where identified weaknesses make collection or liquidation in full, on the basis of existing facts, conditions and values, highly questionable and improbable. These borrowers are usually in default, lack liquidity and capital, as well as, resources necessary to remain an operating entity. Specific pending events, such as capital injections, liquidations or perfection of liens on additional collateral, may strengthen the credit, thus deferring classification of the loan as loss until exact status can be determined. The "loss" rating is assigned to loans considered uncollectible. As of March 31, 2013, Heartland had no loans classified as doubtful or loss. Loans are placed on "nonaccrual" when management does not expect to collect payments of principal and interest in full or when principal or interest has been in default for a period of 90 days or more, unless the loan is both well secured and in the process of collection.

The following table presents loans and leases not covered by loss share agreements by credit quality indicator at March 31, 2013, and December 31, 2012, in thousands:



	Pass		Nonpass		Total
March 31, 2013
Commercial	$	644,980	$	48,255	$	693,235
Commercial real estate	1,139,334		158,249		1,297,583
Total commercial and commercial real estate	1,784,314		206,504		1,990,818
Agricultural and agricultural real estate	271,019		43,587		314,606
Residential real estate	222,487		17,966		240,453
Consumer	236,793		10,203		246,996
Total gross loans and leases receivable held to maturity	$	2,514,613	$	278,260	$	2,792,873
December 31, 2012
Commercial	$	661,118	$	51,190	$	712,308
Commercial real estate	1,134,784		154,400		1,289,184
Total commercial and commercial real estate	1,795,902		205,590		2,001,492
Agricultural and agricultural real estate	286,264		42,047		328,311
Residential real estate	227,925		21,764		249,689
Consumer	235,232		10,446		245,678
Total gross loans and leases receivable held to maturity	$	2,545,323	$	279,847	$	2,825,170

The nonpass category in the table above is comprised of approximately 52% special mention and 48% substandard as of March 31, 2013. The percent of nonpass loans on nonaccrual status as of March 31, 2013, was 12%. As of December 31, 2012, the nonpass category in the table above was comprised of approximately 50% special mention and 50% substandard. The percent of nonpass loans on nonaccrual status as of December 31, 2012, was 15%. Changes in credit risk are monitored on a continuous basis and changes in risk ratings are made when identified. All impaired loans are reviewed at least annually.

The following table sets forth information regarding Heartland's accruing and nonaccrual loans and leases not covered by loss share agreements at March 31, 2013, and December 31, 2012, in thousands:



	Accruing Loans and Leases
	30-59 Days Past Due		60-89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Nonaccrual		Total Loans and Leases
March 31, 2013
Commercial	$	5,245	$	624	$	—	$	5,869	$	685,082	$	2,284	$	693,235
Commercial real estate	1,781		350		404		2,535		1,274,874		20,174		1,297,583
Total commercial and commercial real estate	7,026		974		404		8,404		1,959,956		22,458		1,990,818
Agricultural and agricultural real estate	1,086		10		—		1,096		313,222		288		314,606
Residential real estate	2,006		—		—		2,006		232,241		6,206		240,453
Consumer	1,953		634		50		2,637		240,955		3,404		246,996
Total gross loans and leases receivable held to maturity	$	12,071	$	1,618	$	454	$	14,143	$	2,746,374	$	32,356	$	2,792,873
December 31, 2012
Commercial	$	1,143	$	525	$	—	$	1,668	$	708,459	$	2,181	$	712,308
Commercial real estate	1,631		494		—		2,125		1,259,112		27,947		1,289,184
Total commercial and commercial real estate	2,774		1,019		—		3,793		1,967,571		30,128		2,001,492
Agricultural and agricultural real estate	687		—		—		687		324,545		3,079		328,311
Residential real estate	1,278		234		—		1,512		241,860		6,317		249,689
Consumer	2,434		803		—		3,237		238,809		3,632		245,678
Total gross loans and leases receivable held to maturity	$	7,173	$	2,056	$	—	$	9,229	$	2,772,785	$	43,156	$	2,825,170

The majority of Heartland's impaired loans are those that are nonaccrual, are past due 90 days or more and still accruing or have had their terms restructured in a troubled debt restructuring. The following tables present, for impaired loans not covered by loss share agreements and by category of loan, the unpaid balance that was contractually due at March 31, 2013, and December 31, 2012; the outstanding loan balance recorded on the consolidated balance sheets at March 31, 2013, and December 31, 2012; any related allowance recorded for those loans as of March 31, 2013, and December 31, 2012; the average outstanding loan balance recorded on the consolidated balance sheets during the three months ended March 31, 2013, and year ended December 31, 2012; and the interest income recognized on the impaired loans during the three months ended March 31, 2013, and year ended December 31, 2012, in thousands:



	Unpaid Contractual Balance		Loan Balance		Related Allowance Recorded		Year-to-Date Avg. Loan Balance		Year-to-Date Interest Income Recognized
March 31, 2013
Impaired loans with a related allowance:
Commercial	$	2,561	$	2,561	$	1,026	$	2,631	$	19
Commercial real estate	7,007		6,043		964		5,667		89
Total commercial and commercial real estate	9,568		8,604		1,990		8,298		108
Agricultural and agricultural real estate	1,447		1,447		176		1,447		18
Residential real estate	3,562		3,536		796		3,274		19
Consumer	3,473		3,473		1,530		3,479		25
Total loans held to maturity	$	18,050	$	17,060	$	4,492	$	16,498	$	170
Impaired loans without a related allowance:
Commercial	$	6,266	$	5,896	$	—	$	5,485	$	65
Commercial real estate	39,718		31,151		—		34,884		164
Total commercial and commercial real estate	45,984		37,047		—		40,369		229
Agricultural and agricultural real estate	11,782		11,775		—		11,859		123
Residential real estate	4,314		3,769		—		3,727		16
Consumer	1,608		1,582		—		1,455		5
Total loans held to maturity	$	63,688	$	54,173	$	—	$	57,410	$	373
Total impaired loans held to maturity:
Commercial	$	8,827	$	8,457	$	1,026	$	8,116	$	84
Commercial real estate	46,725		37,194		964		40,551		252
Total commercial and commercial real estate	55,552		45,651		1,990		48,667		336
Agricultural and agricultural real estate	13,229		13,222		176		13,306		141
Residential real estate	7,876		7,305		796		7,001		35
Consumer	5,081		5,055		1,530		4,934		30
Total impaired loans held to maturity	$	81,738	$	71,233	$	4,492	$	73,908	$	542



	Unpaid Contractual Balance		Loan Balance		Related Allowance Recorded		Year-to-Date Avg. Loan Balance		Year-to-Date Interest Income Recognized
December 31, 2012
Impaired loans with a related allowance:
Commercial	$	2,904	$	2,904	$	1,350	$	5,082	$	88
Commercial real estate	6,403		6,384		1,112		12,671		813
Total commercial and commercial real estate	9,307		9,288		2,462		17,753		901
Agricultural and agricultural real estate	1,493		1,493		109		379		83
Residential real estate	3,197		3,170		783		2,737		89
Consumer	3,876		3,836		1,270		3,781		204
Total loans held to maturity	$	17,873	$	17,787	$	4,624	$	24,650	$	1,277
Impaired loans without a related allowance:
Commercial	$	6,596	$	6,127	$	—	$	3,813	$	186
Commercial real estate	48,967		39,199		—		41,814		689
Total commercial and commercial real estate	55,563		45,326		—		45,627		875
Agricultural and agricultural real estate	14,654		14,635		—		13,728		539
Residential real estate	4,741		4,273		—		3,861		65
Consumer	1,708		1,555		—		1,630		18
Total loans held to maturity	$	76,666	$	65,789	$	—	$	64,846	$	1,497
Total impaired loans held to maturity:
Commercial	$	9,500	$	9,031	$	1,350	$	8,895	$	274
Commercial real estate	55,370		45,583		1,112		54,485		1,502
Total commercial and commercial real estate	64,870		54,614		2,462		63,380		1,776
Agricultural and agricultural real estate	16,147		16,128		109		14,107		622
Residential real estate	7,938		7,443		783		6,598		154
Consumer	5,584		5,391		1,270		5,411		222
Total impaired loans held to maturity	$	94,539	$	83,576	$	4,624	$	89,496	$	2,774

On July 2, 2009, Heartland acquired all deposits of The Elizabeth State Bank in Elizabeth, Illinois through its subsidiary Galena State Bank & Trust Co. based in Galena, Illinois, in a whole bank loss sharing transaction facilitated by the FDIC. As of July 2, 2009, The Elizabeth State Bank had loans of $42.7 million. The estimated fair value of the loans acquired was $37.8 million.

The acquired loans and other real estate owned are covered by two loss share agreements between the FDIC and Galena State Bank & Trust Co., which affords Galena State Bank & Trust Co. significant loss protection. Under the loss share agreements, the FDIC covers 80% of the covered loan and other real estate owned losses (referred to as covered assets) up to $10 million and 95% of losses in excess of that amount. The term for loss sharing on non-residential real estate losses is five years with respect to losses and eight years with respect to recoveries, while the term for loss sharing on residential real estate loans is ten years with respect to losses and recoveries. The reimbursable losses from the FDIC are based on the book value of the relevant loan as determined by the FDIC at the date of the transaction. New loans made after the acquisition are not covered by the loss share agreements.

The Elizabeth State Bank acquisition was accounted for under the acquisition method of accounting in accordance with ASC 805, “Business Combinations.” Purchased loans acquired in a business combination, which include loans purchased in The Elizabeth State Bank acquisition, are recorded at estimated fair value on their purchase date, but the purchaser cannot carry over the related allowance for loan and lease losses. Purchased loans are accounted for under ASC 310-30, “Loans and Debt Securities with Deteriorated Credit Quality,” when the loans have evidence of credit deterioration since origination and it is probable at the date of the acquisition that Heartland will not collect all contractually required principal and interest payments. Evidence of credit quality deterioration at the purchase date included statistics such as past due and nonaccrual status. Generally, acquired loans that meet Heartland’s definition for nonaccrual status fall within the scope of ASC 310-30. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the nonaccretable difference which is included in the carrying value of the loans. Subsequent decreases to the expected cash flows will generally result in a provision for loan and lease losses. Subsequent increases in cash flows result in a reversal of the provision for loan and lease losses to the extent of prior charges, or a reclassification of the difference from nonaccretable to accretable with a positive impact on future interest income. Further, any excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable yield and is recognized into interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of such cash flows.

The carrying amount of the loans covered by these loss share agreements at March 31, 2013, and December 31, 2012, consisted of purchased impaired and nonimpaired loans as summarized in the following table, in thousands:



	March 31, 2013						December 31, 2012
	Impaired Purchased Loans		Non Impaired Purchased Loans		Total Covered Loans		Impaired Purchased Loans		Non Impaired Purchased Loans		Total Covered Loans
Commercial and commercial real estate	$	381	$	2,357	$	2,738	$	598	$	2,476	$	3,074
Agricultural and agricultural real estate	—		453		453		—		748		748
Residential real estate	—		2,722		2,722		—		2,645		2,645
Consumer loans	383		445		828		89		697		786
Total Covered Loans	$	764	$	5,977	$	6,741	$	687	$	6,566	$	7,253

On the acquisition date, the preliminary estimate of the contractually required payments receivable for all loans with evidence of credit deterioration since origination acquired in the acquisition was $13.8 million and the estimated fair value of the loans was $9.0 million. At March 31, 2013, and December 31, 2012, a majority of these loans were valued based upon the liquidation value of the underlying collateral, because the expected cash flows are primarily based on the liquidation of underlying collateral and the timing and amount of the cash flows could not be reasonably estimated. There was no allowance for loan and lease losses related to these ASC 310-30 loans at March 31, 2013, and December 31, 2012.

On the acquisition date, the preliminary estimate of the contractually required payments receivable for all nonimpaired loans acquired in the acquisition was $28.9 million and the estimated fair value of the loans was $28.7 million.