CITZ 2012.9.30 10Q

10-Q 1 citz201293010q.htm FORM 10-Q 09-30-12 CITZ 2012.9.30 10Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



þ	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012.



o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to __________.

Commission file number: 000-24611

CFS Bancorp, Inc.

(Exact name of registrant as specified in its charter)



Indiana	35-2042093
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

707 Ridge Road, Munster, Indiana	46321
(Address of principal executive offices)	(Zip code)

(219) 836-2960
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES þ NO o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

YES þ NO o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):



Large accelerated filer o	Accelerated filer o
Non-accelerated filer o (Do not check if a smaller reporting company)	Smaller reporting company þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO þ

The Registrant had 10,875,514 shares of Common Stock issued and outstanding as of October 31, 2012.

CFS BANCORP, INC.

Form 10-Q

TABLE OF CONTENTS



		Page
	PART I - FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)
	Condensed Consolidated Statements of Condition	3
	Condensed Consolidated Statements of Income	4
	Condensed Consolidated Statements of Comprehensive Income	5
	Condensed Consolidated Statements of Changes in Shareholders’ Equity	6
	Condensed Consolidated Statements of Cash Flows	7
	Notes to Condensed Consolidated Financial Statements	9

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	40

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	77

Item 4.	Controls and Procedures	79

	PART II - OTHER INFORMATION

Item 1.	Legal Proceedings	80

Item 1A.	Risk Factors	80

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	80

Item 3.	Defaults Upon Senior Securities	80

Item 4.	Mine Safety Disclosures	80

Item 5.	Other Information	80

Item 6.	Exhibits	81

Signature Page		82

Certifications of Principal Executive Officer and Principal Financial Officer
	Exhibit 31.1
	Exhibit 31.2
	Exhibit 32.0

CFS BANCORP, INC.

Condensed Consolidated Statements of Condition



	September 30, 2012			December 31, 2011
	(Unaudited)
ASSETS	(Dollars in thousands)
Cash and amounts due from depository institutions	$	31,611		$	32,982
Interest-bearing deposits	76,972			59,090
Cash and cash equivalents	108,583			92,072
Investment securities available-for-sale, at fair value	202,498			234,381
Investment securities held-to-maturity, at cost	13,490			16,371
Federal Home Loan Bank stock, at cost	6,188			6,188
Loans receivable	703,907			711,226
Allowance for loan losses	(12,359		)	(12,424		)
Net loans	691,548			698,802
Loans held for sale	2,199			1,124
Bank-owned life insurance	36,586			36,275
Accrued interest receivable	2,697			3,011
Other real estate owned	17,447			19,091
Office properties and equipment	16,121			17,539
Net deferred tax assets	13,801			16,273
Other assets	7,523			7,823
Total assets	$	1,118,681		$	1,148,950

LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits	$	951,061		$	977,424
Borrowed funds	50,018			54,200
Advance payments by borrowers for taxes and insurance	4,075			4,275
Other liabilities	5,468			9,803
Total liabilities	1,010,622			1,045,702

Commitments and contingencies

Shareholders’ equity:
Preferred stock, $.01 par value; 15,000,000 shares authorized	—			—
Common stock, $.01 par value; 85,000,000 shares authorized; 23,423,306 shares issued; 10,876,151 and 10,874,668 shares outstanding	234			234
Additional paid-in capital	187,254			187,030
Retained earnings	75,461			72,683
Treasury stock, at cost; 12,547,155 and 12,548,638 shares	(154,695		)	(154,773		)
Accumulated other comprehensive loss, net of tax	(195		)	(1,926		)
Total shareholders’ equity	108,059			103,248
Total liabilities and shareholders’ equity	$	1,118,681		$	1,148,950

See accompanying notes to the unaudited condensed consolidated financial statements.

CFS BANCORP, INC.

Condensed Consolidated Statements of Income



	Three Months Ended September 30,					Nine Months Ended September 30,
	2012		2011			2012		2011
	(Unaudited)
	(Dollars in thousands, except share and per share data)
Interest income:
Loans receivable	$	8,237	$	8,881		$	24,866	$	26,708
Investment securities	1,923		1,794			6,239		5,879
Other interest-earning assets	88		80			284		401
Total interest income	10,248		10,755			31,389		32,988
Interest expense:
Deposits	1,102		1,602			3,786		5,272
Borrowed funds	297		294			887		813
Total interest expense	1,399		1,896			4,673		6,085
Net interest income	8,849		8,859			26,716		26,903
Provision for loan losses	1,160		2,673			3,360		4,572
Net interest income after provision for loan losses	7,689		6,186			23,356		22,331
Non-interest income:
Deposit related fees	1,662		1,675			4,709		4,708
Commission income	55		100			187		223
Net gain on sale of:
Investment securities	194		758			917		1,450
Loans held for sale	327		66			686		124
Other real estate owned	425		266			464		2,499
Income from bank-owned life insurance	151		216			853		632
Other income	218		229			683		663
Total non-interest income	3,032		3,310			8,499		10,299
Non-interest expense:
Compensation and employee benefits	4,182		4,818			13,362		15,104
Net occupancy expense	697		706			2,084		2,141
FDIC insurance premiums and regulatory assessments	475		481			1,453		1,638
Data processing	462		424			1,345		1,307
Furniture and equipment expense	417		436			1,342		1,353
Marketing	283		213			1,009		670
Professional fees	177		309			628		1,031
Other real estate owned related expense, net	1,074		614			2,008		3,217
Loan collection expense	170		117			407		470
Severance and early retirement expense	—		—			876		—
Other general and administrative expenses	1,032		1,068			3,204		3,293
Total non-interest expense	8,969		9,186			27,718		30,224
Income before income tax expense (benefit)	1,752		310			4,137		2,406
Income tax expense (benefit)	493		(84		)	1,034		307
Net income	$	1,259	$	394		$	3,103	$	2,099

Per share data:
Basic earnings per share	.12		.04			.29		.20
Diluted earnings per share	.12		.04			.29		.20
Cash dividends declared per share	.02		.01			.03		.03
Weighted-average common and common share equivalents outstanding:
Basic	10,747,974		10,693,724			10,732,118		10,678,788
Diluted	10,806,861		10,753,386			10,786,679		10,739,969

See accompanying notes to the unaudited condensed consolidated financial statements.

CFS BANCORP, INC.

Condensed Consolidated Statements of Comprehensive Income



	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	(Unaudited)
	(Dollars in thousands)
Net income	$	1,259		$	394		$	3,103		$	2,099
Other comprehensive income (loss):
Unrealized holding gains (losses) arising during the period related to investment securities available-for-sale:
Unrealized net gains (losses)	3,962			(1,873		)	3,353			1,236
Related income tax (expense) benefit	(1,426		)	663			(1,050		)	(462		)
Net unrealized gains (losses)	2,536			(1,210		)	2,303			774
Less: reclassification adjustment for net gains realized during the period on investment securities available-for-sale:
Realized net gains	194			758			917			1,450
Related income tax expense	(75		)	(272		)	(345		)	(525		)
Net realized gains	119			486			572			925
Other comprehensive income (loss)	2,417			(1,696		)	1,731			(151		)
Comprehensive income (loss)	$	3,676		$	(1,302	)	$	4,834		$	1,948

See accompanying notes to the unaudited condensed consolidated financial statements.

CFS BANCORP, INC.

Condensed Consolidated Statements of Changes in Shareholders’ Equity



	Common Stock		Additional Paid-In Capital			Retained Earnings			Treasury Stock			Accumulated Other Comprehensive Loss			Total
	(Unaudited) (Dollars in thousands)
Balance at January 1, 2011	$	234	$	187,164		$	83,592		$	(155,112	)	$	(2,950	)	$	112,928
Net income	—		—			2,099			—			—			2,099
Other comprehensive income (loss)	—		—			—			—			(151		)	(151		)
Net distribution of Rabbi Trust shares	—		(119		)	—			119			—			—
Forfeiture of restricted stock awards	—		445			2			(445		)	—			2
Vesting of restricted stock awards	—		205			—			—			—			205
Grants of restricted stock awards	—		(672		)	—			672			—			—
Dividends declared on common stock ($.03 per share)	—		—			(328		)	—			—			(328		)
Balance at September 30, 2011	$	234	$	187,023		$	85,365		$	(154,766	)	$	(3,101	)	$	114,755

Balance at January 1, 2012	$	234	$	187,030		$	72,683		$	(154,773	)	$	(1,926	)	$	103,248
Net income	—		—			3,103			—			—			3,103
Other comprehensive income	—		—			—			—			1,731			1,731
Net distribution of Rabbi Trust shares	—		(129		)	—			129			—			—
Amortization of stock based compensation	—		10			—			—			—			10
Forfeiture of restricted stock awards	—		615			2			(615		)	—			2
Vesting of restricted stock awards	—		318			—			(26		)	—			292
Grants of restricted stock awards	—		(590		)	—			590			—			—
Dividends declared on common stock ($.03 per share)	—		—			(327		)	—			—			(327		)
Balance at September 30, 2012	$	234	$	187,254		$	75,461		$	(154,695	)	$	(195	)	$	108,059

See accompanying notes to the unaudited condensed consolidated financial statements.

CFS BANCORP, INC.

Condensed Consolidated Statements of Cash Flows



	Nine Months Ended September 30,
	2012			2011
	(Unaudited) (Dollars in thousands)
OPERATING ACTIVITIES:
Net income	$	3,103		$	2,099
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses	3,360			4,572
Depreciation and amortization	1,115			1,121
Net discount accretion on investment securities available-for-sale	(1,374		)	(7		)
Net premium amortization on investment securities held-to-maturity	98			120
Net gain on sale of:
Loans held for sale	(686		)	(124		)
Investment securities	(917		)	(1,450		)
Other real estate owned	(464		)	(2,499		)
Properties and equipment	(8		)	—
Writedowns on other real estate owned	1,694			2,101
Writedowns on transfer of future branch sites to other real estate owned	—			396
Writedown on construction in process	—			106
Deferred income tax expense	1,652			408
Proceeds from sale of loans held for sale	38,850			5,680
Origination of loans held for sale	(38,722		)	(6,139		)
Increase in cash surrender value of bank-owned life insurance	(853		)	(632		)
Net change in other assets and liabilities	(2,989		)	3,250
Net cash flows provided by operating activities	3,859			9,002
INVESTING ACTIVITIES:
Proceeds from sale of:
Investment securities, available-for-sale	31,898			42,136
Loan participations	—			2,088
Other real estate owned	8,896			13,409
Properties and equipment	26			—
Proceeds from maturities and paydowns of:
Investment securities, available-for-sale	52,746			39,127
Investment securities, held-to-maturity	2,783			2,694
Purchases of:
Investment securities, available-for-sale	(48,032		)	(101,336		)
Properties and equipment	(674		)	(323		)
Redemption of Federal Home Loan Bank stock	—			11,645
Increase in loans receivable	(4,340		)	(6,397		)
Proceeds from bank-owned life insurance	542			—
Net cash flows provided by investing activities	43,845			3,043
FINANCING ACTIVITIES:
Net increase (decrease) in:
Deposit accounts	(26,484		)	40,478
Advance payments by borrowers for taxes and insurance	(200		)	1,250
Short-term borrowed funds	(3,904		)	2,824
Proceeds from Federal Home Loan Bank advances	—			15,000
Repayments of Federal Home Loan Bank advances	(278		)	(15,259		)
Dividends paid on common stock	(327		)	(327		)
Net cash flows provided by (used in) financing activities	(31,193		)	43,966
Increase in cash and cash equivalents	16,511			56,011
Cash and cash equivalents at beginning of period	92,072			61,754
Cash and cash equivalents at end of period	$	108,583		$	117,765

CFS BANCORP, INC.

Condensed Consolidated Statements of Cash Flows (continued)



	Nine Months Ended September 30,
	2012		2011
	(Unaudited) (Dollars in thousands)
Supplemental disclosures:
Loans and land transferred to other real estate owned	$	8,473	$	7,881
Cash paid for interest on deposits	3,781		5,279
Cash paid for interest on borrowed funds	891		834

See accompanying notes to the unaudited condensed consolidated financial statements.

CFS BANCORP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)


1.	Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information or footnotes necessary for a complete presentation of financial condition, results of operations, or cash flows in accordance with U.S. generally accepted accounting principles. In our opinion, all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation have been included. The results of operations for the three and nine months ended September 30, 2012 are not necessarily indicative of the results expected for the year ending December 31, 2012. The September 30, 2012 condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes for the year ended December 31, 2011 included in the Company’s Annual Report on Form 10-K. The Company’s condensed consolidated statement of condition as of December 31, 2011 has been derived from the Company’s audited consolidated statement of condition as of that date.

The preparation of the condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates, judgments, or assumptions that could have a material effect on the carrying value of certain assets and liabilities. These estimates, judgments, and assumptions affect the amounts reported in the condensed consolidated financial statements and the disclosures provided. The determination of the allowance for loan losses, valuations and impairments of investment securities, and the accounting for income tax expense are highly dependent on management’s estimates, judgments, and assumptions where changes in any of these could have a significant impact on the financial statements.

The condensed consolidated financial statements include the accounts of CFS Bancorp, Inc. (the Company), its wholly-owned subsidiary, Citizens Financial Bank (the Bank), and its wholly-owned subsidiaries, CFS Holdings, LTD and WHCC, LLC. All material intercompany balances and transactions have been eliminated in consolidation.

Certain items in the condensed consolidated financial statements of prior periods have been reclassified to conform to the current period’s presentation.


2.	Earnings Per Share

Basic earnings per common share (EPS) is computed by dividing net income by the weighted-average number of common shares outstanding during the year. Restricted stock shares which have not vested and shares held in Rabbi Trust accounts are not considered to be outstanding for purposes of calculating basic EPS. Diluted EPS is computed by dividing net income by the average number of common shares outstanding during the year and includes the dilutive effect of stock options, unearned restricted stock awards, and treasury shares held in Rabbi Trust accounts pursuant to deferred compensation plans. The dilutive common stock equivalents are computed based on the treasury stock method using the average market price for the period.

The following table sets forth the computation of basic and diluted earnings per share:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
	(Dollars in thousands, except per share data)

Net income	$	1,259	$	394	$	3,103	$	2,099
Weighted-average common shares:
Outstanding	10,747,974		10,693,724		10,732,118		10,678,788
Equivalents (1)	58,887		59,662		54,561		61,181
Total	10,806,861		10,753,386		10,786,679		10,739,969
Earnings per share:
Basic	$	.12	$	.04	$	.29	$	.20
Diluted	.12		.04		.29		.20
Number of anti-dilutive stock options excluded from the diluted earnings per share calculation	387,795		516,495		413,102		559,847
Weighted-average exercise price of anti-dilutive option shares	$	14.07	$	14.03	$	14.06	$	13.81


(1)	Assumes exercise of dilutive stock options, a portion of the unearned restricted stock awards, and treasury shares held in Rabbi Trust accounts.


3.	Investment Securities

The amortized cost of investment securities and their fair values are as follows for the periods indicated:



	September 30, 2012
	Par Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
Available-for-sale investment securities:
U.S. Treasury securities	$	14,000	$	13,971	$	443	$	—		$	14,414
Government sponsored entity (GSE) securities	37,000		37,018		924		—			37,942
Corporate bonds	5,420		5,092		152		—			5,244
Collateralized mortgage obligations	79,688		72,559		4,007		(77		)	76,489
Commercial mortgage-backed securities	46,460		47,504		1,310		—			48,814
Asset backed securities	4,392		4,052		242		—			4,294
Pooled trust preferred securities	25,207		22,982		—		(7,682		)	15,300
GSE preferred stock	200		—		1		—			1
Total available-for-sale investment securities	$	212,367	$	203,178	$	7,079	$	(7,759	)	$	202,498

Held-to-maturity investment securities:
Asset backed securities	$	6,888	$	7,050	$	222	$	—		$	7,272
Municipal securities	6,440		6,440		44		—			6,484
Total held-to-maturity investment securities	$	13,328	$	13,490	$	266	$	—		$	13,756



	December 31, 2011
	Par Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
Available-for-sale investment securities:
U.S. Treasury securities	$	15,000	$	14,967	$	447	$	—		$	15,414
Government sponsored entity (GSE) securities	46,800		46,967		1,415		—			48,382
Corporate bonds	5,420		5,022		9		(4		)	5,027
Collateralized mortgage obligations	79,006		71,073		1,178		(1,367		)	70,884
Commercial mortgage-backed securities	72,885		74,664		1,520		(66		)	76,118
Pooled trust preferred securities	27,398		24,804		—		(6,249		)	18,555
GSE preferred stock	200		—		1		—			1
Total available-for-sale investment securities	$	246,709	$	237,497	$	4,570	$	(7,686	)	$	234,381

Held-to-maturity investment securities:
Asset backed securities	$	8,201	$	8,461	$	285	$	—		$	8,746
Municipal securities	7,910		7,910		47		—			7,957
Total held-to-maturity investment securities	$	16,111	$	16,371	$	332	$	—		$	16,703

The Company’s investments in residential collateralized mortgage obligations consisted of $4.3 million and $5.2 million, respectively, of GSE issued investment securities and $72.2 million and $65.7 million, respectively, of non-agency (private issued) residential investment securities at September 30, 2012 and December 31, 2011.

Investment securities with unrealized losses aggregated by investment category and length of time that individual investment securities have been in a continuous unrealized loss position are presented in the following tables for the dates indicated.



	September 30, 2012
	Less than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(Dollars in thousands)
Collateralized mortgage obligations	$	12,864	$	(77	)	$	—	$	—		$	12,864	$	(77	)
Pooled trust preferred securities	—		—			15,300		(7,682		)	15,300		(7,682		)
	$	12,864	$	(77	)	$	15,300	$	(7,682	)	$	28,164	$	(7,759	)



	December 31, 2011
	Less than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(Dollars in thousands)
Corporate bonds	$	3,969	$	(4	)	$	—	$	—		$	3,969	$	(4	)
Collateralized mortgage obligations	34,504		(983		)	3,428		(384		)	37,932		(1,367		)
Commercial mortgage-backed securities	89		(1		)	4,154		(65		)	4,243		(66		)
Pooled trust preferred securities	—		—			18,555		(6,249		)	18,555		(6,249		)
	$	38,562	$	(988	)	$	26,137	$	(6,698	)	$	64,699	$	(7,686	)

In management’s belief, the decline in value of the Company’s investment in collateralized mortgage obligations is minimal and primarily attributable to changes in market interest rates and macroeconomic conditions affecting liquidity and not necessarily the expected cash flows of the individual investment securities. The fair value of these investment securities is expected to recover as macroeconomic conditions improve, interest rates rise, and the investment securities approach their maturity date.

At September 30, 2012, the Company’s pooled trust preferred investment securities consisted of “Super Senior” securities backed by senior securities issued mainly by bank and thrift holding companies. Due to the structure of the securities, as deferrals and defaults on the underlying collateral increase, cash flows are increasingly diverted from mezzanine and subordinate tranches to pay down principal for the “Super Senior” tranches. In management’s belief, the continued decline in value is primarily attributable to macroeconomic conditions affecting the liquidity of these securities and not necessarily the expected cash flows of the individual securities. The fair value of these securities is expected to recover as the securities approach their maturity date.

Unrealized losses on collateralized mortgage obligations and pooled trust preferred investment securities have not been recognized in income because management does not have the intent to sell these securities and has the ability to hold these securities for a period of time sufficient to allow for any anticipated recovery in fair value, which may be at maturity. We may, from time to time, dispose of an impaired security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds could be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time. The Company concluded that the unrealized losses that existed at September 30, 2012 did not constitute other-than-temporary impairments.

The amortized cost and fair value of investment securities at September 30, 2012, by contractual maturity, are shown in the following tables. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Investment securities not due at a single maturity date are shown separately.



	Available-for-Sale
	Amortized Cost		Fair Value
	(Dollars in thousands)
U.S. Treasury securities:
Due in one year or less	$	2,000	$	2,000
Due after one year through five years	11,971		12,414
GSE securities — Due after one year through five years	37,018		37,942
Corporate bonds — Due after one year through five years	5,092		5,244
Collateralized mortgage obligations:
Due after five years through ten years	6,950		7,279
Due after ten years	65,609		69,210
Commercial mortgage-backed securities — Due after ten years	47,504		48,814
Asset backed securities — Due after ten years	4,052		4,294
Pooled trust preferred securities — Due after ten years	22,982		15,300
GSE preferred stock	—		1
	$	203,178	$	202,498



	Held-to-Maturity
	Amortized Cost		Fair Value
	(Dollars in thousands)
Asset backed securities — Due after one year through five years	$	7,050	$	7,272
Municipal securities:
Due in one year or less	2,500		2,507
Due after one year through five years	3,940		3,977
	$	13,490	$	13,756

The following table provides information as to the amount of gross gains and losses realized through the sales of investment securities available-for-sale:



	Three Months Ended September 30,					Nine Months Ended September 30,
	2012			2011		2012			2011
	(Dollars in thousands)
Available-for-sale securities:
Gross realized gains	$	329		$	758	$	1,052		$	1,450
Gross realized losses	(135		)	—		(135		)	—
Net realized gains	$	194		$	758	$	917		$	1,450

The carrying value of investment securities pledged as collateral to secure public deposits, repurchase sweep agreement (Repo Sweep) accounts, and other purposes was $29.2 million and $54.4 million, respectively, at September 30, 2012 and December 31, 2011.

At September 30, 2012, other than the U.S. Government, its agencies, and GSEs, the Company had holdings of investment securities from two separate issuers in an amount greater than 10% of shareholders’ equity as identified in the table below.



Issuer	Book Value	Market Value	# of Underlying Pools
	(Dollars in thousands)
IMPAC CMB Trust	10,591	11,962	3
JP Morgan Chase Commercial Mortgage Securities Corp	18,234	18,723	5

There are three different pools of collateral backing three collateralized mortgage obligation securities issued by IMPAC CMB Trust. These pools consist primarily of floating-rate, first lien mortgages originated prior to 2005 on single-family properties in multiple states. There are five different collateral pools of geographically diversified commercial real estate loans backing five commercial mortgage-backed securities issued by JP Morgan Chase Commercial Mortgage Securities Corp. Four of the five collateral pools consist of commercial real estate loans originated prior to 2006 and one collateral pool consists of loans originated in 2010.

4. Loans Receivable

Loans receivable are summarized as follows:



	September 30, 2012			December 31, 2011
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	93,794		$	85,160
Commercial real estate:
Owner occupied	96,991			93,833
Non-owner occupied	178,621			188,293
Multifamily	76,549			71,876
Commercial construction and land development	21,935			22,045
Commercial participations	5,671			12,053
Total commercial loans	473,561			473,260

Retail loans:
One-to-four family residential	178,280			181,698
Home equity lines of credit	47,605			52,873
Retail construction	1,778			1,022
Other	3,238			2,771
Total retail loans	230,901			238,364
Total loans receivable	704,462			711,624
Net deferred loan fees	(555		)	(398		)
Total loans receivable, net of deferred loan fees	$	703,907		$	711,226

5. Allowance for Loan Losses

The Company maintains an allowance for loan losses at a level management believes is appropriate in relation to the estimated risk inherent in the loan portfolio. The allowance for loan losses represents the Company’s estimate of probable incurred losses in our loan portfolio at each statement of condition date and is based on the review of available and relevant information.

The first component of the allowance for loan losses contains allocations for probable incurred losses that we have identified relating to impaired loans pursuant to ASC 310-10, Receivables. The Company individually evaluates for impairment all loans classified substandard and over $375,000 to enable management to identify potential losses over a larger cross section of the loan portfolio. We also individually evaluate for impairment all loans for which we have initiated foreclosure proceedings. For all portfolio segments, loans are considered impaired when, based on current information and events, it is probable that the borrower will not be able to fulfill its obligation according to the contractual terms of the loan agreement. The impairment loss, if any, is generally measured based on the present value of expected cash flows discounted at the loan’s effective interest rate. As a practical expedient, impairment may be measured based on the loan’s observable market price, or the fair value of the collateral, if the loan is collateral-dependent. A loan is considered collateral-dependent when the repayment of the loan will be provided solely by the underlying collateral and there are no other available and reliable sources of repayment. If management determines a loan is collateral-dependent, management will charge-off any identified collateral shortfall against the allowance for loan losses.

If foreclosure is probable, the Company is required to measure the impairment based on the fair value of the collateral. The fair value of the collateral is generally obtained from the evaluation of the collateral, and one of the methods of evaluation is an independent third-party appraisal. When current appraisals are not available, management utilizes other evaluation methods to estimate the fair value of the collateral giving consideration to several factors including for real estate properties the price at which individual unit(s) could be sold in the current market, the period of time over which the unit(s) could be sold, the estimated cost to complete the unit(s), the risks associated with completing and selling the unit(s), the required return on the investment a potential acquirer may have, and the current market interest rates. The analysis of each loan involves a high degree of judgment in estimating the amount of the loss associated with the loan, including the estimation of the amount and timing of future cash flows and collateral values.

The second component of the Company’s allowance for loan losses contains allocations for probable incurred losses within various pools of loans with similar characteristics pursuant to ASC 450-10, Contingencies. This component is based in part on certain loss factors applied to various stratified loan pools excluding loans evaluated individually for impairment. In determining the appropriate loss factors for all portfolio segments, management considers historical charge-offs and recoveries; levels of and trends in delinquencies, impaired loans, and other classified loans; concentrations of credit within the commercial loan portfolios; volume and type of lending; and current and anticipated economic conditions.

Loan losses for all portfolio segments are charged-off against the allowance when the loan balance or a portion of the loan balance is no longer covered by the repayment capacity of the borrower based on an evaluation of available and projected cash resources and collateral value. Recoveries of amounts previously charged-off are credited to the allowance. The Company assesses the appropriateness of the allowance for loan losses on a quarterly basis and adjusts the allowance for loan losses by recording a provision for loan losses in an amount sufficient to maintain the allowance at a level deemed appropriate by management. The evaluation of the appropriateness of the allowance for loan losses is inherently subjective as it requires estimates that are susceptible to significant revision as additional information becomes available or as future events occur. To the extent that actual outcomes differ from management’s estimates, an additional provision for loan losses could be required which could adversely affect earnings or the Company’s financial position in future periods.

The risk characteristics of each loan portfolio segment are as follows:

Commercial and Industrial Loans (C&I)

C&I loans are primarily based on the identified historic and/or the projected cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, do fluctuate based on changes in the company’s internal and external environment including management, human and capital resources, economic conditions, competition, regulation, and product innovation/obsolescence. The collateral securing these loans may also fluctuate in value and generally has advance rates between 50-80% of the collateral value. Most C&I loans are secured by business assets being financed such as equipment, accounts receivable, and/or inventory and generally incorporate a secured or unsecured personal guarantee. Occasionally, some loans may be made on an unsecured basis. In the case of loans secured by accounts receivable and/or inventory, the collateral securing the advances is generally monitored through a borrowing base certificate submitted by the borrower which may identify deterioration in collateral value. The ability of the borrower to collect amounts due from its customers may be affected by its customers’ economic and financial condition. The availability of funds for the repayment of these loans may be substantially dependent on each of the factors described above.

Commercial Real Estate – Owner Occupied, Non-Owner Occupied, and Multifamily

These types of commercial real estate loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally dependent upon the cash flows from the successful operation of the property securing the loan or the cash flows from the owner occupied business conducted on the property securing the loan. A borrower’s business and/or the property securing the loan may be adversely affected by business conditions generally, and fluctuations in the real estate markets or in the general economy, which if adverse, can negatively affect the borrowers’ ability to repay the loan. The value and cash flow of the property can be influenced by changes in market rental rates, changes in interest rates or investors’ required rates of return, the condition of the property, zoning, or environmental issues. The properties securing the commercial real estate portfolio are diverse in terms of type and are generally located in the Chicagoland/Northwest Indiana market. Owner occupied loans are generally a borrower purchased building where the borrower occupies at least 51% of the space with the primary source of repayment dependent on sources other than the underlying collateral. Non-owner occupied and single tenant properties may have higher risk than owner occupied loans since the primary source of repayment is dependent upon the ability to lease out the collateral as well as the financial stability of the businesses occupying the collateral. Multifamily loans can also be impacted by vacancy/collection losses and tenant turnover due to generally shorter term leases or even month-to-month leases. Management monitors and evaluates commercial real estate loan portfolio concentrations based upon cash flow, collateral, geography, and risk grade criteria. As a general rule, management avoids financing single purpose projects unless other underwriting factors mitigate the credit risk to an acceptable level. The Company’s loan policy generally requires lower loan-to-value ratios against these types of properties.

Commercial Construction and Land Development Loans

Construction loans are underwritten utilizing feasibility studies, independent appraisals, sensitivity analysis of absorption and lease rates, presale or prelease/Letters of Intent analysis, and financial analysis of the developers and property owners. Construction loans are generally based on the estimated cost to construct and cash flows associated with the completed project or stabilized value. These estimates are subjective in nature and if erroneous, may preclude the borrower from being able to repay the loan. Construction loans often involve the disbursement of substantial funds with repayment dependent on the success of the completed project. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions, the ability to sell the property, and the availability of long-term financing.

Commercial Participation Loans

Participation loans generally have larger principal balances, portions of which are sold to multiple participant banks in order to spread credit risk. The collateral securing these loans is often real estate and is often located outside of the Company’s geographic footprint. Loans outside of the Company’s geographical footprint pose additional risk due to the lack of knowledge of general economic conditions where the project is located along with various project specific risks regarding buyer demand and project specific risks regarding project competition risks. The participant banks are required to underwrite these credits utilizing their own internal analysis techniques

and their own credit standards. However, the participant banks are reliant upon the information about the borrowers and the collateral provided by the lead bank. These loans carry higher levels of risk due to the participant banks being dependent on the lead bank for monitoring and managing the credit relationship, including the workout and/or foreclosure process should the borrower default.

Retail Loans

The Company’s retail loans include one-to-four family residential mortgage loans, home equity loans and lines of credit, retail construction, and other consumer loans. Management has established a maximum loan-to-value ratio (LTV) of 80% for one-to-four family residential mortgages and home equity loans and lines of credit that are secured by a first or second mortgage on owner and non-owner occupied residences. Loan applications exceeding 80% LTV require private mortgage insurance (PMI) from a mortgage insurance company deemed acceptable by management. Residential construction loans are underwritten to the same standards and generally require an end loan financing commitment either from the Company or another financial institution acceptable to the Company. Other consumer loans are generally small dollar auto and personal loans based on the credit score and income of the applicant. These loans are homogeneous in nature and are rated in pools based on similar characteristics.

The following tables present the activity in the allowance for loan losses for the three and nine months ended September 30, 2012 and 2011.



	Three Months Ended September 30, 2012
				Commercial Real Estate
	Commercial and Industrial			Owner Occupied			Non-Owner Occupied			Multifamily			Construction and Land Development		Commercial Participations			One-to-four Family Residential			HELOC			Retail Construction			Other			Total
	(Dollars in thousands)
Balance at beginning of period	$	1,284		$	2,347		$	3,799		$	600		$	1,442	$	651		$	1,348		$	468		$	4		$	119		$	12,062
Provision for loan losses	(34		)	250			(199		)	473			195		544			(196		)	32			58			37			1,160
Loans charged-off:
Current period charge-offs	—			(191		)	(384		)	(173		)	—		(203		)	(164		)	(44		)	(40		)	(62		)	(1,261		)
Previously established specific reserves	—			—			—			—			—		—			—			—			—			—			—
Total loans charged-off	—			(191		)	(384		)	(173		)	—		(203		)	(164		)	(44		)	(40		)	(62		)	(1,261		)
Recoveries	8			—			333			—			—		—			18			7			—			32			398
Balance at end of period	$	1,258		$	2,406		$	3,549		$	900		$	1,637	$	992		$	1,006		$	463		$	22		$	126		$	12,359



	Nine Months Ended September 30, 2012
				Commercial Real Estate
	Commercial and Industrial			Owner Occupied			Non-Owner Occupied			Multifamily			Construction and Land Development		Commercial Participations			One-to-four Family Residential			HELOC			Retail Construction			Other			Total
	(Dollars in thousands)
Balance at beginning of period	$	1,236		$	2,129		$	3,935		$	370		$	1,198	$	1,467		$	1,521		$	442		$	3		$	123		$	12,424
Provision for loan losses	544			468			782			1,081			439		(247		)	(195		)	349			59			80			3,360
Loans charged-off:
Current period charge-offs	(555		)	(191		)	(820		)	(551		)	—		(228		)	(348		)	(339		)	(40		)	(122		)	(3,194		)
Previously established specific reserves	—			—			(718		)	—			—		—			—			—			—			—			(718		)
Total loans charged-off	(555		)	(191		)	(1,538		)	(551		)	—		(228		)	(348		)	(339		)	(40		)	(122		)	(3,912		)
Recoveries	33			—			370			—			—		—			28			11			—			45			487
Balance at end of period	$	1,258		$	2,406		$	3,549		$	900		$	1,637	$	992		$	1,006		$	463		$	22		$	126		$	12,359



	Three Months Ended September 30, 2011
				Commercial Real Estate
	Commercial and Industrial			Owner Occupied			Non-Owner Occupied			Multifamily			Construction and Land Development			Commercial Participations			One-to-four Family Residential			HELOC			Retail Construction			Other			Total
	(Dollars in thousands)
Balance at beginning of period	$	1,554		$	829		$	6,515		$	441		$	93		$	4,787		$	1,387		$	1,284		$	5		$	144		$	17,039
Provision for loan losses	717			1,519			502			135			(17		)	(117		)	154			(246		)	(1		)	27			2,673
Loans charged-off:
Current period charge-offs	(532		)	(875		)	(448		)	(109		)	—			(89		)	(113		)	(360		)	—			(30		)	(2,556		)
Previously established specific reserves	—			—			—			—			—			—			—			—			—			—			—
Total loans charged-off	(532		)	(875		)	(448		)	(109		)	—			(89		)	(113		)	(360		)	—			(30		)	(2,556		)
Recoveries	4			4			10			1			—			—			4			1			—			6			30
Balance at end of period	$	1,743		$	1,477		$	6,579		$	468		$	76		$	4,581		$	1,432		$	679		$	4		$	147		$	17,186



	Nine Months Ended September 30, 2011
				Commercial Real Estate
	Commercial and Industrial			Owner Occupied			Non-Owner Occupied			Multifamily			Construction and Land Development			Commercial Participations			One-to-four Family Residential			HELOC			Retail Construction			Other			Total
	(Dollars in thousands)
Balance at beginning of period	$	1,279		$	1,090		$	6,906		$	350		$	188		$	4,559		$	1,356		$	1,309		$	7		$	135		$	17,179
Provision for loan losses	1,139			1,383			97			430			(108		)	1,419			373			(225		)	(3		)	67			4,572
Loans charged-off:
Current period charge-offs	(685		)	(1,000		)	(448		)	(313		)	(4		)	(1,397		)	(304		)	(412		)	—			(80		)	(4,643		)
Previously established specific reserves	—			—			—			—			—			—			—			—			—			—			—
Total loans charged-off	(685		)	(1,000		)	(448		)	(313		)	(4		)	(1,397		)	(304		)	(412		)	—			(80		)	(4,643		)
Recoveries	10			4			24			1			—			—			7			7			—			25			78
Balance at end of period	$	1,743		$	1,477		$	6,579		$	468		$	76		$	4,581		$	1,432		$	679		$	4		$	147		$	17,186

The following tables provide other information regarding the allowance for loan and lease losses and balances by portfolio segment and impairment method at the dates indicated.



	At September 30, 2012
			Commercial Real Estate
	Commercial and Industrial		Owner Occupied		Non-Owner Occupied		Multifamily		Construction and Land Development		Commercial Participations		One-to-four Family Residential		HELOC		Retail Construction		Other		Total
	(Dollars in thousands)
Ending allowance balance:
Individually evaluated for impairment	$	—	$	—	$	217	$	—	$	180	$	—	$	—	$	—	$	—	$	—	$	397
Collectively evaluated for impairment	1,258		2,406		3,332		900		1,457		992		1,006		463		22		126		11,962
Total evaluated for impairment	$	1,258	$	2,406	$	3,549	$	900	$	1,637	$	992	$	1,006	$	463	$	22	$	126	$	12,359

Loans receivable:
Individually evaluated for impairment	$	741	$	10,711	$	31,716	$	3,472	$	2,935	$	472	$	2,497	$	539	$	—	$	—	$	53,083
Collectively evaluated for impairment	93,053		86,280		146,905		73,077		19,000		5,199		175,783		47,066		1,778		3,238		651,379
Total loans receivable	$	93,794	$	96,991	$	178,621	$	76,549	$	21,935	$	5,671	$	178,280	$	47,605	$	1,778	$	3,238	$	704,462



	At December 31, 2011
			Commercial Real Estate
	Commercial and Industrial		Owner Occupied		Non-Owner Occupied		Multifamily		Construction and Land Development		Commercial Participations		One-to-four Family Residential		HELOC		Retail Construction		Other		Total
	(Dollars in thousands)
Ending allowance balance:
Individually evaluated for impairment	$	—	$	—	$	718	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	718
Collectively evaluated for impairment	1,236		2,129		3,217		370		1,198		1,467		1,521		442		3		123		11,706
Total evaluated for impairment	$	1,236	$	2,129	$	3,935	$	370	$	1,198	$	1,467	$	1,521	$	442	$	3	$	123	$	12,424

Loans receivable:
Individually evaluated for impairment	$	2,479	$	11,203	$	25,518	$	673	$	2,781	$	2,355	$	—	$	—	$	—	$	—	$	45,009
Collectively evaluated for impairment	82,681		82,630		162,775		71,203		19,264		9,698		181,698		52,873		1,022		2,771		666,615
Total loans receivable	$	85,160	$	93,833	$	188,293	$	71,876	$	22,045	$	12,053	$	181,698	$	52,873	$	1,022	$	2,771	$	711,624

The Company, as a matter of good risk management practices, utilizes objective loan grading matrices to assign risk ratings to all commercial loans. The risk rating criteria is supported by core credit attributes that emphasize debt service coverage and guarantor support. The loan grading matrices are designed to remove subjective criteria and bias from the grading analysis. Retail loans are rated pass until they become 90 days or more delinquent, transferred to non-accrual status, and generally rated substandard. The Company uses the following definitions for risk ratings:


•	Pass. Loans that meet the conservative underwriting guidelines that include core credit attributes noted above as measured by the loan grading matrices at levels that are in excess of the minimum amounts required to adequately service the loans.

•

Pass Watch. Loans which are performing per their contractual terms and are not necessarily demonstrating signs of credit or operational weakness. A credit will generally be graded as Pass Watch due to a nonrecurring event that has caused a decrease in a cash flow source, a potential future event that could impair the cash flow or repayment of the loan, or lack of current financial information needed to review the credit. Loans in this category are monitored by management for timely payments. This rating is considered transitional because management does not have current financial information to determine the appropriate risk grade or the quality of the loan appears to be changing. Loans may be graded as pass watch when a single event may have occurred that could be indicative of an emerging issue or indicate trending that would warrant a change in the risk rating.


•	Special Mention. Loans that have a potential weakness that will be closely monitored by management. A credit graded special mention does not expose the Company to elevated risk that would warrant an adverse classification.


•	Substandard. Loans that are inadequately protected by the current net worth and paying capacity of the borrower, guarantor, or the collateral pledged. Loans classified as substandard have a well-defined

weakness or weaknesses, characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.


•	Doubtful. Loans that have the same weaknesses as those classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

The Company’s loans receivable portfolio is summarized by risk rating category as follows:



	Risk Rating at September 30, 2012
	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	72,954	$	12,765	$	7,598	$	477	$	—	$	93,794
Commercial real estate:
Owner occupied	75,544		10,892		1,003		9,552		—		96,991
Non-owner occupied	118,270		21,211		18,934		20,088		118		178,621
Multifamily	69,236		3,409		599		3,305		—		76,549
Commercial construction and land development	17,715		1,285		—		2,585		350		21,935
Commercial participations	5,077		122		—		472		—		5,671
Total commercial loans	358,796		49,684		28,134		36,479		468		473,561

Retail loans:
One-to-four family residential	172,376		—		—		5,904		—		178,280
Home equity lines of credit	46,900		—		—		705		—		47,605
Retail construction	1,629		—		—		149		—		1,778
Other	3,238		—		—		—		—		3,238
Total retail loans	224,143		—		—		6,758		—		230,901
Total loans	$	582,939	$	49,684	$	28,134	$	43,237	$	468	$	704,462



	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Current	$	577,647	$	48,024	$	27,512	$	7,004	$	—	$	660,187
Delinquent:
30-59 days	2,998		1,128		599		143		—		4,868
60-89 days	2,204		477		23		—		—		2,704
90 days or more	90		46		—		—		—		136
Non-accrual	—		9		—		36,090		468		36,567
Total loans	$	582,939	$	49,684	$	28,134	$	43,237	$	468	$	704,462



	Risk Rating at December 31, 2011
	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	76,554	$	6,534	$	1,476	$	596	$	—	$	85,160
Commercial real estate:
Owner occupied	69,029		12,036		1,540		11,228		—		93,833
Non-owner occupied	147,678		9,219		7,347		24,049		—		188,293
Multifamily	65,920		3,119		2,331		506		—		71,876
Commercial construction and land development	16,412		805		1,450		3,378		—		22,045
Commercial participations	9,698		—		—		2,355		—		12,053
Total commercial loans	385,291		31,713		14,144		42,112		—		473,260

Retail loans:
One-to-four family residential	176,763		—		—		4,935		—		181,698
Home equity lines of credit	52,332		—		—		541		—		52,873
Retail construction	853		—		—		169		—		1,022
Other	2,771		—		—		—		—		2,771
Total retail loans	232,719		—		—		5,645		—		238,364
Total loans	$	618,010	$	31,713	$	14,144	$	47,757	$	—	$	711,624



	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Current	$	610,127	$	29,528	$	11,670	$	1,568	$	—	$	652,893
Delinquent:
30-59 days	6,083		1,285		93		597		—		8,058
60-89 days	1,800		900		2,381		—		—		5,081
90 days or more	—		—		—		5		—		5
Non-accrual	—		—		—		45,587		—		45,587
Total loans	$	618,010	$	31,713	$	14,144	$	47,757	$	—	$	711,624

For all loan categories, past due status is based on the contractual terms of the loan. Interest income is generally not accrued on loans which are delinquent 90 days or more, or for loans which management believes, after giving consideration to a number of factors, including economic and business conditions and collection efforts, collection of interest is doubtful. In all cases, loans are transferred to non-accrual status or charged-off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not received for loans transferred to non-accrual status is reversed against interest income. Interest subsequently received on non-accrual loans is accounted for using the cost-recovery basis for commercial loans and the cash-basis for retail loans until qualifying for return to accrual status.

Commercial loans are generally transferred to non-accrual status once they become 90 days past due. Management reviews all current financial information of the borrower and guarantor(s) and action plans to bring the loan current before determining if the loan should be transferred to non-accrual status. Management requires appropriate justification to maintain a commercial loan on accrual status once 90 days past due. Occasionally, commercial loans are transferred to non-accrual status before the loan becomes significantly past due if current information indicates that future repayment of principal and interest may be doubtful.

Commercial loans are returned to accrual status when management, based on a thorough analysis of the borrower, can expect the full repayment of principal and interest. The analysis will reflect the borrower’s capacity to service the debt and/or the guarantor’s ability and willingness to make the required debt service payments, either under the original note agreement and terms, or, in the case of an A/B note structure, under the terms of the new A note. Analysis may also include the proceeds from the disposition of the collateral as a potential repayment source based upon the net realizable value of the property.

In addition, a note may be considered for return to accrual status when payments (equal to or greater than those required in the final A note structure) have been made by the borrower for a minimum of six months and the borrower is in compliance with all other terms of the applicable agreement.

Retail loans are returned to accrual status primarily based on the payment status of the loan. A retail loan is automatically transferred to non-accrual status immediately upon becoming 90 days past due. The loan remains on non-accrual status, with interest income recognized on a cash basis when a payment is made, until the loan is paid current. Once current, the loan is automatically returned to accrual status. If management identifies other information to indicate that future repayment of the loan balance may still be questionable, the loan may be manually tranferred to non-accrual status until management determines otherwise.

The Company’s loan portfolio delinquency status and its non-accrual loans are presented in the following tables at the dates indicated. The Company’s loans that are current and in non-accrual status include loans that have been restructured as troubled debt restructurings (TDRs) and have not yet met the required six months of payments under the restructured terms to be returned to accrual status.



	Delinquency at September 30, 2012
	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Non-accrual		Total Past Due and Non-accrual		Current		Total Loans Receivable		Current Non-accrual Loans
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	268	$	610	$	46	$	477	$	1,401	$	92,393	$	93,794	$	252
Commercial real estate:
Owner occupied	549		23		—		6,281		6,853		90,138		96,991		747
Non-owner occupied	210		477		—		17,041		17,728		160,893		178,621		1,088
Multifamily	599		—		—		2,893		3,492		73,057		76,549		—
Commercial construction and land development	403		—		90		2,935		3,428		18,507		21,935		—
Commercial participations	—		—		—		481		481		5,190		5,671		—
Total commercial loans	2,029		1,110		136		30,108		33,383		440,178		473,561		2,087

Retail loans:
One-to-four family residential	2,381		972		—		5,754		9,107		169,173		178,280		1,716
Home equity lines of credit	458		52		—		555		1,065		46,540		47,605		48
Retail construction	—		570		—		150		720		1,058		1,778		—
Other	—		—		—		—		—		3,238		3,238		—
Total retail loans	2,839		1,594		—		6,459		10,892		220,009		230,901		1,764
Total loans receivable	$	4,868	$	2,704	$	136	$	36,567	$	44,275	$	660,187	$	704,462	$	3,851



	Delinquency at December 31, 2011
	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Non-accrual		Total Past Due and Non-accrual		Current		Total Loans Receivable		Current Non-accrual Loans
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	369	$	24	$	—	$	596	$	989	$	84,171	$	85,160	$	262
Commercial real estate:
Owner occupied	551		—		—		11,228		11,779		82,054		93,833		569
Non-owner occupied	1,622		1,173		5		22,294		25,094		163,199		188,293		6,122
Multifamily	1,856		1,732		—		91		3,679		68,197		71,876		—
Commercial construction and land development	—		502		—		3,378		3,880		18,165		22,045		—
Commercial participations	—		—		—		2,355		2,355		9,698		12,053		—
Total commercial loans	4,398		3,431		5		39,942		47,776		425,484		473,260		6,953

Retail loans:
One-to-four family residential	3,439		1,501		—		4,935		9,875		171,823		181,698		741
Home equity lines of credit	221		149		—		541		911		51,962		52,873		50
Retail construction	—		—		—		169		169		853		1,022		—
Other	—		—		—		—		—		2,771		2,771		—
Total retail loans	3,660		1,650		—		5,645		10,955		227,409		238,364		791
Total loans receivable	$	8,058	$	5,081	$	5	$	45,587	$	58,731	$	652,893	$	711,624	$	7,744

The Company’s impaired loans are summarized as follows with the majority of the interest income recognized on a cash basis at the time the payment is received. The below tables include impaired loans that are individually reviewed for impairment as well as $1.9 million of impaired retail loans at September 30, 2012 that have not had foreclosure proceedings initiated and are below management’s scope for individual impairment review due to immateriality.



	At September 30, 2012
	Recorded Investment		Unpaid Principal Balance		Partial Charge-offs to Date		Related Allowance
	(Dollars in thousands)
Loans without a specific valuation allowance:
Commercial loans:
Commercial and industrial	$	741	$	1,618	$	853	$	—
Commercial real estate:
Owner occupied	10,711		14,326		2,973		—
Non-owner occupied	29,129		32,386		2,714		—
Multifamily	3,472		4,082		551		—
Commercial construction and land development	1,491		1,491		—		—
Commercial participations	472		5,584		4,970		—
Retail loans:
One-to-four family residential	7,204		7,502		298		—
Home equity lines of credit	706		795		89		—
Retail construction	150		150		—		—
Total	$	54,076	$	67,934	$	12,448	$	—

Loans with a specific valuation allowance:
Commercial real estate - non-owner occupied	$	2,587	$	2,591	$	—	$	217
Commercial construction and land development	1,444		1,450		—		180
Total	$	4,031	$	4,041	$	—	$	397

Total impaired loans:
Commercial	$	50,047	$	63,528	$	12,061	$	397
Retail	8,060		8,447		387		—
Total	$	58,107	$	71,975	$	12,448	$	397



	At December 31, 2011
	Recorded Investment		Unpaid Principal Balance		Partial Charge-offs to Date		Related Allowance
	(Dollars in thousands)
Loans without a specific valuation allowance:
Commercial loans:
Commercial and industrial	$	2,479	$	2,700	$	216	$	—
Commercial real estate:
Owner occupied	11,203		14,557		2,694		—
Non-owner occupied	20,532		34,130		10,553		—
Multifamily	673		673		—		—
Commercial construction and land development	2,781		2,781		—		—
Commercial participations	2,355		1,796		1,189		—
Retail loans:
One-to-four family residential	7,202		7,504		302		—
Home equity lines of credit	540		630		89		—
Retail construction	169		169		—		—
Total	$	47,934	$	64,940	$	15,043	$	—

Loans with a specific valuation allowance:
Commercial real estate - non-owner occupied	4,986		4,986		—		718
Total	$	4,986	$	4,986	$	—	$	718

Total impaired loans:
Commercial	$	45,009	$	61,623	$	14,652	$	718
Retail	7,911		8,303		391		—
Total	$	52,920	$	69,926	$	15,043	$	718

The following table presents information related to the average recorded investment and interest income recognized on impaired loans for the periods indicated.



	Three Months Ended September 30,								Nine Months Ended September 30,
	2012				2011				2012				2011
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(Dollars in thousands)
Loans without a specific valuation allowance:
Commercial loans:
Commercial and industrial	$	752	$	14	$	3,111	$	36	$	978	$	31	$	3,918	$	121
Commercial real estate:
Owner occupied	10,729		50		9,363		—		10,762		68		9,288		—
Non-owner occupied	29,780		254		7,148		81		30,584		479		7,582		212
Multifamily	3,657		11		675		13		3,819		29		678		26
Commercial construction and land development	1,491		—		7,171		—		1,491		—		7,171		—
Commercial participations	1,756		—		1,140		—		2,260		—		1,367		—
Retail loans:
One-to-four family residential	7,266		70		7,543		51		7,360		176		7,604		136
Home equity lines of credit	705		4		874		2		706		8		874		2
Retail construction	150		—		169		—		151		—		169		—
Total	$	56,286	$	403	$	37,194	$	183	$	58,111	$	791	$	38,651	$	497

Loans with a specific valuation allowance:
Commercial real estate:
Owner occupied	$	—	$	—	$	4,414	$	38	$	—	$	—	$	4,518	$	38
Non-owner occupied	2,589		—		21,845		—		2,592		—		22,116		—
Commercial construction and land development	1,445		—		—		—		1,448		—		—		—
Commercial participations	—		—		5,302		—		—		—		5,302		—
Total	$	4,034	$	—	$	31,561	$	38	$	4,040	$	—	$	31,936	$	38

Total impaired loans:
Commercial	$	52,199	$	329	$	60,169	$	168	$	53,934	$	607	$	61,940	$	397
Retail	8,121		74		8,586		53		8,217		184		8,647		138
Total	$	60,320	$	403	$	68,755	$	221	$	62,151	$	791	$	70,587	$	535

The Company may grant a concession or modification for economic or legal reasons related to a borrower’s financial condition that it would not otherwise consider resulting in a modified loan which is then identified as a TDR. The Company may modify loans through rate reductions, short-term extensions of maturity, interest only payments, or payment modifications to better match the timing of cash flows due under the modified terms with the cash flows from the borrowers’ operations. Loan modifications are intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. TDRs are considered impaired loans for purposes of calculating the Company’s allowance for loan losses.

The Company identifies loans for potential restructure primarily through direct communication with the borrower and evaluation of the borrower’s financial statements, revenue projections, tax returns, and credit reports. Even if the borrower is not presently in default, management will consider the likelihood that cash flow shortages, adverse economic conditions, and negative trends may result in a payment default in the near future.

For one-to-four family residential loans and home equity lines of credit, a restructure often occurs with past due loans and may be offered as an alternative to foreclosure. There are other situations where borrowers, who are not past due, experience a sudden job loss, become over-extended with credit obligations, or other problems, have indicated that they will be unable to make the required monthly payment and request payment relief.

When considering a loan restructure, management will determine if: (i) the financial distress is short or long term; (ii) loan concessions are necessary; and (iii) the restructure is a viable solution.

When a loan is restructured, the new terms often require a reduced monthly debt service payment. For commercial loans, management completes an analysis of the operating entity’s ability to repay the debt. If the operating entity is capable of servicing the new debt service requirements and the underlying collateral value is believed to be sufficient to repay the debt in the event of a future default, the new loan is generally placed on accrual status. To date, there have been no commercial loans restructured and immediately placed on accrual status after the execution of the TDR.

For retail loans, an analysis of the individual’s ability to service the new required payments is performed. If the borrower is capable of servicing the newly restructured debt and the underlying collateral value is believed to be sufficient to repay the debt in the event of a future default, the new loan is generally placed on accrual status. The reason for the TDR is also considered, such as paying past due real estate taxes or payments caused by a temporary job loss, when determining whether a retail TDR loan could be returned to accrual status. Retail TDRs remain in non-accrual status until sufficient payments have been made to bring the past due principal and interest current, at which point the loan would be transferred to accrual status.

The following tables summarize the loans that have been restructured as TDRs during the three and nine months ended September 30, 2012 and 2011:



	Three Months Ended September 30,
	2012					2011
	Count	Balance prior to TDR		Balance after TDR		Count	Balance prior to TDR		Balance after TDR
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	—	$	—	$	—	4	$	995	$	995
Commercial real estate:
Owner occupied	3	3,430		3,291		1	1,861		1,861
Non-owner occupied	—	—		—		1	107		107
Total commercial loans	3	3,430		3,291		6	2,963		2,963

Retail loans – one-to-four family residential	6	281		301		3	171		183
Total loans	9	$	3,711	$	3,592	9	$	3,134	$	3,146



	Nine Months Ended September 30,
	2012					2011
	Count	Balance prior to TDR		Balance after TDR		Count	Balance prior to TDR		Balance after TDR
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	—	$	—	$	—	4	$	995	$	995
Commercial real estate:
Owner occupied	5	3,689		3,596		2	2,459		2,415
Non-owner occupied	1	66		83		1	107		107
Total commercial loans	6	3,755		3,679		7	3,561		3,517

Retail loans – one-to-four family residential	14	1,153		1,207		9	909		962
Total loans	20	$	4,908	$	4,886	16	$	4,470	$	4,479

A default is identified when a TDR is 90 days or more past due, transferred to non-accrual status, or transferred to other real estate owned within twelve months of restructuring. The Company had no TDRs that defaulted during the three months ended September 30, 2012 and had three one-to-four family residential TDRs totaling $254,000 that defaulted during the three months ended September 30, 2011. The Company had one one-to-four family residential TDR totaling $69,000 that defaulted during the nine months ended September 30, 2012 and five one-to-four family residential TDRs totaling $695,000 that defaulted during the nine months ended September 30, 2011.

The tables below summarize the Company’s TDRs by loan category and accrual status at the dates indicated:



	September 30, 2012						December 31, 2011
	Accruing		Non-accruing		Total		Accruing		Non-accruing		Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	454	$	234	$	688	$	2,167	$	259	$	2,426
Commercial real estate:
Owner occupied	3,950		2,230		6,180		369		2,272		2,641
Non-owner occupied	12,780		1,923		14,703		3,814		11,095		14,909
Multifamily	255		—		255		259		—		259
Commercial participations	—		93		93		—		1,748		1,748
Total commercial	17,439		4,480		21,919		6,609		15,374		21,983

Retail loans – one-to-four family residential	1,450		3,224		4,674		2,266		1,600		3,866
Total troubled debt restructurings	$	18,889	$	7,704	$	26,593	$	8,875	$	16,974	$	25,849

At September 30, 2012, TDRs totaled $26.6 million, of which $2.7 million were performing in accordance with their agreements and in non-accrual status.

Management monitors the TDRs based on the type of modification or concession granted to the borrower. These types of modifications may include rate reductions, payment/term extensions, forgiveness of principal, forbearance, and other applicable actions. Of the various noted concessions, management predominantly utilizes rate reductions and lower monthly payments, either from a longer amortization period or interest only repayment schedule, because these concessions provide needed payment relief without risking the loss of principal. Management will also agree to a forbearance agreement when it is deemed appropriate to avoid foreclosure. The following tables set forth the Company’s TDRs by portfolio segment to quantify the type of modification or concession provided:



	September 30, 2012
			Commercial Real Estate
	Commercial and Industrial		Owner Occupied		Non-Owner Occupied		Multifamily		Commercial Participations		One-to-four Family Residential		Total
	(Dollars in thousands)
Rate reduction	$	—	$	1,146	$	—	$	—	$	—	$	1,200	$	2,346
Payment extension	689		2,253		2,189		—		—		776		5,907
Interest only	—		—		—		—		—		134		134
Rate reduction and payment extension	—		1,248		611		255		—		2,187		4,301
Rate reduction and interest only	—		—		2,988		—		—		362		3,350
Payment extension and interest only	—		289		—		—		—		—		289
Forbearance	—		—		—		—		93		—		93
Rate reduction, payment extension, interest only, and forbearance	—		44		—		—		—		—		44
A/B note structure	—		1,200		8,915		—		—		—		10,115
Other	—		—		—		—		—		14		14
Total troubled debt restructurings	$	689	$	6,180	$	14,703	$	255	$	93	$	4,673	$	26,593



	December 31, 2011
			Commercial Real Estate
	Commercial and Industrial		Owner Occupied		Non-Owner Occupied		Multifamily		Commercial Participations		One-to-four Family Residential		Total
	(Dollars in thousands)
Rate reduction	$	—	$	—	$	—	$	—	$	—	$	805	$	805
Payment extension	2,426		2,297		2,210		—		—		948		7,881
Rate reduction and payment extension	—		—		542		259		—		1,858		2,659
Rate reduction and interest only	—		—		9,054		—		—		255		9,309
Payment extension and interest only	—		297		—		—		—		—		297
Forbearance	—		—		3,103		—		1,748		—		4,851
Rate reduction, payment extension, interest only, and forbearance	—		47		—		—		—		—		47
Total troubled debt restructurings	$	2,426	$	2,641	$	14,909	$	259	$	1,748	$	3,866	$	25,849

At September 30, 2012, TDRs were relatively stable at $26.6 million compared to $25.8 million at December 31, 2011. The activity related to the Company’s TDRs is presented in the following table for the periods indicated:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	(Dollars in thousands)
Beginning balance	$	25,168		$	36,451		$	25,849		$	39,581
Restructured loans identified as TDRs	3,592			3,146			4,886			4,479
Protective advances and miscellaneous	311			46			770			127
Repayments and payoffs	(2,385		)	(806		)	(4,772		)	(2,982		)
Charge-offs	(93		)	(19		)	(140		)	(61		)
Transfers to other real estate owned	—			—			—			(2,326		)
Ending balance	$	26,593		$	38,818		$	26,593		$	38,818

6. Fair Value Measurements

The Company measures fair value according to ASC 820-10: Fair Value Measurements and Disclosures. ASC 820-10 establishes a fair value hierarchy that prioritizes the inputs used in valuation techniques, but not the valuation techniques themselves. The fair value hierarchy is designed to indicate the relative reliability of the fair value measure. The highest priority is given to quoted prices in active markets and the lowest to unobservable data such as the Company’s internal information. ASC 820-10 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” There are three levels of inputs into the fair value hierarchy (Level 1 being the highest priority and Level 3 being the lowest priority):

Level 1 – Unadjusted quoted prices for identical instruments in active markets;

Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable; and

Level 3 – Instruments whose significant value drivers or assumptions are unobservable and that are significant to the fair value of the assets or liabilities.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The following tables set forth the Company’s financial assets by level within the fair value hierarchy that were measured at fair value on a recurring basis at the dates indicated.



			Fair Value Measurements at September 30, 2012
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Investment securities available-for-sale:
U.S. Treasury securities	$	14,414	$	—	$	14,414	$	—
GSE securities	37,942		—		37,942		—
Corporate bonds	5,244		—		5,244		—
Collateralized mortgage obligations	76,489		—		76,489		—
Commercial mortgage-backed securities	48,814		—		48,814		—
Asset backed securities	4,294		—		4,294		—
Pooled trust preferred securities	15,300		—		—		15,300
GSE preferred stock	1		1		—		—



			Fair Value Measurements at December 31, 2011
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Investment securities available-for-sale:
U.S. Treasury securities	$	15,414	$	—	$	15,414	$	—
GSE securities	48,382		—		48,382		—
Corporate bonds	5,027		—		5,027		—
Collateralized mortgage obligations	70,884		—		70,884		—
Commercial mortgage-backed securities	76,118		—		76,118		—
Pooled trust preferred securities	18,555		—		—		18,555
GSE preferred stock	1		1		—		—

Level 1 investment securities are valued using quoted prices in active markets for identical assets. The Company uses Level 1 prices for its GSE preferred stock.

Level 2 investment securities are valued by a third-party pricing service commonly used in the banking industry utilizing observable inputs. The pricing provider utilizes evaluated pricing models that vary based on asset class. These models incorporate available market information including quoted prices of investment securities with similar characteristics and, because many fixed-income investment securities do not trade on a daily basis, apply available information through processes such as benchmark yield curves, benchmarking of like investment

securities, sector groupings, and matrix pricing. In addition, model processes, such as an option adjusted spread model, are used to develop prepayment estimates and interest rate scenarios for investment securities with prepayment features.

Management uses a recognized third-party pricing service to obtain market values for the Company’s fixed-income securities portfolio. Documentation is maintained as to the methodology and summary of inputs used by the pricing service for the various types of securities, and management notes that the servicer maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. Management does not have access to all of the individual specific assumptions and inputs used for each security. The significant observable inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including market research publications.

Management validates the market values against fair market curves and other available pricing sources. Bloomberg pricing is used to compare the reasonableness of the third-party pricing service prices for U.S. Treasury securities and GSE bonds. For all securities, the Company’s Investment Officer, who is in the market on a regular basis, monitors the market and is familiar with where similar securities are trading and where specific bonds in specific sectors should be priced. All monthly output from the third-party provider is reviewed against expectations as to pricing based on fair market curves, ratings, coupon, structure, and recent trade reports or offerings.

Based on management’s review of the methodology and summary of inputs used, management has concluded these assets are properly classified as Level 2 assets.

Fair value determinations for Level 3 measurements of securities are the responsibility of the Company’s Investment Officer with review and approval by the Asset/Liability Management Committee. Level 3 models are utilized when quoted prices are not available for certain investment securities or in markets where trading activity has slowed or ceased. When quoted prices are not available and are not provided by third-party pricing services, management judgment is necessary to determine fair value. As such, fair value is determined using discounted cash flow analysis models, incorporating default rate assumptions, estimations of prepayment characteristics, and implied volatilities.

The Company determined that Level 3 pricing models should be utilized for valuing its pooled trust preferred investment securities. The markets for these securities and for similar securities at September 30, 2012 were illiquid. There have been a limited number of observable transactions in the secondary market, however, a new issue market does not exist. Management has determined a valuation approach that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs is more representative of fair value than the market approach valuation technique.

For its Level 3 pricing model, the Company uses externally produced fair values provided by a third-party pricing service and compares them to other external pricing sources. Other external sources provided similar prices, both higher and lower, than those used by the Company. The external model uses observed prices from limited transactions on similar securities to estimate liquidation values.

The following is a reconciliation of the beginning and ending balances for the periods indicated of recurring fair value measurements recognized in the accompanying consolidated statements of condition using Level 3 inputs:



	Pooled Trust Preferred Securities
	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	(Dollars in thousands)
Beginning balance	$	14,946		$	18,371		$	18,555		$	18,125
Total realized and unrealized gains and losses:
Included in accumulated other comprehensive income (loss)	630			(1,189		)	(1,432		)	133
Principal repayments	(381		)	(249		)	(2,191		)	(1,499		)
Discount accretion	105			72			368			246
Ending balance	$	15,300		$	17,005		$	15,300		$	17,005

The following tables set forth the Company’s financial and non-financial assets by level within the fair value hierarchy that were measured at fair value on a non-recurring basis at the dates indicated.



			Fair Value Measurements at September 30, 2012
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Impaired loans (collateral-dependent)	$	16,366	$	—	$	—	$	16,366
Other real estate owned	2,826		—		—		2,826



			Fair Value Measurements at December 31, 2011
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Impaired loans (collateral-dependent)	$	17,180	$	—	$	—	$	17,180
Other real estate owned	2,462		—		—		2,462

Loans for which it is probable that the Bank will not collect all principal and interest due according to their contractual terms are measured for impairment. Allowable methods for determining the amount of impairment include estimating fair value using the fair value of the collateral for collateral-dependent loans. If the impaired loan is identified as collateral-dependent, then the fair value method of measuring the amount of impairment is utilized. Impaired loans that are collateral-dependent are classified within Level 3 of the fair value hierarchy.

When the Bank determines a loan is collateral-dependent, the Bank’s Asset Management Committee (AMC) obtains appraisals on the underlying collateral securing the loan. The Senior Credit Officer (SCO) reviews the appraisals for accuracy and consistency. Appraisers are selected from the list of approved appraisers maintained by the SCO with input from the Bank’s Loan Committee. For purchased participation loans, management is dependent upon the lead bank to order and provide appraisals, which occasionally are broker’s opinions.

In determining the estimated fair value of the real estate, senior liens such as unpaid and current real estate taxes and any perfected liens are subtracted from the appraised value. In addition, the Company generally applies a 10% discount to the current appraisal to allow for reasonable selling expenses, including sales commissions and closing costs.

Fair value measurements for impaired loans are performed pursuant to ASC 310-10, Receivables, and are measured on a non-recurring basis. Certain impaired loans were partially charged-off or re-evaluated during the third quarter of 2012. These impaired loans were carried at fair value as estimated using current and prior appraisals, discounting factors, the borrowers’ financial results, estimated cash flows generated from the property, and other factors. The change in the fair value of impaired loans that were valued based upon Level 3 inputs was approximately $650,000 and $2.5 million for the three months ended September 30, 2012 and 2011, respectively, and $2.3 million and $3.3 million for the nine months ended September 30, 2012 and 2011, respectively. These losses are not recorded directly as an adjustment to current earnings or other comprehensive income (loss), but rather as a component in determining the overall adequacy of the allowance for loan losses. These adjustments to the estimated fair value of impaired loans may result in increases or decreases to the provision for loan losses recorded in future earnings.

The estimated fair value of other real estate owned is based on current or prior appraisals, less estimated costs to sell of 10%. Other real estate owned is classified within Level 3 of the fair value hierarchy. Appraisals of other real estate owned are obtained when the real estate is acquired and subsequently as deemed necessary by the AMC. The SCO reviews the appraisals for accuracy and consistency. Appraisers are selected from the list of approved appraisers maintained by the SCO with input from the Bank’s Loan Committee. The reduction in fair value of other real estate owned was $1.0 million and $316,000, respectively, for the three months ended September 30, 2012 and 2011 and $1.7 million and $2.1 million, respectively, for the nine months ended September 30, 2012 and 2011. The changes were recorded as adjustments to current earnings through other real estate owned related expenses.

The following table sets forth quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements at September 30, 2012 (dollars in thousands):



	Fair Value		Valuation Technique	Unobservable Inputs	Range (Weighted Averages)
Pooled trust preferred securities	$	15,300	Consensus pricing*	Default assumptions Discount Rates	Varies by security 42.4% - 83.4% (57.9%)
Impaired loans (collateral-dependent)	16,366		Market comparable properties	Marketability discount	10%
Other real estate owned	2,826		Market comparable properties	Marketability discount	10%

*Consensus pricing is provided by a widely used pricing source.

The value of the pooled trust preferred securities is determined using multiple pricing models or similar techniques from third-party sources as well as significant unobservable inputs such as judgment or estimations by the Company in the weighting of the models. The unobservable inputs used in the fair value measurement of the Company’s investment in pooled trust preferred securities are offered quotes and comparability adjustments. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, changes in either of those inputs will not affect the other input.

The Company has the option to measure financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis (the Fair Value Option) according to ASC 825-10, Financial Instruments. The Company is not currently engaged in any hedging activities and, as a result, did not elect to measure any financial instruments at fair value under ASC 825-10.

Disclosure of fair value information about financial instruments for which it is practicable to estimate their value, whether or not recognized in the condensed consolidated statements of condition, is summarized below and identified within the fair value hierarchy at the dates indicated. The aggregate fair value amounts presented do not represent the underlying value of the Company.



	September 30, 2012
	Carrying Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Financial Assets:
Cash and cash equivalents	$	108,583	$	108,583	$	—	$	—
Investment securities, available-for-sale	202,498		1		187,197		15,300
Investment securities, held-to-maturity	13,490		—		13,756		—
Federal Home Loan Bank stock	6,188		6,188		—		—
Loans receivable, net of allowance for loan losses	691,548		—		—		697,070
Loans held for sale	2,199		—		2,199		—
Interest receivable	2,697		—		2,697		—
Total financial assets	$	1,027,203	$	114,772	$	205,849	$	712,370

Financial Liabilities:
Deposits	$	951,061	$	602,198	$	—	$	351,170
Borrowed funds	50,018		—		53,033		—
Advance payments by borrowers	4,075		—		4,075		—
Interest payable	91		—		91		—
Total financial liabilities	$	1,005,245	$	602,198	$	57,199	$	351,170



	December 31, 2011
	Carrying Amount		Fair Value
	(Dollars in thousands)
Financial Assets:
Cash and cash equivalents	$	92,072	$	92,072
Investment securities, available-for-sale	234,381		234,381
Investment securities, held-to-maturity	16,371		16,703
Federal Home Loan Bank stock	6,188		6,188
Loans receivable, net of allowance for loan losses	698,802		702,987
Loans held for sale	1,124		1,124
Interest receivable	3,011		3,011
Total financial assets	$	1,051,949	$	1,056,466

Financial Liabilities:
Deposits	$	977,424	$	979,483
Borrowed funds	54,200		57,241
Advance payments by borrowers	4,275		4,275
Interest payable	90		90
Total financial liabilities	$	1,035,989	$	1,041,089

The carrying amount is the estimated fair value for cash and cash equivalents, accrued interest receivable and payable, and advance payments by borrowers. Investment securities fair values are based on quotes received from a third-party pricing source and discounted cash flow analysis models. The fair value of Federal Home Loan Bank stock is based on its redemption value. The fair values for loans receivable are estimated using discounted cash flow analyses. Cash flows are adjusted for estimated prepayments, where appropriate, and are discounted using interest rates currently being offered by the Bank for loans with similar terms and collateral to borrowers of similar credit quality. The carrying amount of loans held for sale is the amount funded and approximates fair value due to the insignificant time between origination and date of sale.

The fair value of core deposits (checking, savings, and money market accounts) is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated by discounting the future cash flows using the rates currently offered by the Bank for deposits of similar remaining maturities. The fair value of borrowed funds is estimated based on rates currently available to the Company for debt with similar terms and remaining maturities. The fair value of the Company’s off-balance sheet instruments, including lending commitments, letters of credit, and credit enhancements, approximates their book value and is not included in the above table.


7.	Share-Based Compensation

The Company accounts for its share-based compensation in accordance with ASC 718-10, Compensation – Stock Based Compensation. ASC 718-10 addresses all forms of share-based payment awards, including shares under employee stock purchase plans, stock options, restricted stock, and stock appreciation rights. ASC 718-10 requires all share-based payments to be recognized as expense, based upon their fair values, in the financial statements over the service period of the awards.

For additional details on the Company’s share-based compensation plans and related disclosures, see “Note 9. Share-Based Compensation” in the consolidated financial statements as presented in the Company’s 2011 Annual Report on Form 10-K.

Omnibus Equity Incentive Plan

The Company’s 2008 Omnibus Equity Incentive Plan (Equity Incentive Plan) authorized the issuance of 270,000 shares of its common stock. In addition, there were 64,500 shares that had not yet been issued or were forfeited, canceled, or unexercised at the end of the option term under the 2003 Stock Option Plan when it was frozen. These shares and any other shares that may be forfeited, canceled, or expired are available for any type of share-based awards in the future under the Equity Incentive Plan. At September 30, 2012, shares available for future grants under the Equity Incentive Plan totaled 209,501 shares.

Restricted Stock

The following table presents the activity for restricted stock for the nine months ended September 30, 2012.



	Number of Shares		Weighted-Average Grant-Date Fair Value
Unvested at December 31, 2011	175,639		$	4.97
Granted	48,186		5.96
Vested	(52,596	)	6.18
Forfeited	(50,242	)	5.21
Unvested at September 30, 2012	120,987		$	4.72

The compensation expense related to restricted stock for the three months ended September 30, 2012 and 2011 totaled $45,000 and $81,000, respectively. The compensation expense related to restricted stock for the nine months ended September 30, 2012 and 2011 totaled $115,000 and $226,000, respectively. At September 30, 2012, the remaining unamortized cost of the restricted stock awards was reflected as a reduction in additional paid-in capital and totaled $572,000. This cost is expected to be recognized over a weighted-average period of 2.9 years, which is subject to the actual number of shares earned and vested.

Stock Options

The Company’s 2008 Equity Incentive Plan allows for the grant of both incentive and non-qualified stock options to directors, officers, and employees. The stock option vesting periods and exercise and expiration dates are determined by the Compensation Committee at the time of the grant. The exercise price of the stock options is equal to the fair market value of the common stock on the grant date.

The following table presents the activity under the Company’s stock option plans for the nine months ended September 30, 2012.



	Number of Options		Weighted-Average Exercise Price
Options outstanding at December 31, 2011	515,995		$	14.01
Granted	20,000		4.40
Forfeited	(56,000	)	13.91
Expired unexercised	(72,200	)	13.76
Options outstanding at September 30, 2012	407,795		$	13.59

For stock options outstanding at September 30, 2012, the range of exercise prices was $4.40 to $14.76, and the weighted-average remaining contractual term was 1.9 years. At September 30, 2012, 387,795 of the Company’s outstanding stock options were fully vested and out-of-the-money with no intrinsic value. The remaining 20,000 stock options were not yet exercisable and were in-the-money with an intrinsic value of $21,200, which represents the difference between the Company’s closing stock price on the last day of trading for the third quarter of 2012 and the exercise price multiplied by the number of in-the-money options, assuming all option holders had exercised their stock options on the last day of trading for the same period. Stock option expense for the three and nine months ended September 30, 2012 was $3,000 and $9,000, respectively. There was no stock option expense for the comparable 2011 periods. There were no stock options exercised during the three and nine months ended September 30, 2012 and 2011. The Company reissues treasury shares to satisfy option exercises.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement Regarding Forward Looking Statements

Certain statements contained in this Form 10-Q, in our other filings with the U.S. Securities and Exchange Commission (SEC), and in our press releases or other shareholder communications are forward-looking statements, as that term is defined in U.S. federal securities laws. Generally, these statements relate to our business plans or strategies, prospects, management, projections involving anticipated revenues, earnings, profitability, or other aspects of operating results, or other future developments in our affairs or the industry in which we conduct business. Forward-looking statements may be identified by reference to a future period or periods or by the use of forward-looking terminology such as “anticipate,” “believe,” “expect,” “intend,” “plan,” “estimate,” “would be,” “will,” “intend to,” “project,” or similar expressions or the negative thereof, as well as statements that include future events, tense or dates, or are not historical or current facts.

We wish to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. These forward-looking statements include but are not limited to statements regarding our ability to continue to successfully execute our strategy and Strategic Growth and Diversification Plan; the level and sufficiency of our current regulatory capital and equity ratios; our ability to continue to diversify the loan portfolio; our efforts at deepening client relationships, increasing our levels of core deposits, lowering our non-performing asset levels, managing and reducing our credit-related costs, and increasing our revenue growth and levels of earning assets; the effects of general economic and competitive conditions nationally and within our core market area; our ability to sell other real estate owned properties and mortgage loans held for sale; the sufficiency of the levels of provision for the allowance for loan losses and amounts of charge-offs; loan and deposit growth; interest on loans; asset yields and cost of funds; net interest income; net interest margin; non-

interest income; non-interest expense; interest rate environment; and other factors. For further discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements see “Part I. Item 1A. Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2011. Such forward-looking statements are not guarantees of future performance. We do not undertake, and specifically disclaim any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements unless required to do so under the federal securities laws.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP), which require us to establish various accounting policies. Certain of these accounting policies require us to make estimates, judgments, or assumptions that could have a material effect on the carrying value of certain assets and liabilities. The estimates, judgments, and assumptions we use are based on historical experience, projected results, internal cash flow modeling techniques, and other factors which we believe are reasonable under the circumstances.

Significant accounting policies are presented in “Note 1. Summary of Significant Accounting Policies” in the notes to consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” of our December 31, 2011 Annual Report on Form 10-K. These policies, along with the disclosures presented in other financial statement notes and in this management’s discussion and analysis, provide information on the methodology used for the valuation of significant assets and liabilities in our financial statements. We view critical accounting policies to be those that are highly dependent on subjective or complex judgments, estimates, and assumptions, and where changes in those estimates and assumptions could have a significant impact on our consolidated financial statements. We currently view the determination of the allowance for loan losses, valuations and impairments of investment securities, and the accounting for income taxes to be critical accounting policies.

Allowance for Loan Losses. We maintain our allowance for loan losses at a level we believe is appropriate to absorb credit losses inherent in our loan portfolio. The allowance for loan losses represents our estimate of probable incurred losses in our loan portfolio at each statement of condition date and is based on our review of available and relevant information.

The first component of the allowance for loan losses contains allocations for probable incurred losses that management has identified relating to impaired loans pursuant to Accounting Standards Codification (ASC) 310-10, Receivables. We individually evaluate for impairment all loans classified substandard and over $375,000 to enable management to identify potential losses over a larger cross section of the loan portfolio. We also individually evaluate for impairment all loans for which we have initiated foreclosure proceedings. For all portfolio segments, loans are considered impaired when, based on current information and events, it is probable that the borrower will not be able to fulfill its obligation according to the contractual terms of the loan agreement. The impairment loss, if any, is generally measured based on the present value of expected cash flows discounted at the loan’s effective interest rate. As a practical expedient, impairment may be measured based on the loan’s observable market price, or the fair value of the collateral, if the loan is collateral-dependent. A loan is considered collateral-dependent when the repayment of the loan will be provided solely by the underlying collateral and there are no other available and reliable sources of repayment. If we determine a loan is collateral-dependent, we will charge-off any identified collateral shortfall against the allowance for loan losses.

If foreclosure is probable, we are required to measure the impairment based on the fair value of the collateral. The fair value of the collateral is generally obtained from the evaluation of the collateral, and one of the methods of evaluation is an independent third-party appraisal. When current appraisals are not available, we utilize other evaluation methods to estimate the fair value of the collateral giving consideration to several factors including for real estate properties the price at which individual unit(s) could be sold in the current market, the period of time over which the unit(s) could be sold, the estimated cost to complete the unit(s), the risks associated with completing and selling the unit(s), the required return on the investment a potential acquirer may have, and the current market interest rates. The analysis of each loan involves a high degree of judgment in estimating the amount of the loss associated with the loan, including the estimation of the amount and timing of future cash flows and collateral values.

The second component of our allowance for loan losses contains allocations for probable incurred losses within various pools of loans with similar characteristics pursuant to ASC 450-10, Contingencies. This component is based in part on certain loss factors applied to various stratified loan pools excluding loans evaluated individually for impairment. In determining the appropriate loss factors for these loan pools, we consider historical charge-offs and recoveries; levels of and trends in delinquencies, impaired loans, and other classified loans; concentrations of credit within the commercial loan portfolios; volume and type of lending; and current and anticipated economic conditions. Our historical charge-offs are determined by evaluating the net charge-offs over the most recent eight quarters, including the current quarter. Prior to the fourth quarter of 2010, we evaluated our net charge-offs by using the four calendar years preceding the current year.

Loan losses are charged-off against the allowance when the loan balance or a portion of the loan balance is no longer covered by the repayment capacity of the borrower based on an evaluation of available and projected cash resources and collateral value. Recoveries of amounts previously charged-off are credited to the allowance. We assess the appropriateness of the allowance for loan losses on a quarterly basis and adjust the allowance for loan losses by recording a provision for loan losses in an amount sufficient to maintain the allowance at a level deemed appropriate by management. The evaluation of the appropriateness of the allowance for loan losses is inherently subjective as it requires estimates that are susceptible to significant revision as additional information becomes available or as future events occur. To the extent that actual outcomes differ from our estimates, an additional provision for loan losses could be required which could adversely affect earnings or our financial position in future periods.

Investment Securities. Under ASC 320-10, Investments – Debt and Equity Securities, investment securities must be classified as held-to-maturity, available-for-sale, or trading. We determine the appropriate classification at the time of purchase. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on investment securities. Debt investment securities are classified as held-to-maturity and carried at amortized cost when we have the positive intent and the ability to hold the investment securities to maturity. Investment securities not classified as held-to-maturity are classified as available-for-sale and are carried at fair value, with the unrealized holding gains and losses, net of tax, reported in other comprehensive income and do not affect earnings until realized. Investment in Federal Home Loan Bank (FHLB) stock is carried at cost. We have no trading account investment securities.

The fair values of our investment securities are generally determined by reference to quoted prices from reliable independent sources utilizing observable inputs. Certain of the fair values of investment securities are determined using models whose significant value drivers or assumptions are unobservable and are significant to the fair value of the investment securities. These models are utilized when quoted prices are not available for certain investment securities or in markets where trading activity has slowed or ceased. When quoted prices are

not available and are not provided by third-party pricing services, our judgment is necessary to determine fair value. As such, fair value is determined using discounted cash flow analysis models, incorporating default rates, estimation of prepayment characteristics, and implied volatilities.

We evaluate all investment securities on a quarterly basis, and more frequently when economic conditions warrant additional evaluations, for determining if an other-than-temporary impairment (OTTI) exists pursuant to guidelines established in ASC 320-10. In evaluating the possible impairment of investment securities, consideration is given to many factors including the length of time and the extent to which the fair value has been less than cost, whether the market decline was affected by macroeconomic conditions, the financial conditions and near-term prospects of the issuer, and management’s ability and intent to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, we may consider whether the investment securities are issued by the federal government or its agencies or government sponsored agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

If we determine that an investment experienced an OTTI, we must then determine the amount of the OTTI to be recognized in earnings. If we do not intend to sell the investment security and it is more likely than not that we will not be required to sell the investment security before recovery of its amortized cost basis less any current period loss, the OTTI will be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the OTTI related to other factors will be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings will become the new amortized cost basis of the investment. If we intend to sell the investment security or it is more likely than not we will be required to sell the investment security before recovery of its amortized cost basis less any current period credit loss, the OTTI will be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. Any recoveries related to the value of these investment securities are recorded as an unrealized gain (as other comprehensive income (loss) in shareholders’ equity) and not recognized in income until the investment security is ultimately sold. From time to time, we may dispose of an impaired investment security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds can be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time.

Income Tax Accounting. We file a consolidated federal income tax return. The provision for income taxes is based upon income in our consolidated financial statements, rather than amounts reported on our income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on our deferred tax assets and liabilities is recognized as income or expense in the period that includes the enactment date.

Under U.S. GAAP, a valuation allowance is required to be recognized if it is more likely than not that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning our evaluation of both positive and negative evidence, our forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. Positive evidence includes current positive earning trends, the existence of taxes paid in

available carryback years, and the probability that taxable income will continue to be generated in future periods, while negative evidence includes any cumulative losses in the current year and prior two years and general business and economic trends.

At September 30, 2012, based on the results of our regular assessment of the ability to realize our deferred tax assets, we concluded that, based on all available evidence, both positive and negative, approximately $6.5 million of our deferred tax assets did not meet the “more likely than not” threshold for realization. Although realization of the remaining net deferred tax assets of $13.8 million is not assured, we believe it is more likely than not that all of the recorded deferred tax assets will be realized based on available tax planning strategies and our projections of future taxable income. The positive evidence considered in our analysis of the remaining deferred tax assets included our long-term history of generating taxable income; the cyclical nature of the industry in which we operate; the fact that a portion of the losses realized in 2011 were partly attributable to syndicated/participation lending which we stopped investing in during 2007; our history of fully realizing net operating losses, including the federal net operating loss from a $45.0 million taxable loss in 2004; and the relatively long remaining tax loss carryforward periods (19 years for federal income tax purposes, ten years for the state of Indiana, and eight years for the state of Illinois). The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during tax loss carryforward periods are reduced. Any reduction in estimated future taxable income may require us to record an additional valuation allowance against our deferred tax assets, which would result in additional income tax expense in the period and could have a significant impact on our future earnings.

Positions taken in our tax returns may be subject to challenge upon examination by the taxing authorities. The benefit of an uncertain tax position is initially recognized in the financial statements only when it is more likely than not the position will be sustained upon examination by the taxing authorities. Such tax positions are both initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with the taxing authority, assuming full knowledge of the position and all relevant facts. Differences between our position and the position of taxing authorities could result in a reduction of a tax benefit or an increase to a tax liability, which could adversely affect our future income tax expense.

We believe our tax policies and practices are critical accounting policies because the determination of our tax provision and current and deferred tax assets and liabilities have a material impact on our results of operations and the carrying value of our assets. We believe our tax assets and liabilities are adequate and are properly recorded in the condensed consolidated financial statements at September 30, 2012.

Results of Operations for the Three and Nine Months Ended September 30, 2012 and 2011

Performance Overview

The following tables provide selected financial and performance information for the periods presented.



	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	(Dollars in thousands, except per share data)
Net income	$	1,259		$	394		$	3,103		$	2,099
Diluted earnings per share	.12			.04			.29			.20
Pre-tax, pre-provision earnings, as adjusted (1)	3,537			2,690			9,407			6,716
Return on average assets (2)	.45		%	.14		%	.36		%	.25		%
Return on average equity (2)	4.72			1.34			3.96			2.44
Average interest-earning assets	$	1,014,769		$	1,036,064		$	1,037,445		$	1,025,231
Net interest income	8,849			8,859			26,716			26,903
Net interest margin	3.47		%	3.39		%	3.44		%	3.51		%
Non-interest income	$	3,032		$	3,310		$	8,499		$	10,299
Non-interest expense	8,969			9,186			27,718			30,224
Efficiency ratio (3)	76.74		%	80.50		%	80.82		%	84.54		%



	September 30, 2012			December 31, 2011			September 30, 2011
Book value per share	$	9.94		$	9.49		$	10.55
Shareholders’ equity to total assets	9.66		%	8.99		%	9.82		%
Bank Capital Ratios:
Tangible capital ratio	8.85			8.26			8.87
Tier 1 core capital ratio	8.85			8.26			8.87
Tier 1 risk-based capital ratio	12.56			11.40			12.31
Risk-based capital ratio	13.82			12.65			13.57


(1)	See “Non-U.S. GAAP Financial Information” on page 46.


(2)	Annualized.


(3)	The efficiency ratio is calculated by dividing non-interest expense by the sum of net interest income and non-interest income, excluding net gain on sale of investment securities.

The following discussion and analysis presents the more significant factors affecting our financial condition as of September 30, 2012 and results of operations for the three and nine months ended September 30, 2012. This discussion and analysis should be read in conjunction with our condensed consolidated financial statements and notes thereto included in this report.

Our problem asset resolution efforts have reduced our level of non-performing assets by 24% during the third quarter of 2012. We have been resolving individual credits by seeking to either restructure specific non-performing loans or foreclose, obtain title, and transfer the loan to other real estate owned where management can take control of and liquidate the underlying collateral. Our ratio of non-performing loans to total loans decreased to 5.19% at September 30, 2012 from 6.41% at December 31, 2011, primarily due to transfers back to accrual

status of $9.8 million of commercial real estate A-Note troubled debt restructurings that were performing for at least six months; a $1.7 million paydown of a non-accrual commercial participation loan; and $5.6 million of commercial real estate loans transferred to other real estate owned, of which $3.7 million was also sold during the quarter. The ratio of non-performing assets to total assets decreased to 4.83% at September 30, 2012 compared to 5.63% at December 31, 2011.

During the third quarter of 2012, we recorded net income of $1.3 million, or $.12 per diluted share, an increase from net income of $394,000, or $.04 per diluted share, for the third quarter of 2011. Our earnings were favorably impacted by a $217,000, or 2.4%, decrease in non-interest expense to $9.0 million from $9.2 million for the third quarter of 2011 as we continue to reduce non-interest expense. Excluding credit related costs totaling $1.2 million, non-interest expense decreased to $7.7 million for the third quarter of 2012 from $8.5 million from the third quarter of 2011. These decreases were related to a significant decrease in compensation and employee benefit expense due to our Voluntary Early Retirement Offering (VERO) announced in the first quarter of 2012, the March 31, 2012 branch closings in Bolingbrook and Orland Park, Illinois, the outsourcing of certain support functions, and lower professional fees. The number of full time equivalent (FTE) employees decreased to 259 at September 30, 2012 from 303 at December 31, 2011 and 311 at September 30, 2011.

We continue to target specific segments in our loan portfolio for growth, including commercial and industrial and owner occupied and multifamily commercial real estate, which in the aggregate comprised 56.5% of the commercial loan portfolio at September 30, 2012, up from 53.0% at December 31, 2011 and 52.2% at September 30, 2011. Our focus on deepening client relationships continues to emphasize core deposit growth. Total core deposits as a percentage of total deposits increased to 63.3% at September 30, 2012 from 61.1% at December 31, 2011 and 60.5% at September 30, 2011. The increase was primarily due to continued shrinkage in certificates of deposit in this low interest rate environment. In addition, the Bank’s High Performance Checking (HPC) deposit acquisition marketing program implemented during the first quarter of 2012 has enhanced growth in core deposits while attracting a younger demographic (20-49 age group) for retail accounts, which will continue to provide additional cross-sell opportunities.

At September 30, 2012, our common shareholders’ equity was $108.1 million, or 9.66% of assets, compared to $103.2 million, or 8.99%, of assets at December 31, 2011 and $114.8 million, or 9.82% of assets, at September 30, 2011. The Bank’s Tier 1 core capital ratio was 8.85% at September 30, 2012 compared to 8.26% at December 31, 2011 and 8.87% at September 30, 2011. The Bank’s total risk-based capital ratio increased to 13.82% at September 30, 2012 from 12.65% at December 31, 2011 and 13.57% at September 30, 2011.

Non-U.S. GAAP Financial Information

Our accounting and reporting policies conform to U.S. GAAP and general practice within the banking industry. Management uses certain non-U.S. GAAP financial measures to evaluate our financial performance and has provided the non-U.S. GAAP financial measures of pre-tax, pre-provision earnings, as adjusted, and pre-tax, pre-provision earnings, as adjusted, to average assets. In these non-U.S. GAAP financial measures, the provision for loan losses, other real estate owned related income and expense, loan collection expense, and certain other items, such as gains and losses on sales of investment securities and other assets, and severance and early retirement expense, are excluded. Management believes that these measures are useful because they provide a more comparable basis for evaluating financial performance excluding certain credit-related costs and other non-recurring items period to period and allows management and others to assess our ability to generate pre-tax earnings to cover our provision for loan losses and other credit-related costs. Although these non-U.S. GAAP financial

measures are intended to enhance investors understanding of our business performance, these operating measures should not be considered as an alternative to U.S. GAAP.

The risks associated with utilizing operating measures (such as the pre-tax, pre-provision earnings, as adjusted) are that various persons might disagree as to the appropriateness of items included or excluded in these measures and that other companies might calculate these measures differently. Management compensates for these limitations by providing detailed reconciliations between U.S. GAAP information and our pre-tax, pre-provision earnings, as adjusted, as noted above.

The following table reconciles income before income taxes in accordance with U.S. GAAP to the non-U.S. GAAP measurement of pre-tax, pre-provision earnings, as adjusted.



	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	(Dollars in thousands)
Reconciliation of Income Before Income Taxes to Pre-Tax, Pre-Provision Earnings, as adjusted:
Income before income taxes	$	1,752		$	310		$	4,137		$	2,406
Provision for loan losses	1,160			2,673			3,360			4,572
Pre-tax, pre-provision earnings	2,912			2,983			7,497			6,978

Add back (subtract):
Net gain on sale of:
Investment securities	(194		)	(758		)	(917		)	(1,450		)
Other real estate owned	(425		)	(266		)	(464		)	(2,499		)
Other real estate owned related expense, net	1,074			614			2,008			3,217
Loan collection expense	170			117			407			470
Severance and early retirement expense	—			—			876			—
Pre-tax, pre-provision earnings, as adjusted	$	3,537		$	2,690		$	9,407		$	6,716

Pre-tax, pre-provision earnings, as adjusted, to average assets (annualized)	1.25		%	.93		%	1.09		%	.79		%

Pre-tax, pre-provision earnings, as adjusted, increased $847,000, or 31.5%, to $3.5 million for the third quarter of 2012 compared to $2.7 million for the third quarter of 2011. These increases were primarily due to a $261,000 increase in gain on sale of loans held for sale along with a $636,000 decrease in compensation and employee benefits expense.

The pre-tax, pre-provision earnings, as adjusted, for the nine months ended September 30, 2012 increased $2.7 million, or 40.1%, to $9.4 million compared to $6.7 million for the 2011 period primarily due to increases in gain on sale of loans held for sale; income from bank-owned life insurance as a result of the death of an insured in the first quarter 2012; and decreases in compensation and employee benefits, professional fees, and Federal Deposit Insurance Corporation (FDIC) insurance premiums and regulatory assessments. These favorable variances were partially offset by an increase in marketing expenses and a slight decrease in net interest income.

Average Balances/Rates

The following tables reflect the average yield on assets and average cost of liabilities for the periods indicated. Average balances are derived from average daily balances.



	Three Months Ended September 30,
	2012						2011
	Average Balance		Interest		Average Yield/Cost		Average Balance		Interest		Average Yield/Cost
	(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)	$	712,663	$	8,237	4.60	%	$	730,524	$	8,881	4.82	%
Investment securities (2)	234,395		1,923		3.21		239,655		1,794		2.93
Other interest-earning assets (3)	67,711		88		.52		65,885		80		.48
Total interest-earning assets	1,014,769		10,248		4.02		1,036,064		10,755		4.12
Non-interest earning assets	109,008						114,085
Total assets	$	1,123,777					$	1,150,149
Interest-bearing liabilities:
Deposits:
Checking accounts	$	177,238	$	51	.11	%	$	161,854	$	96	.24	%
Money market accounts	181,390		98		.21		187,523		190		.40
Savings accounts	146,244		70		.19		130,985		66		.20
Certificates of deposit	354,179		883		.99		391,275		1,250		1.27
Total deposits	859,051		1,102		.51		871,637		1,602		.73
Borrowed funds:
Other short-term borrowed funds	11,062		5		.18		15,562		15		.38
FHLB advances	39,728		292		2.88		34,850		279		3.13
Total borrowed funds	50,790		297		2.29		50,412		294		2.28
Total interest-bearing liabilities	909,841		1,399		.61		922,049		1,896		.82
Non-interest bearing deposits	97,888						100,849
Other non-interest bearing liabilities	9,903						10,843
Total liabilities	1,017,632						1,033,741
Shareholders’ equity	106,145						116,408
Total liabilities and shareholders’ equity	$	1,123,777					$	1,150,149
Net interest-earning assets	$	104,928					$	114,015
Net interest income / interest rate spread			$	8,849	3.41	%			$	8,859	3.30	%
Net interest margin					3.47	%					3.39	%
Ratio of average interest-earning assets to average interest-bearing liabilities					111.53	%					112.37	%


(1)	The average balance of loans receivable includes loans held for sale and non-performing loans, interest on which is recognized on a cash basis.


(2)	Average balances of investment securities are based on amortized cost.


(3)	Includes FHLB stock and interest-earning bank deposits.



	Nine Months Ended September 30,
	2012						2011
	Average Balance		Interest		Average Yield/Cost		Average Balance		Interest		Average Yield/Cost
	(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)	$	708,942	$	24,866	4.69	%	$	730,242	$	26,708	4.89	%
Investment securities (2)	248,606		6,239		3.30		248,905		5,879		3.11
Other interest-earning assets (3)	79,897		284		.47		46,084		401		1.16
Total interest-earning assets	1,037,445		31,389		4.04		1,025,231		32,988		4.30
Non-interest earning assets	110,845						115,560
Total assets	$	1,148,290					$	1,140,791
Interest-bearing liabilities:
Deposits:
Checking accounts	$	179,057	$	210	.16	%	$	159,993	$	315	.26	%
Money market accounts	190,928		408		.29		186,769		666		.48
Savings accounts	141,743		207		.20		127,922		214		.22
Certificates of deposit	367,699		2,961		1.08		398,228		4,077		1.37
Total deposits	879,427		3,786		.58		872,912		5,272		.81
Borrowed funds:
Other short-term borrowed funds	11,734		14		.16		14,385		48		.45
FHLB advances	39,774		873		2.88		28,573		765		3.53
Total borrowed funds	51,508		887		2.26		42,958		813		2.50
Total interest-bearing liabilities	930,935		4,673		.67		915,870		6,085		.89
Non-interest bearing deposits	101,805						98,815
Other non-interest bearing liabilities	10,795						10,907
Total liabilities	1,043,535						1,025,592
Shareholders’ equity	104,755						115,199
Total liabilities and shareholders’ equity	$	1,148,290					$	1,140,791
Net interest-earning assets	$	106,510					$	109,361
Net interest income / interest rate spread			$	26,716	3.37	%			$	26,903	3.41	%
Net interest margin					3.44	%					3.51	%
Ratio of average interest-earning assets to average interest-bearing liabilities					111.44	%					111.94	%


(1)	The average balance of loans receivable includes loans held for sale and non-performing loans, interest on which is recognized on a cash basis.


(2)	Average balances of investment securities are based on amortized cost.


(3)	Includes FHLB stock and interest-earning bank deposits.

Rate/Volume Analysis

The following tables show the impact of changes in the volume of interest-earning assets and interest-bearing liabilities and changes in interest rates on our interest income and interest expense for the periods indicated. Changes attributable to the combined impact of rate and volume have been allocated proportionally to the changes due to rate and changes due to volume.



	Three Months Ended September 30,									Nine Months Ended September 30,
	2012 Compared to 2011									2012 Compared to 2011
	Change due to Rate			Change due to Volume			Total Change			Change due to Rate			Change due to Volume			Total Change
	(Dollars in thousands)
Interest income:
Loans receivable	$	(431	)	$	(213	)	$	(644	)	$	(1,076	)	$	(766	)	$	(1,842	)
Investment securities	169			(40		)	129			367			(7		)	360
Other interest-earning assets	6			2			8			(315		)	198			(117		)
Total interest income	(256		)	(251		)	(507		)	(1,024		)	(575		)	(1,599		)

Interest expense:
Deposits:
Checking accounts	(53		)	8			(45		)	(140		)	35			(105		)
Money market accounts	(86		)	(6		)	(92		)	(273		)	15			(258		)
Savings accounts	(4		)	8			4			(29		)	22			(7		)
Certificates of deposit	(256		)	(111		)	(367		)	(821		)	(295		)	(1,116		)
Total deposits	(399		)	(101		)	(500		)	(1,263		)	(223		)	(1,486		)
Borrowed funds:
Other short-term borrowed funds	(7		)	(3		)	(10		)	(26		)	(8		)	(34		)
FHLB advances	(24		)	37			13			(155		)	263			108
Total borrowed funds	(31		)	34			3			(181		)	255			74
Total interest expense	(430		)	(67		)	(497		)	(1,444		)	32			(1,412		)
Net change in net interest income	$	174		$	(184	)	$	(10	)	$	420		$	(607	)	$	(187	)

Net Interest Income

Net Interest Income. Net interest income totaled $8.8 million for the three months ended September 30, 2012 compared to $8.9 million for the three months ended September 30, 2011. Net interest income totaled $26.7 million for the nine months ended September 30, 2012 compared to $26.9 million for the nine months ended September 30, 2011. The net interest margin for the three months ended September 30, 2012 increased eight basis points to 3.47% from 3.39% for the comparable 2011 period and for the nine months ended September 30, 2012 decreased seven basis points to 3.44% from 3.51% for the 2011 period. Our net interest margin benefited from loans comprising a larger proportion of interest-earning assets and decreases in non-performing assets and the cost of interest-bearing liabilities during the three and nine months ended September 30, 2012. Higher levels of liquidity, modest loan demand, reduced but still elevated levels of non-performing assets, the continued low interest rate environment, and narrowing of spreads on new investment security purchases will create pressure on our net interest margin for the foreseeable future.

Interest Income. Interest income decreased 4.7% to $10.2 million for the three months ended September 30, 2012 from $10.8 million for the comparable 2011 period. For the nine months ended September 30, 2012, interest income decreased 4.8% to $31.4 million from $33.0 million for the comparable 2011 period. The weighted-average rate on interest-earning assets decreased to 4.02% and 4.04%, respectively, for the three and nine months ended September 30, 2012 from 4.12% and 4.30%, respectively, for the comparable 2011 periods. The decreases are primarily related to the reinvestment of proceeds from sales and maturities of investment securities in lower yielding investments and maintaining higher levels of short-term liquid investments due to the lack of suitable higher yielding investment alternatives in the current low interest rate environment combined with modest loan demand.

Interest Expense. Interest expense decreased 26.2% to $1.4 million for the three months ended September 30, 2012 from $1.9 million for the comparable 2011 period. The average cost of interest-bearing liabilities decreased 21 basis points to .61% for the three months ended September 30, 2012 from .82% for the 2011 period. For the nine months ended September 30, 2012, interest expense decreased 23.2% to $4.7 million from $6.1 million for the 2011 period. The average cost of interest-bearing liabilities decreased 22 basis points to .67% for the nine months ended September 30, 2012 from .89% for the 2011 period. Interest expense continues to be positively affected by our continuing success in increasing the proportion of low-cost core deposits to total deposits and continued disciplined pricing on new and renewing certificates of deposit.

Interest expense on interest-bearing deposits decreased to $1.1 million and $3.8 million, respectively, for the three and nine month periods ended September 30, 2012 from $1.6 million and $5.3 million, respectively, for the comparable 2011 periods. The weighted-average cost of deposits decreased 22 basis points to .51% for the three month period ended September 30, 2012 from .73% for the comparable 2011 period and 23 basis points to .58% for the nine month period ended September 30, 2012 from .81% for the comparable 2011 period. The decreases are primarily the result of disciplined pricing on core deposits and the repricing of certificates of deposit at lower interest rates.

Interest expense on borrowed funds increased to $297,000 and $887,000, respectively, for the three and nine months ended September 30, 2012 from $294,000 and $813,000, respectively, for the 2011 periods primarily as a result of increases in the average balance of FHLB advances during 2012 compared to 2011. The weighted-average cost of borrowed funds was relatively stable at 2.29% for the three months ended September 30, 2012 compared to 2.28% for the 2011 period and decreased 24 basis points during the nine months ended September 30, 2012 to 2.26% from 2.50% for the 2011 period. The decrease for the year to date period was primarily due to a decrease in the cost of Repo Sweeps, the previously discussed $15.0 million FHLB advance, and the scheduled repayments of higher cost amortizing FHLB advances.

Provision for Loan Losses

The Company’s provision for loan losses was $1.16 million for the three months ended September 30, 2012 compared to $2.67 million for the 2011 period. The provision for loan losses was $3.36 million compared to $4.57 million, respectively, for the nine months ended September 30, 2012 and 2011. For more information, see “Changes in Financial Condition – Allowance for Loan Losses” below in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Non-Interest Income

The following tables identify the changes in non-interest income for the periods presented:



	Three Months Ended September 30,
	2012		2011		$ Change			% Change
	(Dollars in thousands)
Deposit related fees	$	1,662	$	1,675	$	(13	)	(.8	)%
Commission income	55		100		(45		)	(45.0	)
Income from bank-owned life insurance	151		216		(65		)	(30.1	)
Other income	218		229		(11		)	(4.8	)
Subtotal	2,086		2,220		(134		)	(6.0	)
Net gain on sale of:
Investment securities	194		758		(564		)	(74.4	)
Loans held for sale	327		66		261			395.5
Other real estate owned	425		266		159			59.8
Subtotal	946		1,090		(144		)	(13.2	)
Total non-interest income	$	3,032	$	3,310	$	(278	)	(8.4	)



	Nine Months Ended September 30,
	2012		2011		$ Change			% Change
	(Dollars in thousands)
Deposit related fees	$	4,709	$	4,708	$	1		—	%
Commission income	187		223		(36		)	(16.1	)
Income from bank-owned life insurance	853		632		221			35.0
Other income	683		663		20			3.0
Subtotal	6,432		6,226		206			3.3
Net gain on sale of:
Investment securities	917		1,450		(533		)	(36.8	)
Loans held for sale	686		124		562			453.2
Other real estate owned	464		2,499		(2,035		)	(81.4	)
Subtotal	2,067		4,073		(2,006		)	(49.3	)
Total non-interest income	$	8,499	$	10,299	$	(1,800	)	(17.5	)

Deposit related fees include service charges, card-based fees, and other fees related to deposit accounts. Deposit related fees were impacted by a decrease in business deposit service charges due to the loss of one large business depositor during 2012 which was partially offset by a modest increase in card-based fees due to the success of the High Performance Checking (HPC) program growing checking accounts in a younger demographic that is more inclined to debit card usage. Commission income for the 2012 periods decreased due to lower sales activity in non-deposit investment-related products. Income from bank-owned life insurance during 2012 has been negatively impacted by a decrease in yields. For the nine months ended September 30, 2012, we recorded income of $378,000 relating to the first quarter 2012 death of an insured which more than offset the impact of the lower yields for the period. The increases for the 2012 periods in net gain on the sale of loans held for sale was related to our expanded residential loan origination and mortgage banking activities. The decrease in net gain on the sale of other real estate owned for the nine months ended September 30, 2012 from the same 2011 period was primarily

due to a $2.2 million gain recognized during the second quarter of 2011 on the sale of a large commercial property. For information related to net gain on sale of investment securities, see “Changes in Financial Condition – Investment Securities” below in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Non-Interest Expense

The following tables identify changes in our non-interest expense for the periods presented:



	Three Months Ended September 30,
	2012		2011		$ Change			% Change
	(Dollars in thousands)
Compensation and mandatory benefits	$	3,571	$	4,243	$	(672	)	(15.8	)%
Retirement and stock related compensation	285		198		87			43.9
Medical and life benefits	305		365		(60		)	(16.4	)
Other employee benefits	21		12		9			75.0
Subtotal compensation and employee benefits	4,182		4,818		(636		)	(13.2	)
Net occupancy expense	697		706		(9		)	(1.3	)
FDIC insurance premiums and regulatory assessments	475		481		(6		)	(1.2	)
Furniture and equipment expense	417		436		(19		)	(4.4	)
Data processing	462		424		38			9.0
Marketing	283		213		70			32.9
Professional fees	177		309		(132		)	(42.7	)
Other real estate owned related expense, net	1,074		614		460			74.9
Loan collection expense	170		117		53			45.3
Other general and administrative expenses	1,032		1,068		(36		)	(3.4	)
Total non-interest expense	$	8,969	$	9,186	$	(217	)	(2.4	)



	Nine Months Ended September 30,
	2012		2011		$ Change			% Change
	(Dollars in thousands)
Compensation and mandatory benefits	$	11,290	$	12,906	$	(1,616	)	(12.5	)%
Retirement and stock related compensation	866		627		239			38.1
Medical and life benefits	1,155		1,532		(377		)	(24.6	)
Other employee benefits	51		39		12			30.8
Subtotal compensation and employee benefits	13,362		15,104		(1,742		)	(11.5	)
Net occupancy expense	2,084		2,141		(57		)	(2.7	)
FDIC insurance premiums and regulatory assessments	1,453		1,638		(185		)	(11.3	)
Furniture and equipment expense	1,342		1,353		(11		)	(.8	)
Data processing	1,345		1,307		38			2.9
Marketing	1,009		670		339			50.6
Professional fees	628		1,031		(403		)	(39.1	)
Other real estate owned related expense, net	2,008		3,217		(1,209		)	(37.6	)
Loan collection expense	407		470		(63		)	(13.4	)
Severance and early retirement expense	876		—		876			100.0
Other general and administrative expenses	3,204		3,293		(89		)	(2.7	)
Total non-interest expense	$	27,718	$	30,224	$	(2,506	)	(8.3	)

Total non-interest expense decreased $217,000, or 2.4%, for the three months ended September 30, 2012 and $2.5 million, or 8.3%, for the nine months ended September 30, 2012 from the same 2011 periods as we continue to make progress in reducing our cost structure. Compensation and employee benefits expense decreased for the three and nine months ended September 30, 2012 from the 2011 periods primarily as a result of our VERO program, branch closings, and outsourcing during 2012. These cost reduction initiatives resulted in a 16.7% decrease in the number of FTE employees to 259 at September 30, 2012 from 311 at September 30, 2011. In addition, medical and life benefits were significantly lower during the 2012 periods due to the lack of several individual large self-insurance claims made during the prior year periods. FDIC insurance premiums and regulatory assessments expense decreased during 2012 from the 2011 periods due to the premium assessment methodology implemented in April 2011. Professional fees also decreased during 2012 primarily due to lower legal, strategic adviser, and investor relations fees. Partially offsetting the favorable variances, marketing expense increased in 2012 and VERO severance and retirement compensation expense totaled $876,000 during the nine months ended September 30, 2012.

Also, other real estate owned related expense and loan collection expense increased during the third quarter of 2012 compared to the same 2011 period due to additional valuation reserves totaling $1.0 million and higher legal fees incurred in resolving certain non-performing assets. Other real estate owned expense decreased during the nine months ended September 30, 2012 from the 2011 period due to lower valuation reserves recognized during the 2012 year to date period.

Income Tax Expense

Income tax expense for the three months ended September 30, 2012 totaled $493,000, which was equal to an effective tax rate of 28.1%. During the third quarter of 2011, we recorded an income tax benefit of $84,000. The income tax expense for the nine months ended September 30, 2012 totaled $1.0 million, or an effective tax

rate of 25.0%, and an increase of $727,000 from $307,000, or an effective tax rate of 12.8%, for the comparable 2011 period. The increases in the effective income tax rate during the 2012 periods were due to the increased level of income before income tax expense partially offset by the tax sheltering impact of income from bank-owned life insurance and other tax credits.

Changes in Financial Condition

Our total assets decreased slightly to $1.12 billion at September 30, 2012 from $1.15 billion at December 31, 2011 primarily due to our efforts to exit certain select deposit relationships which reduced our level of investments and liquidity and improved our Tier 1 core capital ratios.



	September 30, 2012		December 31, 2011		$ Change			% Change
	(Dollars in thousands)
Assets:
Cash and cash equivalents	$	108,583	$	92,072	$	16,511		17.9	%
Investment securities available-for-sale, at fair value	202,498		234,381		(31,883		)	(13.6	)
Investment securities held-to-maturity, at cost	13,490		16,371		(2,881		)	(17.6	)
Federal Home Loan Bank stock, at cost	6,188		6,188		—			—
Loans receivable, net	691,548		698,802		(7,254		)	(1.0	)
Investment in bank-owned life insurance	36,586		36,275		311			.9
Other real estate owned	17,447		19,091		(1,644		)	(8.6	)
Other assets	42,341		45,770		(3,429		)	(7.5	)
Total assets	$	1,118,681	$	1,148,950	$	(30,269	)	(2.6	)

Liabilities and Shareholders’ Equity:
Deposits	$	951,061	$	977,424	$	(26,363	)	(2.7	)%
Borrowed funds	50,018		54,200		(4,182		)	(7.7	)
Other liabilities	9,543		14,078		(4,535		)	(32.2	)
Total liabilities	1,010,622		1,045,702		(35,080		)	(3.4	)
Shareholders’ equity	108,059		103,248		4,811			4.7
Total liabilities and shareholders’ equity	$	1,118,681	$	1,148,950	$	(30,269	)	(2.6	)

Loans Receivable

The following table provides the balance and percentage of loans by category at the dates indicated.



	September 30, 2012					December 31, 2011
	Amount			% of Total		Amount			% of Total		% Change
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	93,794		13.3	%	$	85,160		12.0	%	10.1	%
Commercial real estate:
Owner occupied	96,991			13.8		93,833			13.2		3.4
Non-owner occupied	178,621			25.4		188,293			26.5		(5.1	)
Multifamily	76,549			10.9		71,876			10.1		6.5
Commercial construction and land development	21,935			3.1		22,045			3.1		(.5	)
Commercial participations	5,671			.8		12,053			1.7		(52.9	)
Total commercial loans	473,561			67.3		473,260			66.6		.1

Retail loans:
One-to-four family residential	178,280			25.2		181,698			25.6		(1.9	)
Home equity lines of credit	47,605			6.8		52,873			7.4		(10.0	)
Retail construction	1,778			.3		1,022			.1		74.0
Other	3,238			.5		2,771			.4		16.9
Total retail loans	230,901			32.8		238,364			33.5		(3.1	)
Total loans receivable	704,462			100.1		711,624			100.1		(1.0	)
Net deferred loan fees	(555		)	(.1	)	(398		)	(.1	)	39.4
Total loans receivable, net of deferred loan fees	$	703,907		100.0	%	$	711,226		100.0	%	(1.0	)

Total loans receivable, net of deferred loan fees decreased $7.3 million at September 30, 2012 from December 31, 2011 primarily due to a decrease of $7.5 million in retail loans outstanding as a result of increased mortgage loan refinance activity with us or other institutions and the majority of our one-to-four family originations being sold into the secondary market. Loan fundings during the nine months ended September 30, 2012 totaled $99.7 million compared to $65.4 million for the nine months ended September 30, 2011, which reflects an increase in loan demand during 2012. Loan fundings in 2012 were partially offset by loan repayments and amortization of $58.7 million, one-to-four family loans sold of $37.7 million, transfers to other real estate owned totaling $7.5 million in total retail loans, and gross loan charge-offs totaling $3.8 million.

Commercial participations decreased 52.9% compared to December 31, 2011 through net paydowns totaling $1.7 million and the payoff of one non-owner occupied commercial real estate participation totaling $4.8 million. In addition, non-owner occupied commercial real estate loans decreased by $9.7 million, or 5.1%, since December 31, 2011 primarily due to five loan payoffs aggregating $6.7 million and gross charge-offs of $1.5 million. Partially offsetting this decrease, commercial and industrial loans increased $8.6 million, or 10.1%, since December 31, 2011 primarily due to increased line usage.

As more fully discussed in our Annual Report on Form 10-K for the year ended December 31, 2011, we began a shift in mid-2007 to diversify our loan portfolio to reduce our focus on commercial real estate lending, including non-owner occupied, commercial construction and land development, and purchased participation and

syndication loans. We have identified and segregated the remaining credit risk related to our deemphasized loan categories that were originated prior to our current risk tolerances, credit policy, and underwriting standards, by segregating our loan portfolio based upon each loan’s initial origination date. Loans that were renewed or modified subsequent to their initial origination are included for disclosure purposes based on their initial loan origination date. The categories of the loan portfolio that we continue to focus on growing, which are commercial and industrial and commercial real estate owner occupied and multifamily, comprised 56.5% of the commercial loan portfolio at September 30, 2012 compared to 53.0% at December 31, 2011 and 52.2% at September 30, 2011. Over 79% of the loans outstanding at September 30, 2012 in these growth categories were originated after January 1, 2008 (Post-1/1/08). During 2012, these targeted growth categories grew by $16.5 million due to $30.9 million in new fundings which were partially offset by $12.1 million in loan repayments. At September 30, 2012, our total commercial loans outstanding originated prior to January 1, 2008 (Pre-1/1/08) decreased to $172.3 million, or 36.4%, of our total commercial loan portfolio primarily due to normal amortization, charge-offs, and repayments, including the full repayment of a $4.8 million performing participation loan.

The following tables present the categories of our commercial loan portfolio at the dates indicated segregated by the origination date of the lending relationship, and highlights the shift in our lending focus to those growth categories in accordance with our strategic plan.



	September 30, 2012
	Pre-1/1/08 Loans		Post-1/1/08 Loans		Total		% of Pre-1/1/08 to Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	7,790	$	86,004	$	93,794	8.3	%
Commercial real estate:
Owner occupied	36,169		60,822		96,991		37.3
Non-owner occupied	110,029		68,592		178,621		61.6
Multifamily	9,889		66,660		76,549		12.9
Commercial construction and land development	4,117		17,818		21,935		18.8
Commercial participations	4,332		1,339		5,671		76.4
Total commercial loans	$	172,326	$	301,235	$	473,561	36.4



	December 31, 2011
	Pre-1/1/08 Loans		Post-1/1/08 Loans		Total		% of Pre-1/1/08 to Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	11,878	$	73,282	$	85,160	13.9	%
Commercial real estate:
Owner occupied	43,510		50,323		93,833		46.4
Non-owner occupied	118,956		69,337		188,293		63.2
Multifamily	10,453		61,423		71,876		14.5
Commercial construction and land development	6,280		15,765		22,045		28.5
Commercial participations	11,537		516		12,053		95.7
Total commercial loans	$	202,614	$	270,646	$	473,260	42.8

Total commercial participations by loan type and state where the collateral is located are presented in the following tables as of the dates indicated.



	September 30, 2012				December 31, 2011
	Amount		% of Total		Amount		% of Total		% Change
	(Dollars in thousands)
Commercial and industrial	$	1,354	23.9	%	$	151	1.3	%	796.7	%
Commercial real estate:
Owner occupied	98		1.7		102		.8		(3.9	)
Non-owner occupied	3,840		67.7		11,193		92.9		(65.7	)
Commercial construction and land development	379		6.7		607		5.0		(37.6	)
Total commercial participations	$	5,671	100.0	%	$	12,053	100.0	%	(52.9	)



	September 30, 2012				December 31, 2011
	Amount		% of Total		Amount		% of Total		% Change
	(Dollars in thousands)
Illinois	$	1,100	19.4	%	$	1,534	12.7	%	(28.3	)%
Indiana	532		9.4		2,203		18.3		(75.9	)
Ohio	—		—		4,875		40.5		(100.0	)
Florida	379		6.7		607		5.0		(37.6	)
Colorado	1,080		19.0		1,338		11.1		(19.3	)
Texas	1,339		23.6		1,496		12.4		(10.5	)
Michigan	1,241		21.9		—		—		100.0
Total commercial participations	$	5,671	100.0	%	$	12,053	100.0	%	(52.9	)

During the third quarter of 2012, we received a paydown totaling $1.7 million related to a non-performing non-owner occupied commercial participation loan located in the state of Indiana. This paydown was partially repaid through the proceeds of a new commercial and industrial participation loan secured by the beneficial ownership interests in two other hotel properties. The new loan was underwritten in accordance with our current underwriting standards with cash flows from the collateral more than sufficient to service the debt.

Asset Quality and Allowance for Loan Losses

Non-performing Assets. The following table provides information relating to non-performing assets at the dates presented.



	September 30, 2012			June 30, 2012			December 31, 2011
	(Dollars in thousands)
Non-performing loans:
Commercial loans:
Commercial and industrial	$	477		510			$	596
Commercial real estate:
Owner occupied	6,281			11,492			11,228
Non-owner occupied	17,041			24,791			22,294
Multifamily	2,893			1,521			91
Commercial construction and land development	2,935			4,766			3,378
Commercial participations	481			2,339			2,355
Total commercial loans	30,108			45,419			39,942

Retail loans:
One-to-four family residential	5,754			5,562			4,935
Home equity lines of credit	555			550			541
Retail construction	150			319			169
Total retail loans	6,459			6,431			5,645
Total non-performing loans	36,567			51,850			45,587

Other real estate owned:
Commercial	17,032			17,666			17,688
Retail	415			1,557			1,403
Total other real estate owned	17,447			19,223			19,091
Total non-performing assets	54,014			71,073			64,678

90 days past due loans still accruing interest	136			846			5
Total non-performing assets plus 90 days past due loans still accruing interest	$	54,150		$	71,919		$	64,683

Accruing troubled debt restructurings	$	18,889		$	7,197		$	8,875

Non-performing assets to total assets	4.83		%	6.28		%	5.63		%
Non-performing loans to total loans, net of deferred fees	5.19			7.27			6.41

Total non-performing loans decreased $15.3 million, or 29.5%, to $36.6 million at September 30, 2012 from $51.9 million at June 30, 2012 primarily due to the transfer back to accrual status of two commercial real estate non-owner occupied and one commercial real estate owner occupied A-Note troubled debt restructurings totaling $9.8 million; a $1.7 million paydown on a non-accrual commercial participation loan; two commercial real estate loans transferred to other real estate owned totaling $5.6 million, of which $3.7 million was also sold during the quarter; and gross loan charge-offs totaling $1.0 million. Partially offsetting these decreases, loans transferred to non-accrual status during the quarter included $3.1 million of commercial and $1.2 million of retail

loans. Of the total non-accrual loans at September 30, 2012, $3.9 million, or 10.5% are current and performing in accordance with their loan agreements.

Total performing troubled debt restructurings increased during the quarter due to the aforementioned A-Note troubled debt restructurings being transferred back into accrual status. The additional disclosure required with respect to impaired loans and troubled debt restructurings is contained in “Note 5. Allowance for Loan Losses” in the notes to the condensed consolidated financial statements in “Item 1. Financial Statements” of this Quarterly Report on Form 10-Q.

Included in the non-performing loan totals are non-performing syndications and purchased participations as identified by loan category and states in the following table.



	September 30, 2012			June 30, 2012			December 31, 2011			% change from December 31, 2011 to September 30, 2012
	(Dollars in thousands)
Commercial and industrial	$	9		$	9		$	—		100.0	%
Commercial real estate – non-owner occupied	93			1,748			1,748			(94.7	)
Commercial construction and land development	379			582			607			(37.6	)
Total non-performing commercial participations	$	481		$	2,339		$	2,355		(79.6	)

Illinois	$	9		$	9		$	—		100.0	%
Indiana	93			1,748			1,748			(94.7	)
Florida	379			582			607			(37.6	)
Total non-performing commercial participations	$	481		$	2,339		$	2,355		(79.6	)

Percentage of total non-performing loans	1.32		%	4.51		%	5.17		%
Percentage of total commercial participations	8.48			36.25			19.54

The decrease in non-performing non-owner occupied commercial real estate loans at September 30, 2012 from June 30, 2012 was primarily related to the aforementioned $1.7 million paydown. See the “Loans Receivable” section for further details.

The following tables present additional information about the balances of our non-accrual loans outstanding at the dates indicated.



	September 30, 2012
	Unpaid Principal Balance		Partial Charge-offs to Date		Interest Paid to Principal		Recorded Investment		Related Allowance		Recorded Investment less Related Allowance		Recorded Investment as a % of Unpaid Principal
	(Dollars in thousands)
Non-performing loans:
Commercial loans:
Commercial and industrial	$	750	$	216	$	57	$	477	$	—	$	477	63.6	%
Commercial real estate:
Owner occupied	9,668		2,690		697		6,281		—		6,281		65.0
Non-owner occupied	20,030		2,714		275		17,041		217		16,824		85.1
Multifamily	3,503		532		78		2,893		—		2,893		82.6
Commercial construction and land development	2,942		—		7		2,935		180		2,755		99.8
Commercial participations	5,610		4,988		141		481		—		481		8.6
Total commercial loans	42,503		11,140		1,255		30,108		397		29,711		70.8

Retail loans:
One-to-four family residential	6,052		298		—		5,754		—		5,754		95.1
Home equity lines of credit	644		89		—		555		—		555		86.2
Retail construction	150		—		—		150		—		150		100.0
Total retail loans	6,846		387		—		6,459		—		6,459		94.3
Total non-performing loans	$	49,349	$	11,527	$	1,255	$	36,567	$	397	$	36,170	74.1



	December 31, 2011
	Unpaid Principal Balance		Partial Charge-offs to Date		Interest Paid to Principal		Recorded Investment		Related Allowance		Recorded Investment less Related Allowance		Recorded Investment as a % of Unpaid Principal
	(Dollars in thousands)
Non-performing loans:
Commercial loans:
Commercial and industrial	$	841	$	216	$	29	$	596	$	—	$	596	70.9	%
Commercial real estate:
Owner occupied	14,638		2,694		716		11,228		—		11,228		76.7
Non-owner occupied	30,825		7,403		1,128		22,294		718		21,576		72.3
Multifamily	105		—		14		91		—		91		86.7
Commercial construction and land development	3,378		—		—		3,378		—		3,378		100.0
Commercial participations	7,239		4,742		142		2,355		—		2,355		32.5
Total commercial loans	57,026		15,055		2,029		39,942		718		39,224		70.0

Retail loans:
One-to-four family residential	5,180		245		—		4,935		—		4,935		95.3
Home equity lines of credit	630		89		—		541		—		541		85.9
Retail construction	169		—		—		169		—		169		100.0
Total retail loans	5,979		334		—		5,645		—		5,645		94.4
Total non-performing loans	$	63,005	$	15,389	$	2,029	$	45,587	$	718	$	44,869	72.4

Non-performing assets decreased to $54.0 million at September 30, 2012 from $64.7 million at December 31, 2011 primarily due to the aforementioned decreases in non-performing loans. Of the transfers during the third quarter of 2012 to other real estate owned totaling $5.8 million, $3.7 million was also sold during the quarter for a gain of $478,000. The activity for the three and nine months ended September 30, 2012 for our other real estate owned is set forth in the following table.



	September 30, 2012
	Three Months Ended			Nine Months Ended
	(Dollars in thousands)
Balance at beginning of period	$	19,223		$	19,091
Transfers to other real estate owned	5,754			8,473
Net repayments and improvements of properties	(1		)	7
Sales of other real estate owned	(6,519		)	(8,430		)
Valuation allowances recorded for declines in net realizable value	(1,010		)	(1,694		)
Balance at end of period	$	17,447		$	17,447

The following table identifies our other real estate owned properties based on the loan category in which they were originated:



	September 30, 2012		December 31, 2011		% Change
	(Dollars in thousands)
Commercial loans:
Commercial real estate:
Owner occupied	$	—	$	1,275	(100.0	)%
Non-owner occupied	2,761		2,193		25.9
Multifamily	419		557		(24.8	)
Commercial construction and land development	6,652		5,341		24.5
Commercial participations:
Commercial real estate – non-owner occupied	2,673		2,673		—
Commercial construction and land development	4,527		5,649		(19.9	)
Total commercial loans	17,032		17,688		(3.7	)

Retail loans:
One-to-four family residential	156		1,374		(88.6	)
Home equity lines of credit	70		29		141.4
Retail construction	189		—		100.0
Total retail loans	415		1,403		(70.4	)
Total other real estate owned	$	17,447	$	19,091	(8.6	)

As more fully discussed in our Annual Report on Form 10-K for the year ended December 31, 2011, we believe that our loans that were originated Pre-1/1/08 have a higher degree of risk of loss due to the nature of the types of these loans and the credit environment under which they were originated, particularly given the downturn in the economic environment over the last five years. During the one year and five years ended December 31, 2011, $18.3 million and $53.3 million, respectively, or 87.8% and 95.5%, of total commercial charge-offs were from the Pre-1/1/08 portfolio. The following tables illustrate that a large portion of our non-performing loans and other real estate owned were originated Pre-1/1/08 and that we have experienced a significantly higher level of charge-offs and other real estate owned writedowns in the Pre-1/1/08 portfolios. As presented in the following tables, 70.8% of our non-performing commercial loans and our entire commercial other real estate owned portfolio at September 30, 2012 were originated Pre-1/1/08.



	September 30, 2012
	Pre-1/1/08 Loans			Post-1/1/08 Loans			Total			% of Pre-1/1/08 to Total
	(Dollars in thousands)
Non-performing commercial loans:
Commercial and industrial	$	443		$	34		$	477		92.9	%
Commercial real estate:
Owner occupied	4,341			1,940			6,281			69.1
Non-owner occupied	14,104			2,937			17,041			82.8
Multifamily	468			2,425			2,893			16.2
Commercial construction and land development	1,491			1,444			2,935			50.8
Commercial participations	481			—			481			100.0
Total non-performing commercial loans	$	21,328		$	8,780		$	30,108		70.8

Total commercial loans outstanding at September 30, 2012	$	172,326		$	301,235		$	473,561
Non-performing commercial loans to total commercial loans	12.38		%	2.91		%	6.36		%



	September 30, 2012
	Pre-1/1/08 Loans		Post-1/1/08 Loans		Total		% of Pre-1/1/08 to Total
	(Dollars in thousands)
Other real estate owned – commercial:
Commercial real estate:
Non-owner occupied	$	2,761	$	—	$	2,761	100.0	%
Multifamily	419		—		419		100.0
Commercial construction and land development	6,652		—		6,652		100.0
Commercial participations:
Commercial real estate – non-owner occupied	2,673		—		2,673		100.0
Commercial construction and land development	4,527		—		4,527		100.0
Total other real estate owned – commercial	$	17,032	$	—	$	17,032	100.0

During 2012, we recorded gross loan charge-offs and other real estate owned writedowns related to our commercial loan portfolio totaling $4.7 million, of which $3.4 million, or 72.8%, were related to loans originated Pre-1/1/08. The breakdown of gross charge-offs of commercial loans and other real estate owned writedowns on commercial properties are identified in the following table.



	Nine Months Ended September 30, 2012
	Pre-1/1/08 Loans		Post-1/1/08 Loans		Total		% of Pre-1/1/08 to Total
	(Dollars in thousands)
Commercial loan charge-offs:
Commercial and industrial	$	120	$	435	$	555	21.6	%
Commercial real estate:
Owner occupied	191		—		191		100.0
Non-owner occupied	1,238		300		1,538		80.5
Multifamily	—		551		551		—
Commercial participations	228		—		228		100.0
Total commercial loan charge-offs	1,777		1,286		3,063		58.0

Writedowns on other real estate owned – commercial properties:
Commercial real estate:
Owner occupied	3		—		3		100.0
Non-owner occupied	252		—		252		100.0
Multifamily	136		—		136		100.0
Commercial construction and land development	300		—		300		100.0
Commercial participations – construction and land development	974		—		974		100.0
Total writedowns on other real estate owned – commercial properties	1,665		—		1,665		100.0
Total commercial loan charge-offs and writedowns on other real estate owned	$	3,442	$	1,286	$	4,728	72.8

Potential Problem Assets. Potential problem assets, defined as loans classified substandard pursuant to our internal loan grading system that do not meet the definition of a non-performing loan, increased to $7.1 million at September 30, 2012 from $2.2 million at December 31, 2011. This increase is due to the substandard classification of two loans to an owner occupied and non-owner occupied commercial real estate loan relationship totaling $1.6 million, two owner occupied commercial real estate loans totaling $2.1 million, a non-owner occupied commercial real estate loan totaling $943,000, and four retail loans totaling $300,000.

Allowance for Loan Losses. The following is a summary of changes in the allowance for loan losses for the periods presented:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	(Dollars in thousands)
Balance at beginning of period	$	12,062		$	17,039		$	12,424		$	17,179
Loan charge-offs:
Current period loan charge-offs	(1,261		)	(2,556		)	(3,194		)	(4,643		)
Previously established specific reserves	—			—			(718		)	—
Total loan charge-offs	(1,261		)	(2,556		)	(3,912		)	(4,643		)
Recoveries of loans previously charged-off	398			30			487			78
Net loan charge-offs	(863		)	(2,526		)	(3,425		)	(4,565		)
Provision for loan losses	1,160			2,673			3,360			4,572
Balance at end of period	$	12,359		$	17,186		$	12,359		$	17,186



	September 30, 2012			December 31, 2011			September 30, 2011
	(Dollars in thousands)
Allowance for loan losses	$	12,359		$	12,424		$	17,186
Total loans receivable, net of unearned fees	703,907			711,226			725,467
Allowance for loan losses to total loans	1.76		%	1.75		%	2.37		%
Allowance for loan losses to non-performing loans	33.80			27.25			28.96
Ratio of net loans charged-off to average loans outstanding for the quarter ended, annualized	.48			9.47			1.37

The allowance for loan losses was stable at $12.4 million at September 30, 2012 and December 31, 2011 and decreased $4.8 million from $17.2 million at September 30, 2011. The large decrease in the allowance for loan losses compared to September 30, 2011 was primarily due to the charge-offs of previously established ASC 310-10 impairment reserves recorded during the fourth quarter of 2011. The ratio of the allowance for loan losses to total loans increased slightly to 1.76% at September 30, 2012 from 1.75% at December 31, 2011 primarily due to the decrease in total loans and decreased from 2.37% September 30, 2011 as a result of the fourth quarter of 2011 charge-offs.

The provision for losses on loans decreased to $1.16 million for the third quarter of 2012 from $2.67 million for the prior year quarter. The decrease was primarily related to the lower level of charge-offs combined with $398,000 of loan loss recoveries received during the third quarter of 2012. Total recoveries during the quarter included a $325,000 repayment of a previous $476,000 charge-off on a non-owner occupied commercial real estate loan recorded in 2010.

When we determine that a non-performing collateral-dependent loan has a collateral shortfall, we will immediately charge off the collateral shortfall. As a result, we are not required to maintain an allowance for loan losses on these loans as the loan balance has already been written down to its net realizable value (fair value less estimated costs to sell the collateral). As such, the ratio of the allowance for loan losses to total loans and the ratio of the allowance for loan losses to non-performing loans has continued to be negatively affected by cumulative partial charge-offs of $12.3 million recorded through September 30, 2012 on $24.8 million (net of charge-offs) of

non-performing collateral-dependent loans. At September 30, 2012, the ratio of the allowance for loan losses to non-performing loans, excluding the $24.8 million of non-performing collateral-dependent loans with partial charge-offs, improved to 105.3%.

Investment Securities

We manage our investment securities portfolio to adjust balance sheet interest rate sensitivity to insulate net interest income against the impact of changes in market interest rates, maximize the return on invested funds within acceptable risk guidelines, and meet pledging and liquidity requirements.

We adjust the size and composition of our investment securities portfolio according to a number of factors including expected loan and deposit growth, the interest rate environment, and projected liquidity. The amortized cost of investment securities and their fair values were as follows at the dates indicated:



	September 30, 2012
	Par Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
Available-for-sale investment securities:
U.S. Treasury securities	$	14,000	$	13,971	$	443	$	—		$	14,414
Government sponsored entity (GSE) securities	37,000		37,018		924		—			37,942
Corporate bonds	5,420		5,092		152		—			5,244
Collateralized mortgage obligations	79,688		72,559		4,007		(77		)	76,489
Commercial mortgage-backed securities	46,460		47,504		1,310		—			48,814
Asset backed securities	4,392		4,052		242		—			4,294
Pooled trust preferred securities	25,207		22,982		—		(7,682		)	15,300
GSE preferred stock	200		—		1		—			1
Total available-for-sale investment securities	$	212,367	$	203,178	$	7,079	$	(7,759	)	$	202,498

Held-to-maturity investment securities:
Asset backed securities	$	6,888	$	7,050	$	222	$	—		$	7,272
Municipal securities	6,440		6,440		44		—			6,484
Total held-to-maturity investment securities	$	13,328	$	13,490	$	266	$	—		$	13,756



	December 31, 2011
	Par Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
Available-for-sale investment securities:
U.S. Treasury securities	$	15,000	$	14,967	$	447	$	—		$	15,414
Government sponsored entity (GSE) securities	46,800		46,967		1,415		—			48,382
Corporate bonds	5,420		5,022		9		(4		)	5,027
Collateralized mortgage obligations	79,006		71,073		1,178		(1,367		)	70,884
Commercial mortgage-backed securities	72,885		74,664		1,520		(66		)	76,118
Pooled trust preferred securities	27,398		24,804		—		(6,249		)	18,555
GSE preferred stock	200		—		1		—			1
Total available-for-sale investment securities	$	246,709	$	237,497	$	4,570	$	(7,686	)	$	234,381

Held-to-maturity investment securities:
Asset backed securities	$	8,201	$	8,461	$	285	$	—		$	8,746
Municipal securities	7,910		7,910		47		—			7,957
Total held-to-maturity investment securities	$	16,111	$	16,371	$	332	$	—		$	16,703

The fair value of investment securities available-for-sale totaled $202.5 million at September 30, 2012 compared to $234.4 million at December 31, 2011. Our investment securities portfolio decreased from December 31, 2011 as proceeds from repayments, prepayments, and sales were utilized to exit certain select deposit relationships.

At September 30, 2012, our collateralized mortgage obligation portfolio totaled $76.5 million, with 87% of the portfolio maintaining a credit rating of A or better. The composition of this portfolio includes $4.3 million backed by Ginnie Mae. The portfolio is mainly backed by residential mortgages originated prior to 2005. Included in our collateralized mortgage obligation portfolio is $64.9 million of floating-rate bonds with unaccreted discounts totaling $7.1 million.

Our commercial mortgage-backed investment securities portfolio consists mainly of senior tranches of issues that were originated prior to 2006 and have extensive subordination. All bonds in this portfolio were AAA-rated at September 30, 2012.

Our corporate bond portfolio consists of three A-rated to AA-rated, floating-rate notes purchased at large discounts with maturities ranging from 2014 to 2016.

At September 30, 2012, management believed the unrealized losses in our investment securities portfolio were primarily attributable to macroeconomic conditions affecting the liquidity of these securities and not necessarily the expected cash flows of the individual securities. The fair value of these securities is expected to recover as the economy recovers, as interest rates rise, and as the performance of the underlying collateral improves.

All of our pooled trust preferred investments were AAA-rated when they were purchased in late 2007 and early 2008 at discounts in excess of 10%. In 2009, the market for this type of investment was severely impacted by the credit crisis leading to increased deferrals and defaults. Credit ratings were also negatively affected in 2009,

and all of these securities in our portfolio have at least one rating below investment grade. Rating agencies have started to note the improving collateral statistics, limited number of new deferrals, number of cures, lack of defaults, and rapidly increasing redemptions and coverage ratios. Additionally, rating agencies are increasingly analyzing deferring issuers for probability of default instead of treating all, or nearly all, deferring issuers as defaulted issuers. All of the Bank’s pooled trust preferred investments have received ratings upgrades by at least one rating agency during 2012. Two of the five issues we hold, representing approximately 45% of our total pooled trust preferred investments, were upgraded during 2012 and now have composite investment-grade ratings.

We utilize extensive external and internal analysis on the pooled trust preferred investments. Our internal model stress tests all underlying issuers in the pools to project probabilities of deferral or default. Management’s internal modeling runs multiple stress scenarios. The high-stress scenario utilizes immediate defaults for all deferring collateral. Any collateral that management believes may be at risk for deferring or defaulting, based upon its review of the underlying issuers’ most recent financial and regulatory information, is assumed to default immediately. Despite a recent trend of recoveries from previously defaulted trust preferred collateral, the high-stress scenario assumes no recoveries on defaulted collateral. All external and internal stress testing at September 30, 2012 currently projects no loss of principal or interest on any of our pooled trust preferred investments.

All of our pooled trust preferred investments are “Super Senior” tranches purchased at large discounts. The “Super Senior” tranches are the most senior tranches. Due to the structure of the securities, as deferrals and defaults on the underlying collateral increase, cash flows are increasingly diverted from mezzanine and subordinate tranches to pay down principal on the “Super Senior” tranches. If certain senior coverage tests are not met, all interest is diverted from subordinate classes to pay down principal on the “Super Senior” tranche. Four of the five issues we hold are failing the senior coverage test. This test is structured to protect the holders of the “Super Senior” tranches if deferrals or defaults exceed a specific threshold as a percent of the outstanding senior tranches. As such, the proceeds of any early redemptions, successful tenders, or cures will be used to further pay down principal of the “Super Senior” tranches on these issues. In the third quarter of 2012, the annualized principal pay down rate on these investments was 6.0% and has averaged 10.0% for the past four quarters. Management expects additional cure and redemption announcements in the near term. The percentage of original collateral backing the investments deemed at risk by management was stable during the third quarter of 2012.

A number of previously deferring issuers of our pooled trust preferred investments are resuming payments. Of the previously deferring issues, 8.3% “cured,” or resumed payments, in the first quarter of 2012, 2.3% cured in the second quarter of 2012, and 1.4% cured in the third quarter of 2012. When a previously deferring issuer cures, all past interest and accrued interest on the past due interest is paid to the trust.

Management is expecting redemption activity to remain strong over the near term as call windows are now open on all of the remaining securities, certain issuers reevaluate the impact of Dodd-Frank changes to Tier 1 capital treatment for these securities, and issuers consider the high cost of this capital in the current low interest rate market.

Due to the current credit ratings on the pooled trust preferred investments being below investment grade, the aggregate amortized cost of $23.0 million of these investments is classified as substandard in accordance with regulatory requirements.

Deposits

The following table sets forth the dollar amount of deposits and the percentage of total deposits in each category offered at the dates indicated:



	September 30, 2012				December 31, 2011
	Amount		% of Total		Amount		% of Total		% Change
	(Dollars in thousands)
Checking accounts:
Non-interest bearing	$	98,723	10.4	%	$	96,321	9.9	%	2.5	%
Interest-bearing	177,458		18.6		175,150		17.9		1.3
Money market accounts	179,400		18.9		192,593		19.7		(6.9	)
Savings accounts	146,617		15.4		133,292		13.6		10.0
Core deposits	602,198		63.3		597,356		61.1		.8
Certificates of deposit accounts	348,863		36.7		380,068		38.9		(8.2	)
Total deposits	$	951,061	100.0	%	$	977,424	100.0	%	(2.7	)

During the first quarter of 2012, we initiated our HPC deposit acquisition marketing program that targets both retail and business clients. This ongoing program is designed to attract a younger demographic and enhance growth in core deposits and related fee income as well as to provide additional cross-selling opportunities. Core deposits also benefited during 2012 from clients moving maturing certificates of deposit into money market and savings accounts due to the current low interest rate environment. During 2012, we reviewed the pricing and cross-sell potential and decided to exit four of our larger single-service deposit relationships resulting in a decrease of $42.0 million in core deposits since December 31, 2011. This decision enabled us to decrease our level of liquidity and improve our Tier 1 core capital ratios.

Total deposits decreased $26.4 million, or 2.7%, to $951.1 million at September 30, 2012 from $977.4 million at December 31, 2011. This decrease was primarily due to a $31.2 million, or 8.2%, decrease in certificates of deposit as management continues to be disciplined about pricing these deposits coupled with a $13.2 million, or 6.9%, decrease in money market accounts. Partially offsetting these decreases was a $4.7 million, or 1.7%, increase in checking accounts and a $13.3 million, or 10%, increase in savings accounts.

In addition, we offer a repurchase sweep agreement (Repo Sweep) account which allows public entities and other business depositors to earn interest with respect to checking and savings deposit products offered. The depositor’s excess funds are swept from a deposit account and are used to purchase an interest in investment securities that we own. The swept funds are not recorded as deposits and instead are classified as other short-term borrowed funds which generally provide a lower-cost funding alternative to FHLB advances. At September 30, 2012, we had $10.4 million in Repo Sweeps compared to $14.3 million at December 31, 2011. The Repo Sweeps are included in the table under “Borrowed Funds” and are treated as financings, and the obligations to repurchase investment securities sold are reflected as short-term borrowed funds. The investment securities underlying these Repo Sweeps continue to be reflected as assets.

Borrowed Funds

Borrowed funds consisted of the following at the dates indicated:



	September 30, 2012				December 31, 2011
	Amount		Weighted-Average Contractual Rate		Amount		Weighted-Average Contractual Rate
	(Dollars in thousands)
Advances from FHLB of Indianapolis:
Fixed rate advances due in:
2013	$	15,000	2.22	%	$	15,000	2.22	%
2014 (1)	1,038		6.71		1,069		6.71
2015	15,000		1.42		15,000		1.42
2018 (1)	2,439		5.54		2,439		5.54
2019 (1)	6,111		6.29		6,358		6.29
Total FHLB advances	39,588		2.87		39,866		2.89
Short-term variable-rate borrowed funds - Repo Sweep accounts	10,430		.15		14,334		.20
Total borrowed funds	$	50,018	2.30		$	54,200	2.18


(1)	These are amortizing advances and are listed by their contractual final maturity date.

At September 30, 2012 and December 31, 2011, the Bank had a line of credit with a large commercial bank with a maximum of $15.0 million in secured overnight federal funds availability at the federal funds market rate at the time of any borrowing. The Bank also has a borrowing relationship with the Federal Reserve Bank (FRB) discount window. These lines were not utilized during the nine months ended September 30, 2012 and 2011.

Shareholders’ Equity

Shareholders’ equity at September 30, 2012 increased to $108.1 million, or 9.66% of total assets, from $103.2 million, or 8.99% of total assets, at December 31, 2011. The increase was primarily due to net income of $3.1 million for the period and a decrease in accumulated other comprehensive loss, net of tax, of $1.7 million, partially offset by dividends declared of $327,000.

Liquidity and Capital Resources

Liquidity, represented by cash and cash equivalents, is a product of operating, investing, and financing activities. Our primary sources of funds are:


•	deposits and Repo Sweeps;


•	scheduled payments of amortizing loans and mortgage-backed investment securities;


•	prepayments and maturities of outstanding loans and mortgage-backed investment securities;


•	maturities of investment securities and other short-term investments;


•	funds provided from operations;


•	federal funds line of credit; and


•	borrowed funds from the FHLB and FRB.

The Asset/Liability Management Committee is responsible for measuring and monitoring our liquidity profile. We manage our liquidity to ensure stable, reliable, and cost-effective sources of funds to satisfy demand for credit, deposit withdrawals, and investment opportunities. Our general approach to managing liquidity involves preparing a monthly “funding gap” report which forecasts cash inflows and outflows over various time horizons and rate scenarios to identify potential cash imbalances. We supplement our funding gap report with the monitoring of several liquidity ratios to assist in identifying any trends that may have an effect on available liquidity in future periods.

We maintain a contingency funding plan that outlines the process for addressing a liquidity crisis. The plan assigns specific roles and responsibilities for effectively managing liquidity through a problem period.

Scheduled payments from the amortization of loans, maturing investment securities, and short-term investments are relatively predictable sources of funds, while deposit flows and loan prepayments are greatly influenced by market interest rates, economic conditions, and competitive rate offerings.

At September 30, 2012, we had cash and cash equivalents of $108.6 million, a $16.5 million, or 17.9%, increase from $92.1 million at December 31, 2011. The increase was mainly the result of proceeds received from $87.4 million from the sales, maturities, and repayments of investment securities which were partially offset by cash outflows related to $48.0 million of investment securities purchases and a $26.5 million decrease in deposit accounts.

We use our sources of funds primarily to meet our ongoing commitments, fund loan commitments, fund maturing certificates of deposit and savings withdrawals, and maintain an investment securities portfolio. We anticipate that we will continue to have sufficient funds to meet our current commitments.

The parent company’s liquidity needs consist primarily of operating expenses and dividend payments to shareholders. The primary sources of liquidity are cash and cash equivalents and dividends from the Bank. We are prohibited from repurchasing shares, incurring any debt at the parent company, and paying dividends to our shareholders without the prior approval of the FRB.

Additionally, the Bank requires the prior approval of the Office of the Comptroller of the Currency (OCC) before paying dividends to the Company. Absent such restriction, OCC regulations provide various standards under which the Bank may declare and pay dividends to the parent company without prior approval. The dividends from the Bank are limited to the extent of its cumulative earnings for the year plus the net earnings (adjusted by prior distributions) of the prior two calendar years. At September 30, 2012, under current regulations, the Bank had no net earnings available for dividend declarations to the parent company. At September 30, 2012, the parent company had $2.0 million in cash and cash equivalents. We do not anticipate that these restrictions will have a material adverse impact on our liquidity in the short-term.

Contractual Obligations

The following table presents our contractual obligations to third parties at September 30, 2012 by maturity:



	Payments Due By Period
	One Year or less		Over One through Three Years		Over Three Through Five Years		Over Five Years		Total
	(Dollars in thousands)
Certificates of deposit	$	264,938	$	69,265	$	13,799	$	861	$	348,863
FHLB advances (1)	376		31,767		871		6,574		39,588
Short-term borrowed funds (2)	10,430		—		—		—		10,430
Service bureau contract	1,676		3,351		3,351		—		8,378
Operating leases	424		453		272		1,777		2,926
Dividends payable on common stock	109		—		—		—		109
	$	277,953	$	104,836	$	18,293	$	9,212	$	410,294


(1)	Does not include interest expense at the weighted-average contractual rate of 2.87% for the periods presented.


(2)	Does not include interest expense at the weighted-average contractual rate of .15% for the periods presented.

See the “Borrowed Funds” section for further discussion surrounding FHLB advances. The operating lease obligations reflected above include the future minimum rental payments, by year, required under the lease terms for premises and equipment. Many of these leases contain renewal options, and certain leases provide options to purchase the leased property during or at the expiration of the lease period at specific prices.

Off-Balance-Sheet Obligations

We are party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our clients. These financial instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the statement of condition. Our exposure to credit loss in the event of non-performance by the third-party to the financial instrument for commitments to extend credit and letters of credit is represented by the contractual notional amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments.

The following table details the amounts and expected maturities of significant commitments at September 30, 2012:



	One Year or Less		Over One through Three Years		Over Three through Five Years		Over Five Years		Total
	(Dollars in thousands)
Commitments to extend credit:
Commercial and industrial	$	7,640	$	75	$	—	$	16	$	7,731
Commercial real estate:
Owner occupied	8,576		135		—		—		8,711
Non-owner occupied	4,117		3,883		—		—		8,000
Multifamily	5,538		21		—		—		5,559
Commercial construction and land development	1,234		—		—		—		1,234
Commercial participations	48		—		—		—		48
Retail	4,224		—		—		—		4,224
Commitments to fund unused:
Equity lines of credit	—		—		—		37,990		37,990
Commercial business lines	44,768		4,831		—		—		49,599
Construction loans	191		250		—		—		441
Consumer overdraft lines	123		—		—		—		123
Credit enhancements	2,665		—		4,426		8,512		15,603
Letters of credit	1,921		—		—		—		1,921
	$	81,045	$	9,195	$	4,426	$	46,518	$	141,184

The commitments listed above do not necessarily represent future cash requirements, in that these commitments often expire without being drawn upon. Credit enhancements expire at various dates through 2018. Letters of credit expire at various dates through 2013.

We also have commitments to fund community investments through investments in various limited partnerships, which represent future cash outlays for the construction and development of properties for low-income housing, small business real estate, and historic tax credit projects that qualify under the Community Reinvestment Act. These commitments include $376,000 to be funded over two years. The timing and amounts of these commitments are projected based upon the financing arrangements provided in each project’s partnership agreement, and could change due to variances in the construction schedule, project revisions, or the cancellation of the project. These commitments are not included in the commitment table above.

Credit enhancements are related to the issuance by municipalities of taxable and nontaxable revenue bonds. The proceeds from the sale of such bonds are loaned to for-profit and not-for-profit companies for economic development projects. In order for the bonds to receive AAA ratings, which provide for a lower interest rate, the FHLB issues, in favor of the bond trustee, an Irrevocable Direct Pay Letter of Credit (IDPLOC) for our account. Since we, in accordance with the terms and conditions of a Reimbursement Agreement with the FHLB, would be required to reimburse the FHLB for draws against the IDPLOC, these facilities are analyzed, appraised, secured by real estate mortgages, and monitored as if we had funded the project initially.

Regulatory Capital

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to quantitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios set forth in the below table of total risk-based, tangible, and core capital, as defined in the regulations. The Bank met all capital adequacy requirements to which it is subject as of September 30, 2012 and December 31, 2011.

At September 30, 2012, the Bank was deemed to be “well-capitalized” and in excess of regulatory requirements set by the OCC. The total amount of deferred tax assets not included for regulatory capital purposes was $8.4 million and $8.6 million, respectively, at September 30, 2012 and December 31, 2011. Determining the amount of deferred tax assets included or excluded in periodic regulatory capital calculations requires significant judgment when assessing a number of factors. In assessing the amount of the deferred tax assets includable in capital, management considers a number of relevant factors including the amount of deferred tax assets dependent on future taxable income, the amount of taxes that could be recovered through loss carrybacks, the reversal of temporary book/tax differences, projected future taxable income within one year, tax planning strategies, and OCC limitations. Using all information available to management at each statement of condition date, these factors are reviewed and can and do vary from period to period.

The current regulatory capital requirements and the actual capital levels of the Bank at September 30, 2012 and December 31, 2011 are presented in the following table. There are no conditions or events since September 30, 2012 that management believes have changed the Bank’s category.



	Actual				For Capital Adequacy Purposes			To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Amount		Ratio	Amount		Ratio
	(Dollars in thousands)
At September 30, 2012:
Tangible capital to adjusted total assets	$	98,192	8.85	%	$	16,646	>= 1.5	$	22,194	>= 2.0
Tier 1 (core) capital to adjusted total assets	98,192		8.85		44,388		>= 4.0	55,485		>= 5.0
Tier 1 (core) capital to risk-weighted assets	98,192		12.56		31,269		>= 4.0	46,903		>= 6.0
Total capital to risk-weighted assets	107,996		13.82		62,537		>= 8.0	78,172		>= 10.0

At December 31, 2011:
Tangible capital to adjusted total assets	$	94,502	8.26	%	$	17,151	>= 1.5	$	22,868	>= 2.0
Tier 1 (core) capital to adjusted total assets	94,502		8.26		45,737		>= 4.0	57,171		>= 5.0
Tier 1 (core) capital to risk-weighted assets	94,502		11.40		33,168		>= 4.0	49,752		>= 6.0
Total capital to risk-weighted assets	104,892		12.65		66,336		>= 8.0	82,920		>= 10.0

The following table reflects the adjustments required to reconcile the Bank’s shareholders’ equity to the Bank’s regulatory capital at September 30, 2012:



	Tangible			Core			Risk-Based
	(Dollars in thousands)
Shareholders’ equity of the Bank	$	107,211		$	107,211		$	107,211
Disallowed deferred tax asset	(8,381		)	(8,381		)	(8,381		)
Adjustment for unrealized losses on certain available-for-sale securities	195			195			195
Other	(833		)	(833		)	(833		)
General allowance for loan losses	—			—			9,804
Regulatory capital of the Bank	$	98,192		$	98,192		$	107,996

Total adjusted assets for Tangible and Tier 1 (Core) capital purposes	$	1,109,703		$	1,109,703
Total risk-weighted assets for risk-based capital purposes							$	781,716

The increase in the Bank’s risk-based capital ratio from December 31, 2011 is primarily a result of an increase in the Bank’s shareholders’ equity from net income for the nine months ended September 30, 2012 combined with a decrease in total risk-weighted assets due to a decrease in 20% risk-weighted mortgage backed securities and a decrease in 100% risk-weighted loans and other real estate owned.

Determining the amount of deferred tax assets included or excluded in periodic regulatory capital calculations requires significant judgment when assessing a number of factors. In assessing the amount of the disallowed deferred tax asset, we consider a number of relevant factors including the amount of deferred tax assets dependent on future taxable income, the amount of taxes that could be recovered through loss carrybacks, the reversal of temporary book tax differences, projected future taxable income within one year, available tax planning strategies, and OCC limitations. Using all information available to us at each statement of condition date, these factors are reviewed and vary from period to period.

On June 7, 2012, the U.S. banking regulators released a notice of proposed rule-making that would substantially revise the regulatory risk-based capital rules currently applicable to the Company and the Bank. The proposed rules implement the “Basel III” international regulatory capital reforms and certain changes required by the Dodd-Frank Act. The proposed rules are subject to a comment period that ended on October 22, 2012.

The proposed rules include new risk-based capital and leverage ratios, which would be phased in beginning in 2013 through 2019, and would refine the definition of what constitutes “capital” for purposes of calculating those ratios. The proposed new minimum capital level requirements applicable to the Company and the Bank under the proposals would be: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4%. The proposed rules would also establish a “capital conservation buffer” of 2.5% above the new regulatory minimum capital requirements. The new capital conservation buffer requirement would be phased in beginning in January 2016 until fully implemented in January 2019. An institution would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. The proposed rules also implement revisions and clarifications consistent with Basel III regarding the various components of Tier 1 capital, including common equity, unrealized gains and losses, as well as certain instruments that will no longer qualify as Tier 1 capital, some of which would be phased out over time.

The proposed rules also set forth certain changes to the calculation of risk-weighted assets, which we would be required to utilize beginning January 1, 2015. Risk-weighted assets would be calculated using new and expanded risk-weighting categories, including higher risk-weightings assigned to certain commercial real estate loans, past due or non-accrual loans, certain residential mortgage loans, unfunded commitments of less than one year, and portions of deferred tax assets exceeding certain limits.

The federal bank regulatory agencies also proposed revisions to the prompt corrective action framework, which is designed to place restrictions on insured depository institutions, including the Bank, if their capital levels begin to show signs of weakness. These revisions would take effect January 1, 2015. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions would be required to meet the following increased capital level requirements in order to qualify as “well capitalized:” (i) a new common equity Tier 1 capital ratio of 6.5%; (ii) a Tier 1 capital ratio of 8% (increased from 6%); (iii) a total capital ratio of 10% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 5% (increased from 4%).

We continue to evaluate the impact of the proposed rules, and based on our current capital and balance sheet composition, we expect to meet the requirements as set forth in the proposed rules if adopted by U.S. banking regulators within the specified timelines. However, until the proposals are finalized and the timing of the implementation of the rules is determined, some uncertainty exists with respect to the ultimate impact on the Company and the Bank.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Our primary market risk is considered to be interest rate risk. Interest rate risk on our balance sheet arises from the maturity mismatch of interest-earning assets versus interest-bearing liabilities, as well as the potential for maturities to shorten or lengthen on our interest-earning assets, and to a lesser extent on our interest-bearing liabilities due to the exercise of options. The most common of these are prepayment options on mortgage loans, and commercial mortgage-backed securities, and to a lesser extent jump-rate features in certain of our certificates

of deposit. Management’s goal, through policies established by the Asset/Liability Management Committee of the Board of Directors (ALCO), is to maximize net interest income while achieving adequate returns on equity capital and managing our balance sheet within the established interest rate risk policy limits prescribed by the ALCO.

We maintain a written Asset/Liability Management Policy that establishes written guidelines for the asset/liability management function, including the management of net interest margin, interest rate risk (IRR), and liquidity. The Asset/Liability Management Policy falls under the authority of the Board of Directors which in turn assigns its formulation, revision, and administration to the ALCO. The ALCO schedules monthly meetings and consists of certain senior officers and one outside director. The results of the meetings are reported to the Board of Directors. The primary duties of the ALCO are to develop reports and establish procedures to measure and monitor IRR, verify compliance with Board approved IRR tolerance limits, take appropriate actions to mitigate those risks, monitor and discuss the status and results of implemented strategies and tactics, monitor our capital position, review the current and prospective liquidity positions, and monitor alternative funding sources. The policy requires management to measure overall IRR exposure using Net Present Value analysis and earnings-at-risk analysis.

We use Net Portfolio Value Analysis as the primary measurement of our IRR. Under prior OTS regulations in Thrift Bulletin 13a, we are required to measure our IRR assuming various increases and decreases in general interest rates and their effect on our market value of portfolio equity. The Board of Directors has established limits to changes in Net Portfolio Value (NPV), (including limits regarding the change in net interest income discussed below), across a range of hypothetical interest rate changes. If estimated changes to NPV and net interest income are not within these limits, the Board may direct management to adjust its asset/liability mix to bring its IRR within Board limits. NPV is computed as the difference between the market value of assets and the market value of liabilities, adjusted for the value of off-balance-sheet items.

As of September 30, 2012, the Company is reporting IRR results based on output from its recently installed internal model. The goals of the model change are: to increase the ability to model multiple scenarios and on a more timely basis; to improve securities cash flow projections and shocked economic values for securities; and to allow for improved modeling for rate caps and floors on individual loans, investments, or deposits.

NPV analysis measures our IRR by calculating the estimated change in NPV of our cash flows from interest-sensitive assets and liabilities, as well as certain off-balance-sheet items, in the event of a shock in interest rates ranging down 100 to up 300 basis points. The following table shows the change in NPV applying the various instantaneous rate shocks to the Bank’s interest-earning assets and interest-bearing liabilities as of September 30, 2012 and December 31, 2011.



		Net Portfolio Value
		At September 30, 2012							At December 31, 2011
		$ Amount		$ Change			% Change		$ Amount		$ Change			% Change
		(Dollars in thousands)
Assumed Change in Interest Rates (Basis Points):
+	300	$	130,097	$	10,541		8.8	%	$	128,623	$	18,838		17.2	%
+	200	128,158		8,602			7.2		125,450		15,665			14.3
+	100	124,243		4,687			3.9		119,804		10,019			9.1
	0	119,556		—			—		109,785		—			—
-	100	116,751		(2,805		)	(2.3	)	95,325		(14,460		)	(13.2	)

The increase in the base NPV from December 31, 2011 to September 30, 2012 was caused mainly by an increase in the market value of investment securities and longer durations on non-maturity deposits.

Our reported earnings at risk analysis models the impact of instantaneous parallel shifts in yield curve changes in interest rates (assuming interest rates rise and fall in increments of 100 basis points), on anticipated net interest income over a twelve-month horizon. These models are modeling underlying cash flows in each of our interest-sensitive portfolios under these changing rate environments. This includes adjusting anticipated prepayments as well as modeling anticipated changes in interest rates paid on core deposit accounts, whose rates do not necessarily move in any relationship to movements in U.S. Treasury rates. We compare these results to our results assuming flat interest rates.

The following table presents the projected changes in net interest income over a twelve-month period for the various interest rate change (rate shocks) scenarios at September 30, 2012 and December 31, 2011, respectively.



		Change in Net Interest Income Over a Twelve Month Period
		September 30, 2012				December 31, 2011
		$ Change		% Change		$ Change		% Change
		(Dollars in thousands)
Assumed Change in Interest Rates (Basis Points):
+	300	$	3,698	11.4	%	$	1,008	2.8	%
+	200	2,397		7.4		678		1.9
+	100	1,157		3.6		297		.8
-	100	226		.7		155		.4

The table above indicates that if interest rates were to move up 200 basis points, net interest income would be expected to increase 7.4% in year one; and if interest rates were to move down 100 basis points, net interest income would be expected to increase .7% in year one. The primary causes for the changes in net interest income over the twelve-month period were a result of the changes in the composition of interest-earning assets and interest-bearing liabilities, their repricing characteristics and frequencies, and related interest rates. The net interest income projections for rising rates have improved since December 31, 2011 as the Bank has been growing low-cost core deposits, shifting the investment securities portfolio from fixed-rate bonds to floating-rate bonds, and growing interest-earning bank deposit assets. Actual results will differ from the above model results due to timing, magnitude, and frequency of interest rate changes, as well as changes in market conditions and management strategies. The above table does not reflect any actions we might take in response to changes in interest rates.

We manage our IRR position by holding assets with various desired IRR characteristics, implementing certain pricing strategies for loans and deposits, and implementing various investment securities portfolio strategies. On a quarterly basis, the ALCO reviews the calculations of all IRR measures for compliance with the Board approved tolerance limits. At September 30, 2012, we were in compliance with all of our tolerance limits.

The IRR analyses include the assets and liabilities of the Bank only. Inclusion of the parent company assets and liabilities would not have a material impact on the results presented.

Item 4. Controls and Procedures

No change in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) or 15d-15(f) under the Securities Exchange Act of 1934, as amended) occurred during the quarter ended September 30, 2012 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Management evaluated, with the participation of the Chief Executive Officer and Chief Financial Officer, the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) or 15(d)-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based on such evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s

disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and regulations and are operating in an effective manner as of such date.

Part II. OTHER INFORMATION

Item 1. Legal Proceedings

The Company is involved in routine legal proceedings occurring in the ordinary course of business, which, in the aggregate, are believed to be immaterial to the financial condition, results of operations, and cash flows of the Company.

Item 1A. Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in “Item 1A. Risk Factors” contained in our Annual Report on Form 10-K for the year ended December 31, 2011 (the 2011 Form 10-K), which could materially affect our business, financial condition, or future results. There have been no material changes from the risk factors as disclosed in the 2011 Form 10-K.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds


(a)	Not applicable.


(b)	Not applicable.

(c)

We did not repurchase any shares of our common stock during the quarter ended September 30, 2012. Under our repurchase plan publicly announced on March 20, 2008 for 530,000 shares, we have 448,612 shares that may yet be purchased. We are currently prohibited from repurchasing our common stock without prior approval of the FRB of Chicago pursuant to an informal regulatory agreement with the FRB of Chicago.

Item 3. Defaults Upon Senior Securities


(a)	None.


(b)	Not applicable.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information


(a)	Not applicable.


(b)	None.

Item 6. Exhibits



(a)		List of exhibits (filed herewith unless otherwise noted).
3.1		Articles of Incorporation of CFS Bancorp, Inc. (1)
3.2		Amended and Restated Bylaws of CFS Bancorp, Inc. (2)
4.0		Form of Stock Certificate of CFS Bancorp, Inc. (3)
31.1		Rule 13a-14(a) Certification of Chief Executive Officer
31.2		Rule 13a-14(a) Certification of Chief Financial Officer
32.0		Section 1350 Certifications
101.0		The following financial statements from the CFS Bancorp, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 2012, filed on November 2, 2012, formatted in Extensive Business Reporting Language (XBRL): (i) condensed consolidated statements of condition, (ii) condensed consolidated statements of income, (iii) condensed consolidated statements of comprehensive income, (iv) condensed consolidated statements of changes in shareholders’ equity, (v) condensed consolidated statements of cash flows, and (vi) the notes to condensed consolidated financial statements (4)


(1)	Incorporated herein by Reference to the Company’s Definitive Proxy Statement from the 2005 Annual Meeting of Shareholders filed with the SEC on March 25, 2005 (File No. 000-24611).


(2)	Incorporated herein by Reference to the Company’s Form 8-K filed with the SEC on December 17, 2010.


(3)	Incorporated herein by Reference to the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 filed with the SEC on March 15, 2007.


(4)	As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1033 and Section 18 of the Securities Exchange Act of 1934.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

CFS BANCORP, INC.



Date:	November 2, 2012	By:	/s/ Daryl D. Pomranke
			Daryl D. Pomranke President and Chief Executive Officer

Date:	November 2, 2012	By:	/s/ Jerry A. Weberling
			Jerry A. Weberling Executive Vice President and Chief Financial Officer