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 June 30, 2013.

OR

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 10,893,810 shares of Common Stock issued and outstanding as of July 31, 2013.

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 Operations	4
	Condensed Consolidated Statements of Comprehensive Income (Loss)	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	38
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	69
Item 4.	Controls and Procedures	71
	PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	71
Item 1A.	Risk Factors	71
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	72
Item 3.	Defaults Upon Senior Securities	72
Item 4.	Mine Safety Disclosures	72
Item 5.	Other Information	72
Item 6.	Exhibits	72
Signature Page		73
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

	June 30, 2013			December 31, 2012
	(Unaudited)
	(Dollars in thousands)
ASSETS
Cash and amounts due from depository institutions	$	16,697		$	20,577
Interest-earning deposits with banks	132,929			114,122
Cash and cash equivalents	149,626			134,699
Investment securities available-for-sale, at fair value	219,931			203,290
Investment securities held-to-maturity, at cost	12,984			15,458
Loans receivable, net of deferred fees	660,072			692,267
Allowance for loan losses	(12,660		)	(12,185		)
Net loans	647,412			680,082
Loans held for sale	1,620			1,509
Federal Home Loan Bank stock, at cost	6,188			6,188
Bank-owned life insurance	36,367			36,604
Accrued interest receivable	2,470			2,528
Other real estate owned	21,878			23,347
Office properties and equipment	15,293			15,768
Net deferred tax assets	12,375			11,302
Other assets	5,404			7,334
Total assets	$	1,131,548		$	1,138,109
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits	$	961,945		$	965,791
Borrowed funds	49,306			50,562
Advance payments by borrowers for taxes and insurance	4,322			4,734
Other liabilities	4,763			5,200
Total liabilities	1,020,336			1,026,287
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; 10,894,112 and 10,874,687 shares outstanding	234			234
Additional paid-in capital	187,207			187,260
Retained earnings	78,033			76,914
Treasury stock, at cost; 12,529,194 and 12,548,619 shares	(154,443		)	(154,698		)
Accumulated other comprehensive income, net of tax	181			2,112
Total shareholders’ equity	111,212			111,822
Total liabilities and shareholders’ equity	$	1,131,548		$	1,138,109

See accompanying notes to the unaudited condensed consolidated financial statements.

3

CFS BANCORP, INC.

Condensed Consolidated Statements of Operations

	Three Months Ended June 30,					Six Months Ended June 30,
	2013			2012		2013			2012
	(Unaudited)
	(Dollars in thousands, except share and per share data)
Interest income:
Loans receivable	$	7,495		$	8,243	$	15,195		$	16,629
Investment securities	1,731			2,186		3,324			4,316
Other interest-earning assets	121			103		245			196
Total interest income	9,347			10,532		18,764			21,141
Interest expense:
Deposits	828			1,294		1,759			2,684
Borrowed funds	286			294		571			590
Total interest expense	1,114			1,588		2,330			3,274
Net interest income	8,233			8,944		16,434			17,867
Provision for loan losses	1,076			1,150		1,586			2,200
Net interest income after provision for loan losses	7,157			7,794		14,848			15,667
Non-interest income:
Deposit related fees	1,648			1,578		3,168			3,047
Net gain (loss) on sale of:
Investment securities (includes $192 and $305 for the three months ended June 30, 2013 and 2012, respectively, and $376 and $723 for the six months ended June 30, 2013 and 2012, respectively, related to accumulated other comprehensive earnings reclassifications)	192			305		376			723
Loans held for sale	106			200		569			359
Other real estate owned	(542		)	86		(532		)	39
Income from bank-owned life insurance	134			162		464			702
Other income	268			312		615			597
Total non-interest income	1,806			2,643		4,660			5,467
Non-interest expense:
Compensation and employee benefits	4,418			4,467		8,788			9,180
Professional fees	1,141			198		1,469			451
Net occupancy expense	625			679		1,319			1,387
Data processing expense	544			445		1,057			883
FDIC insurance premiums and regulatory assessments	479			490		960			978
Furniture and equipment expense	398			468		801			925
Marketing	315			322		584			726
Other real estate owned related expense, net	114			316		364			934
Loan collection expense	248			119		381			237
Severance and early retirement expense	—			—		—			876
Other general and administrative expenses	1,182			1,038		2,196			2,172
Total non-interest expense	9,464			8,542		17,919			18,749
Income (loss) before income tax expense (benefit)	(501		)	1,895		1,589			2,385
Income tax expense (benefit)	(334		)	541		254			541
Net income (loss)	$	(167	)	$	1,354	$	1,335		$	1,844
Per share data:
Basic earnings (loss) per share	$	(.02	)	$	.13	$	.12		$	.17
Diluted earnings (loss) per share	(.02		)	.13		.12			.17
Cash dividends declared per share	.01			—		.02			.01
Weighted-average common and common share equivalents outstanding:
Basic	10,790,267			10,750,313		10,764,855			10,724,103
Diluted	10,869,069			10,806,555		10,840,096			10,776,476

See accompanying notes to the unaudited condensed consolidated financial statements.

4

CFS BANCORP, INC.

Condensed Consolidated Statements of Comprehensive Income (Loss)

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
	(Unaudited)
	(Dollars in thousands)
Net income (loss)	$	(167	)	$	1,354		$	1,335		$	1,844
Other comprehensive loss:
Unrealized holding losses arising during the period related to investment securities available-for-sale:
Unrealized net losses	(2,230		)	(291		)	(2,799		)	(609		)
Related income tax benefit	860			90			1,099			376
Net unrealized losses	(1,370		)	(201		)	(1,700		)	(233		)
Less: reclassification adjustment for net gains realized during the period on investment securities available-for-sale:
Realized net gains	192			305			376			723
Related income tax expense	(74		)	(119		)	(145		)	(270		)
Net realized gains	118			186			231			453
Other comprehensive loss	(1,488		)	(387		)	(1,931		)	(686		)
Comprehensive income (loss)	$	(1,655	)	$	967		$	(596	)	$	1,158

See accompanying notes to the unaudited condensed consolidated financial statements.

5

CFS BANCORP, INC.

Condensed Consolidated Statements of Changes in Shareholders’ Equity

	Common Stock		Additional Paid-In Capital			Retained Earnings			Treasury Stock			Accumulated Other Comprehensive Income (Loss)			Total
	(Unaudited) (Dollars in thousands)
Balance at January 1, 2012	$	234	$	187,030		$	72,683		$	(154,773	)	$	(1,926	)	$	103,248
Net income	—		—			1,844			—			—			1,844
Other comprehensive loss	—		—			—			—			(686		)	(686		)
Amortization of stock based compensation	—		6			—			—			—			6
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 ($.01 per share)	—		—			(109		)	—			—			(109		)
Balance at June 30, 2012	$	234	$	187,379		$	74,420		$	(154,824	)	$	(2,612	)	$	104,597
Balance at January 1, 2013	$	234	$	187,260		$	76,914		$	(154,698	)	$	2,112		$	111,822
Net income	—		—			1,335			—			—			1,335
Other comprehensive loss	—		—			—			—			(1,931		)	(1,931		)
Amortization of stock based compensation	—		5			—			—			—			5
Forfeiture of restricted stock awards	—		538			3			(538		)	—			3
Vesting of restricted stock awards	—		229			—			(32		)	—			197
Grants of restricted stock awards	—		(825		)	—			825			—			—
Dividends declared on common stock ($.02 per share)	—		—			(219		)	—			—			(219		)
Balance at June 30, 2013	$	234	$	187,207		$	78,033		$	(154,443	)	$	181		$	111,212

See accompanying notes to the unaudited condensed consolidated financial statements.

6

CFS BANCORP, INC.

Condensed Consolidated Statements of Cash Flows

	Six Months Ended June 30,
	2013			2012
	(Unaudited)
	(Dollars in thousands)
OPERATING ACTIVITIES:
Net income	$	1,335		$	1,844
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses	1,586			2,200
Depreciation and amortization	638			760
Net discount accretion on investment securities available-for-sale	(667		)	(881		)
Net premium amortization on investment securities held-to-maturity	54			66
Net (gain) loss on sale of:
Investment securities	(376		)	(723		)
Loans held for sale	(569		)	(359		)
Other real estate owned	532			(39		)
Properties and equipment	(3		)	(8		)
Writedowns on other real estate owned	318			684
Deferred income tax expense	178			554
Amortization of cost of stock benefit plans	5			—
Proceeds from sale of loans held for sale	25,657			20,790
Origination of loans held for sale	(25,003		)	(19,689		)
Increase in cash surrender value of bank-owned life insurance	(464		)	(702		)
Net change in other assets and liabilities	3,067			(3,169		)
Net cash flows provided by operating activities	6,288			1,328
INVESTING ACTIVITIES:
Proceeds from sale of:
Investment securities, available-for-sale	23,366			22,343
Other real estate owned	2,902			1,950
Properties and equipment	3			26
Proceeds from maturities and paydowns of:
Investment securities, available-for-sale	21,958			31,715
Investment securities, held-to-maturity	2,420			2,340
Purchases of:
Investment securities, available-for-sale	(64,096		)	(46,032		)
Properties and equipment	(163		)	(423		)
Net change in loans receivable	27,409			(6,854		)
Proceeds from bank-owned life insurance	701			542
Net cash flows provided by investing activities	14,500			5,607
FINANCING ACTIVITIES:
Net decrease in:
Deposit accounts	(3,974		)	(10,330		)
Advance payments by borrowers for taxes and insurance	(412		)	(32		)
Short-term borrowed funds	(1,150		)	(2,794		)
Repayments of Federal Home Loan Bank advances	(106		)	(100		)
Dividends paid on common stock	(219		)	(218		)
Net cash flows used for financing activities	(5,861		)	(13,474		)
Increase (decrease) in cash and cash equivalents	14,927			(6,539		)
Cash and cash equivalents at beginning of period	134,699			92,072
Cash and cash equivalents at end of period	$	149,626		$	85,533

7

CFS BANCORP, INC.

Condensed Consolidated Statements of Cash Flows (continued)

	Six Months Ended June 30,
	2013		2012
	(Unaudited)
	(Dollars in thousands)
Supplemental disclosures:
Loans and land transferred to other real estate owned	$	2,337	$	2,719
Cash paid for interest on deposits	1,744		2,687
Cash paid for interest on borrowed funds	574		594
Cash paid for income taxes	—		—

See accompanying notes to the unaudited condensed consolidated financial statements.

8

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 six months ended June 30, 2013 are not necessarily indicative of the results expected for the year ending December 31, 2013. The June 30, 2013 condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes for the year ended December 31, 2012 included in the Company’s Annual Report on Form 10-K. The Company’s condensed consolidated statement of condition as of December 31, 2012 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 subsidiary, 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.

9

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

	Three Months Ended June 30,					Six Months Ended June 30,
	2013			2012		2013		2012
	(Dollars in thousands, except share and per share data)
Net income (loss)	$	(167	)	$	1,354	$	1,335	$	1,844
Weighted-average common shares:
Outstanding	10,790,267			10,750,313		10,764,855		10,724,103
Equivalents (1)	78,802			56,242		75,241		52,373
Total	10,869,069			10,806,555		10,840,096		10,776,476
Earnings (loss) per share:
Basic	$	(.02	)	$	.13	$	.12	$	.17
Diluted	(.02		)	.13		.12		.17
Number of anti-dilutive stock options excluded from the diluted earnings (loss) per share calculation	242,995			399,795		314,995		425,895
Weighted-average exercise price of anti-dilutive option shares	$	14.12		$	14.06	$	14.09	$	14.06

(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:

	June 30, 2013
	Par Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
Available-for-sale investment securities:
U.S. Treasury securities	$	61,000	$	61,395	$	324	$	(535	)	$	61,184
Government sponsored entity (GSE) securities	23,000		23,477		354		(277		)	23,554
Collateralized mortgage obligations	64,285		60,680		3,013		(24		)	63,669
Commercial mortgage-backed securities	47,104		48,683		706		(20		)	49,369
GSE residential mortgage-backed securities	2,201		2,368		—		(190		)	2,178
Asset backed securities	3,818		3,569		181		—			3,750
Pooled trust preferred securities	21,178		19,466		—		(3,239		)	16,227
Total available-for-sale investment securities	$	222,586	$	219,638	$	4,578	$	(4,285	)	$	219,931
Held-to-maturity investment securities:
Asset backed securities	$	5,526	$	5,604	$	160	$	—		$	5,764
Municipal securities	7,380		7,380		23		(10		)	7,393
Total held-to-maturity investment securities	$	12,906	$	12,984	$	183	$	(10	)	$	13,157

10

	December 31, 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	$	17,000	$	16,964	$	405	$	(6	)	$	17,363
Government sponsored entity (GSE) securities	45,000		45,628		848		(8		)	46,468
Collateralized mortgage obligations	67,902		63,367		3,735		(36		)	67,066
Commercial mortgage-backed securities	44,267		45,178		1,251		—			46,429
GSE residential mortgage-backed securities	2,224		2,400		—		(32		)	2,368
Asset backed securities	4,182		3,876		177		—			4,053
Pooled trust preferred securities	24,508		22,409		—		(2,867		)	19,542
GSE preferred stock	200		—		1		—			1
Total available-for-sale investment securities	$	205,283	$	199,822	$	6,417	$	(2,949	)	$	203,290
Held-to-maturity investment securities:
Asset backed securities	$	6,446	$	6,578	$	219	$	—		$	6,797
Municipal securities	8,880		8,880		45		—			8,925
Total held-to-maturity investment securities	$	15,326	$	15,458	$	264	$	—		$	15,722

The Company’s investments in collateralized mortgage obligations consisted of $10.3 million and $4.0 million fair value, respectively, of GSE issued investment securities and $53.4 million and $63.1 million, respectively, of non-agency (private issued) residential investment securities at June 30, 2013 and December 31, 2012.

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:

	June 30, 2013
	Less than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(Dollars in thousands)
Available-for-sale investment securities:
U.S. Treasury securities	$	43,978	$	(535	)	$	—	$	—		$	43,978	$	(535	)
GSE securities	8,285		(277		)	—		—			8,285		(277		)
Collateralized mortgage obligations	7,595		(22		)	699		(2		)	8,294		(24		)
Commercial mortgage-backed securities	9,646		(20		)	—		—			9,646		(20		)
GSE residential mortgage-backed securities	2,178		(190		)	—		—			2,178		(190		)
Pooled trust preferred securities	—		—			16,227		(3,239		)	16,227		(3,239		)
Total available-for-sale investment securities	$	71,682	$	(1,044	)	$	16,926	$	(3,241	)	$	88,608	$	(4,285	)
Held-to-maturity investment securities:
Municipal securities	$	1,680	$	(10	)	$	—	$	—		$	1,680	$	(10	)
Total held-to-maturity investment securities	$	1,680	$	(10	)	$	—	$	—		$	1,680	$	(10	)

11

	December 31, 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)
Available-for-sale investment securities:
U.S. Treasury securities	$	4,984	$	(6	)	$	—	$	—		$	4,984	$	(6	)
GSE securities	2,468		(8		)	—		—			2,468		(8		)
Collateralized mortgage obligations	6,705		(36		)	—		—			6,705		(36		)
GSE residential mortgage-backed securities	2,368		(32		)	—		—			2,368		(32		)
Pooled trust preferred securities	—		—			19,542		(2,867		)	19,542		(2,867		)
	$	16,525	$	(82	)	$	19,542	$	(2,867	)	$	36,067	$	(2,949	)

Management evaluates 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 the Financial Accounting Standards Board Accounting Standards Codification (ASC) 320-10, Investments - Debt and Equity Securities. Current accounting guidance generally provides that if a marketable security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the investment securities must assess whether the impairment is other-than-temporary.

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 June 30, 2013, 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 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, regulatory considerations, 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 June 30, 2013 did not constitute other-than-temporary impairments.

12

The amortized cost and fair value of investment securities at June 30, 2013, 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 after one year through five years	$	61,395	$	61,184
GSE securities:
Due after one year through five years	17,031		17,348
Due after five years through ten years	6,446		6,206
Collateralized mortgage obligations:
Due after one year through five years	210		215
Due after five years through ten years	4,108		4,301
Due after ten years	56,362		59,153
Commercial mortgage-backed securities:
Due after ten years	48,683		49,369
GSE residential mortgage-backed securities:
Due after ten years	2,368		2,178
Asset backed securities:
Due after ten years	3,569		3,750
Pooled trust preferred securities:
Due after ten years	19,466		16,227
	$	219,638	$	219,931

	Held-to-Maturity
	Amortized Cost		Fair Value
	(Dollars in thousands)
Asset backed securities:
Due after one year through five years	$	5,604	$	5,764
Municipal securities:
Due in one year or less	3,000		3,011
Due after one year through five years	4,380		4,382
	$	12,984	$	13,157

The Company realized gross gains of $192,000 and $305,000, respectively, on the sale of available-for-sale investment securities for the three months ended June 30, 2013 and 2012. Gross gains realized on the sale of available-for-sale investment securities for the six months ended June 30, 2013 and 2012 totaled $376,000 and $723,000, respectively.

The carrying value of investment securities pledged as collateral to secure public deposits, repurchase sweep agreement (Repo Sweep) accounts, and other purposes was $16.7 million and $29.1 million, respectively, at June 30, 2013 and December 31, 2012.

13

At June 30, 2013, other than the U.S. Government, its agencies, and GSEs, the Company had holdings of investment securities from one separate issuer in an amount greater than 10% of shareholders’ equity as identified in the following table:

	Book Value		Market Value		# of Underlying Pools
	(Dollars in thousands)
Issuer:
JP Morgan Chase Commercial Mortgage Securities Corp	$	17,879	$	18,211	4

There are four different collateral pools of geographically diversified commercial real estate loans backing four commercial mortgage-backed securities issued by JP Morgan Chase Commercial Mortgage Securities Corp. Three of the four 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:

	June 30, 2013			December 31, 2012
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	95,675		$	102,628
Commercial real estate:
Owner occupied	97,906			98,046
Non-owner occupied	157,517			164,392
Multifamily	72,806			75,228
Commercial construction and land development	14,166			20,228
Commercial participations	3,661			5,311
Total commercial loans	441,731			465,833
Retail loans:
One-to-four family residential	170,879			175,943
Home equity lines of credit	44,026			46,477
Retail construction	913			1,176
Consumer	3,232			3,305
Total retail loans	219,050			226,901
Total loans receivable	660,781			692,734
Net deferred loan fees	(709		)	(467		)
Total loans receivable, net of deferred loan fees	$	660,072		$	692,267

14

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 on non-accrual status 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 450-20, Contingencies: Loss 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.

As a result of the significant economic downturn that was occurring both locally and nationally during 2008, it was necessary to redefine the Company’s credit and underwriting policies to better identify and evaluate the risks in the various categories of its loan portfolio. To continue the shift in the Company’s lending focus that began in mid-2007, it hired a Chief Operating Officer, who is now the Company’s Chief Executive Officer, to develop and execute a business and lending strategy focused on different markets than those the Company had historically pursued. In connection with implementing this lending strategy, a new Senior Credit Officer, credit manager, and four new credit analysts were also hired. Additionally, management developed and implemented a new credit policy and enhanced the Company’s underwriting standards and objective underwriting matrix. Based upon its revised lending strategy and defined risk tolerances, management continued to reduce its reliance on non-owner occupied commercial real estate loans, substantially reduced originations of commercial construction and land development loans, and stopped purchasing commercial participation and syndication loans. These loan portfolios carry a higher degree of risk due to the overall larger size of individual loans as well as repayment being dependent on the successful management of the project, the sale of the property securing the loan, or management of the participation by the lead lender.

In order to identify, segregate, and attempt to illustrate the remaining credit risk related to the deemphasized loan categories that were originated prior to the Company’s current risk tolerances, credit policy, and underwriting standards, management segregated the Company’s loan portfolio by the loans initial origination date into two categories. Loans that were originated prior to January 1, 2008 are included in the Pre-1/1/08 portfolio (Pre-1/1/08) whereas loans originated subsequent to January 2, 2008, are included in the Post-1/1/08 portfolio (Post-1/1/08). Loans that were renewed or modified subsequent to their initial origination are included in the respective portfolios based on their initial loan origination date.

15

During the second quarter of 2013, management revised its calculation methodology for the second component of the allowance for loan losses to segregate the historical losses on the Pre-1/1/08 and Post-1/1/08 loan portfolios. The revised analysis first identifies the historical loss experience by the Pre-1/1/08 and Post-1/1/08 portfolios in order to better identify the losses associated with each of the portfolios. Management then segregates the Pre-1/1/08 and Post-1/1/08 portfolios by loan reporting category and loan risk rating including pass, special mention, substandard, and doubtful rated credits. The historical loss factors are then applied to the respective loan Pre-1/1/08 and Post-1/1/08 portfolios, loan categories, and risk ratings. Management will then factor in additional qualitative adjustments based on a subjective determination and review of the underlying trends in internal and external factors currently affecting the loan portfolio. The net impact of the changes in the allowance methodology was a $2.94 million reduction in the required allowance at June 30, 2013 which was primarily due to the higher historical loss factors being applied to the smaller amount of loans within the Pre-1/1/08 portfolio and the calculation of a separate historical loss experience factor for pass-rated credits within the Pre-1/1/08 and the Post-1/1/08 portfolios.

Loan losses for all portfolio segments are charged-off against the allowance for loan losses 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 on a quarterly basis and adjusts the allowance 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 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.

16

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 six month periods ended June 30, 2013 and 2012:

	Three Months Ended June 30, 2013
				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			Consumer			Total
	(Dollars in thousands)
Balance at beginning of period	$	1,081		$	2,644		$	3,703		$	911		$	1,172		$	647		$	1,118		$	554		$	47		$	147		$	12,024
Provision for loan losses	(200		)	(154		)	3,788			(38		)	(918		)	(1,671		)	54			174			(26		)	67			1,076
Loans   charged-off:
Current period charge-offs	—			(232		)	(954		)	(91		)	(33		)	—			(9		)	(121		)	—			(74		)	(1,514		)
Previously established specific reserves	—			(55		)	—			—			—			—			—			—			—			—			(55		)
Total loans charged-off	—			(287		)	(954		)	(91		)	(33		)	—			(9		)	(121		)	—			(74		)	(1,569		)
Recoveries	5			22			54			1			—			1,035			3			2			—			7			1,129
Balance at end of period	$	886		$	2,225		$	6,591		$	783		$	221		$	11		$	1,166		$	609		$	21		$	147		$	12,660

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	Six Months Ended June 30, 2013
				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			Consumer			Total
	(Dollars in thousands)
Balance at beginning of period	$	1,169		$	2,470		$	3,761		$	926		$	1,436		$	601		$	1,101		$	552		$	16		$	153		$	12,185
Provision for loan losses	(216		)	(8		)	4,026			16			(1,182		)	(1,625		)	161			237			69			108			1,586
Loans   charged-off:
Current period charge-offs	(80		)	(232		)	(1,389		)	(161		)	(33		)	—			(119		)	(183		)	(64		)	(131		)	(2,392		)
Previously established specific reserves	—			(55		)	—			—			—			—			—			—			—			—			(55		)
Total loans charged-off	(80		)	(287		)	(1,389		)	(161		)	(33		)	—			(119		)	(183		)	(64		)	(131		)	(2,447		)
Recoveries	13			50			193			2			—			1,035			23			3			—			17			1,336
Balance at end of period	$	886		$	2,225		$	6,591		$	783		$	221		$	11		$	1,166		$	609		$	21		$	147		$	12,660

	Three Months Ended June 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		Consumer			Total
	(Dollars in thousands)
Balance at beginning of period	$	1,063		$	2,196	$	3,697		$	600	$	1,313	$	951		$	1,459		$	374		$	4	$	111		$	11,768
Provision for loan losses	645			151		163			—		129		(275		)	(43		)	334			—		46			1,150
Loans   charged-off:
Current period charge-offs	(436		)	—		(75		)	—		—		(25		)	(70		)	(243		)	—		(43		)	(892		)
Previously established specific reserves	—			—		—			—		—		—			—			—			—		—			—
Total loans charged-off	(436		)	—		(75		)	—		—		(25		)	(70		)	(243		)	—		(43		)	(892		)
Recoveries	12			—		14			—		—		—			2			3			—		5			36
Balance at end of period	$	1,284		$	2,347	$	3,799		$	600	$	1,442	$	651		$	1,348		$	468		$	4	$	119		$	12,062

18

	Six Months Ended June 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		Consumer			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	578			218		981			608			244		(791		)	1			317			1		43			2,200
Loans   charged-off:
Current period charge-offs	(555		)	—		(436		)	(378		)	—		(25		)	(184		)	(295		)	—		(60		)	(1,933		)
Previously established specific reserves	—			—		(718		)	—			—		—			—			—			—		—			(718		)
Total loans charged-off	(555		)	—		(1,154		)	(378		)	—		(25		)	(184		)	(295		)	—		(60		)	(2,651		)
Recoveries	25			—		37			—			—		—			10			4			—		13			89
Balance at end of period	$	1,284		$	2,347	$	3,799		$	600		$	1,442	$	651		$	1,348		$	468		$	4	$	119		$	12,062

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

	At June 30, 2013
			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		Consumer		Total
	(Dollars in thousands)
Ending allowance balance:
Individually evaluated for impairment	$	—	$	363	$	3,201	$	—	$	207	$	—	$	—	$	—	$	—	$	—	$	3,771
Collectively evaluated for impairment	886		1,862		3,390		783		14		11		1,166		609		21		147		8,889
Total evaluated for impairment	$	886	$	2,225	$	6,591	$	783	$	221	$	11	$	1,166	$	609	$	21	$	147	$	12,660
Loans receivable:
Individually evaluated for impairment	$	1,868	$	8,677	$	30,691	$	2,544	$	2,324	$	1,235	$	2,845	$	534	$	85	$	—	$	50,803
Collectively evaluated for impairment	93,807		89,229		126,826		70,262		11,842		2,426		168,034		43,492		828		3,232		609,978
Total loans receivable	$	95,675	$	97,906	$	157,517	$	72,806	$	14,166	$	3,661	$	170,879	$	44,026	$	913	$	3,232	$	660,781

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	At December 31, 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		Consumer		Total
	(Dollars in thousands)
Ending allowance balance:
Individually evaluated for impairment	$	—	$	—	$	217	$	—	$	180	$	—	$	—	$	—	$	—	$	—	$	397
Collectively evaluated for impairment	1,169		2,470		3,544		926		1,256		601		1,101		552		16		153		11,788
Total evaluated for impairment	$	1,169	$	2,470	$	3,761	$	926	$	1,436	$	601	$	1,101	$	552	$	16	$	153	$	12,185
Loans receivable:
Individually evaluated for impairment	$	2,039	$	9,082	$	21,503	$	3,351	$	2,366	$	339	$	1,808	$	620	$	—	$	—	$	41,108
Collectively evaluated for impairment	100,589		88,964		142,889		71,877		17,862		4,972		174,135		45,857		1,176		3,305		651,626
Total loans receivable	$	102,628	$	98,046	$	164,392	$	75,228	$	20,228	$	5,311	$	175,943	$	46,477	$	1,176	$	3,305	$	692,734

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.

20

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

	Risk Rating at June 30, 2013
	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	84,197	$	2,059	$	2,373	$	7,046	$	—	$	95,675
Commercial real estate:
Owner occupied	79,891		6,582		3,282		7,899		252		97,906
Non-owner occupied	103,195		5,787		17,364		31,171		—		157,517
Multifamily	61,007		2,218		6,523		3,058		—		72,806
Commercial construction and land development	4,427		390		—		8,999		350		14,166
Commercial participations	2,317		—		109		1,235		—		3,661
Total commercial loans	335,034		17,036		29,651		59,408		602		441,731
Retail loans:
One-to-four family residential	165,428		—		—		5,451		—		170,879
Home equity lines of credit	43,358		—		—		668		—		44,026
Retail construction	828		—		—		85		—		913
Consumer	3,232		—		—		—		—		3,232
Total retail loans	212,846		—		—		6,204		—		219,050
Total loans receivable	$	547,880	$	17,036	$	29,651	$	65,612	$	602	$	660,781

	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Current	$	543,095	$	17,036	$	29,651	$	39,274	$	—	$	629,056
Delinquent:
30-59 days	3,388		—		—		266		—		3,654
60-89 days	1,397		—		—		—		—		1,397
90 days or more	—		—		—		—		—		—
Non-accrual	—		—		—		26,072		602		26,674
Total loans receivable	$	547,880	$	17,036	$	29,651	$	65,612	$	602	$	660,781

21

	Risk Rating at December 31, 2012
	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	79,622	$	12,896	$	8,411	$	1,699	$	—	$	102,628
Commercial real estate:
Owner occupied	78,247		11,121		745		7,933		—		98,046
Non-owner occupied	116,080		19,115		18,899		10,214		84		164,392
Multifamily	68,213		3,233		597		3,185		—		75,228
Commercial construction and land development	17,088		774		—		2,016		350		20,228
Commercial participations	4,860		112		—		339		—		5,311
Total commercial loans	364,110		47,251		28,652		25,386		434		465,833
Retail loans:
One-to-four family residential	170,138		—		—		5,805		—		175,943
Home equity lines of credit	45,638		—		—		839		—		46,477
Retail construction	1,027		—		—		149		—		1,176
Consumer	3,305		—		—		—		—		3,305
Total retail loans	220,108		—		—		6,793		—		226,901
Total loans receivable	$	584,218	$	47,251	$	28,652	$	32,179	$	434	$	692,734

	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Current	$	580,930	$	46,469	$	27,037	$	5,650	$	—	$	660,086
Delinquent:
30-59 days	2,307		782		597		30		—		3,716
60-89 days	981		—		1,018		—		—		1,999
90 days or more	—		—		—		—		—		—
Non-accrual	—		—		—		26,499		434		26,933
Total loans receivable	$	584,218	$	47,251	$	28,652	$	32,179	$	434	$	692,734

22

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 transferred 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 on 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.

23

The Company’s loan portfolio delinquency status is summarized as follows:

	Delinquency at June 30, 2013
	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	$	—	$	385	$	—	$	1,499	$	1,884	$	93,791	$	95,675	$	304
Commercial real estate:
Owner occupied	291		306		—		5,815		6,412		91,494		97,906		1,713
Non-owner occupied	470		—		—		7,241		7,711		149,806		157,517		568
Multifamily	—		—		—		2,357		2,357		70,449		72,806		1,700
Commercial construction and land development	—		—		—		2,324		2,324		11,842		14,166		250
Commercial participations	—		—		—		1,235		1,235		2,426		3,661		1,235
Total commercial loans	761		691		—		20,471		21,923		419,808		441,731		5,770
Retail loans:
One-to-four family residential	2,528		706		—		5,451		8,685		162,194		170,879		1,468
Home equity lines of credit	365		—		—		667		1,032		42,994		44,026		16
Retail construction	—		—		—		85		85		828		913		—
Consumer	—		—		—		—		—		3,232		3,232		—
Total retail loans	2,893		706		—		6,203		9,802		209,248		219,050		1,484
Total loans receivable	$	3,654	$	1,397	$	—	$	26,674	$	31,725	$	629,056	$	660,781	$	7,254

	Delinquency at December 31, 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	$	152	$	917	$	—	$	449	$	1,518	$	101,110	$	102,628	$	228
Commercial real estate:
Owner occupied	426		21		—		5,417		5,864		92,182		98,046		2,976
Non-owner occupied	276		153		—		9,083		9,512		154,880		164,392		1,564
Multifamily	597		—		—		2,775		3,372		71,856		75,228		—
Commercial construction and land development	—		—		—		2,366		2,366		17,862		20,228		250
Commercial participations	—		—		—		339		339		4,972		5,311		—
Total commercial loans	1,451		1,091		—		20,429		22,971		442,862		465,833		5,018
Retail loans:
One-to-four family residential	1,836		908		—		5,671		8,415		167,528		175,943		1,596
Home equity lines of credit	417		—		—		683		1,100		45,377		46,477		48
Retail construction	—		—		—		150		150		1,026		1,176		—
Consumer	12		—		—		—		12		3,293		3,305		—
Total retail loans	2,265		908		—		6,504		9,677		217,224		226,901		1,644
Total loans receivable	$	3,716	$	1,999	$	—	$	26,933	$	32,648	$	660,086	$	692,734	$	6,662

24

The Company’s impaired loans are summarized in the following tables and include loans that are individually reviewed for impairment as well as impaired retail loans at June 30, 2013 that have not had foreclosure proceedings initiated and are below management’s scope for individual impairment review due to immateriality.

	At June 30, 2013
	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	$	1,868	$	1,989	$	80	$	—
Commercial real estate:
Owner occupied	5,008		6,968		1,851		—
Non-owner occupied	9,357		12,011		2,298		—
Multifamily	2,544		2,627		—		—
Commercial construction and land development	924		1,017		93		—
Commercial participations	1,235		1,235		—		—
Retail loans:
One-to-four family residential	6,851		7,007		156		—
Home equity lines of credit	667		784		117		—
Retail construction	85		150		65		—
Total	$	28,539	$	33,788	$	4,660	$	—
Loans with a specific valuation allowance:
Commercial real estate:
Owner occupied	$	3,669	$	4,201	$	470	$	363
Non-owner occupied	21,334		21,573		—		3,201
Commercial construction and land development	1,400		1,450		—		207
Total	$	26,403	$	27,224	$	470	$	3,771
Total impaired loans:
Commercial	$	47,339	$	53,071	$	4,792	$	3,771
Retail	7,603		7,941		338		—
Total	$	54,942	$	61,012	$	5,130	$	3,771

25

	At December 31, 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	$	2,039	$	2,498	$	423	$	—
Commercial real estate:
Owner occupied	9,082		11,201		2,034		—
Non-owner occupied	18,979		21,290		1,740		—
Multifamily	3,351		3,979		550		—
Commercial construction and land development	956		1,017		60		—
Commercial participations	339		5,583		5,104		—
Retail loans:
One-to-four family residential	7,041		7,206		165		—
Home equity lines of credit	713		808		95		—
Retail construction	150		150		—		—
Total	$	42,650	$	53,732	$	10,171	$	—
Loans with a specific valuation allowance:
Commercial real estate:
Non-owner occupied	$	2,524	$	2,586	$	—	$	217
Commercial construction and land development	1,410		1,450		—		180
Total	$	3,934	$	4,036	$	—	$	397
Total impaired loans:
Commercial	$	38,680	$	49,604	$	9,911	$	397
Retail	7,904		8,164		260		—
Total	$	46,584	$	57,768	$	10,171	$	397

26

The following table presents information related to the average recorded investment and interest income recognized on impaired loans for the periods indicated. The majority of the interest income is recognized on a cash basis at the time the payment is received.

	Three Months Ended June 30,								Six Months Ended June 30,
	2013				2012				2013				2012
	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	$	1,878	$	9	$	1,835	$	20	$	1,947	$	16	$	2,066	$	47
Commercial real estate:
Owner occupied	5,295		13		11,811		13		5,325		36		11,792		21
Non-owner occupied	10,167		44		28,547		113		10,532		84		29,179		182
Multifamily	2,545		4		3,703		10		2,546		7		3,890		21
Commercial construction and land development	952		—		3,316		—		954		—		3,316		—
Commercial participations	1,238		—		2,450		—		1,239		—		2,515		—
Retail loans:
One-to-four family residential	6,873		62		7,086		79		6,907		120		7,103		118
Home equity lines of credit	737		3		550		5		751		6		550		7
Retail construction	85		—		320		—		116		—		321		—
Total	$	29,770	$	135	$	59,618	$	240	$	30,317	$	269	$	60,732	$	396
Loans with a specific valuation allowance:
Commercial real estate:
Owner occupied	$	3,688	$	15	$	—	$	—	$	3,711	$	27	$	—	$	—
Non-owner occupied	21,369		413		2,592		—		21,420		694		2,593		—
Commercial construction and land development	1,400		—		1,450		—		1,402		—		1,450		—
Total	$	26,457	$	428	$	4,042	$	—	$	26,533	$	721	$	4,043	$	—
Total impaired loans:
Commercial	$	48,532	$	498	$	55,704	$	156	$	49,076	$	864	$	56,801	$	271
Retail	7,695		65		7,956		84		7,774		126		7,974		125
Total	$	56,227	$	563	$	63,660	$	240	$	56,850	$	990	$	64,775	$	396

27

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 experience 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 on 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 six months ended June 30, 2013 and 2012. The increase in the commercial real estate - non-owner occupied TDR balances was related to one performing and current $13.1 million loan which was deemed a TDR during the second quarter of 2013, resulting in the establishment of a $2.8 million specific reserve.

	Three Months Ended June 30,
	2013					2012
	Count	Balance prior to TDR		Balance after TDR		Count	Balance prior to TDR		Balance after TDR
	(Dollars in thousands)
Commercial loans:
Commercial real estate:
Non-owner occupied	1	$	13,123	$	13,123	—	$	—	$	—
Multifamily	1	1,612		1,700		—	—		—
Total commercial loans	2	14,735		14,823		—	—		—
Retail loans – one-to-four family residential	4	245		264		2	386		389
Total loans	6	$	14,980	$	15,087	2	$	386	$	389

28

	Six Months Ended June 30,
	2013					2012
	Count	Balance prior to TDR		Balance after TDR		Count	Balance prior to TDR		Balance after TDR
	(Dollars in thousands)
Commercial loans:
Commercial real estate:
Owner occupied	—	$	—	$	—	2	$	259	$	305
Non-owner occupied	1	13,123		13,123		1	66		83
Multifamily	1	1,612		1,700		—	—		—
Total commercial loans	2	14,735		14,823		3	325		388
Retail loans – one-to-four family residential	4	245		264		8	872		906
Total loans	6	$	14,980	$	15,087	11	$	1,197	$	1,294

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 and six months ended June 30, 2013 and had a one-to-four family residential TDR totaling $69,000 that defaulted during the three and six months ended June 30, 2012.

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

	June 30, 2013						December 31, 2012
	Accruing		Non- accruing		Total		Accruing		Non- accruing		Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	514	$	209	$	723	$	543	$	228	$	771
Commercial real estate:
Owner occupied	1,989		2,718		4,707		3,926		2,434		6,360
Non-owner occupied	15,249		2,691		17,940		11,524		3,057		14,581
Multifamily	250		1,700		1,950		253		—		253
Commercial construction and land development	—		250		250		—		250		250
Commercial participations	—		—		—		—		93		93
Total commercial loans	18,002		7,568		25,570		16,246		6,062		22,308
Retail loans – one-to-four family residential	1,400		3,160		4,560		1,370		3,307		4,677
Total troubled debt restructurings	$	19,402	$	10,728	$	30,130	$	17,616	$	9,369	$	26,985

At June 30, 2013, TDRs totaled $30.1 million, of which $5.2 million were performing in accordance with their agreements and on non-accrual status.

29

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 table sets forth the Company’s TDRs by portfolio segment to quantify the type of modification or concession provided for the three and six months ended June 30, 2013 and 2012:

	Three Months Ended June 30,
	2013								2012
	Commercial Real Estate
	Non- Owner Occupied		Multifamily		One-to- four Family Residential		Total		One-to- four Family Residential		Total
	(Dollars in thousands)
Rate reduction	$	—	$	—	$	77	$	77	$	169	$	169
Payment extension	—		—		50		50		—		—
Rate reduction and payment extension	13,123		—		79		13,202		220		220
A/B note structure	—		1,700		—		1,700		—		—
Other	—		—		58		58		—		—
Total troubled debt restructurings	$	13,123	$	1,700	$	264	$	15,087	$	389	$	389

	Six Months Ended June 30,
	2013								2012
	Commercial Real Estate								Commercial Real Estate
	Non- Owner Occupied		Multifamily		One-to- four Family Residential		Total		Owner Occupied		Non- Owner Occupied		One-to- four Family Residential		Total
	(Dollars in thousands)
Rate reduction	$	—	$	—	$	77	$	77	$	—	$	—	$	414	$	414
Payment extension	—		—		50		50		—		—		36		36
Rate reduction and payment extension	13,123		—		79		13,202		305		83		456		844
A/B note structure	—		1,700		—		1,700		—		—		—		—
Other	—		—		58		58		—		—		—		—
Total troubled debt restructurings	$	13,123	$	1,700	$	264	$	15,087	$	305	$	83	$	906	$	1,294

At June 30, 2013, TDRs increased $3.1 million to $30.1 million from $27.0 million at December 31, 2012. The activity related to the Company’s TDRs is presented in the following table for the periods indicated:

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
	(Dollars in thousands)
Beginning balance	$	16,633		$	25,883		$	26,985		$	25,849
Restructured loans identified as TDRs	15,087			389			15,087			1,294
Protective advances and miscellaneous	28			10			70			459
Repayments and payoffs	(577		)	(1,067		)	(802		)	(2,387		)
Charge-offs	(1,041		)	(47		)	(1,142		)	(47		)
Performing TDRs no longer considered impaired	—			—			(10,068		)	—
Ending balance	$	30,130		$	25,168		$	30,130		$	25,168

30

6.  Fair Value of Assets and Liabilities

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  June 30, 2013
	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	$	61,184	$	—	$	61,184	$	—
GSE securities	23,554		—		23,554		—
Collateralized mortgage obligations	63,669		—		63,669		—
Commercial mortgage-backed securities	49,369		—		49,369		—
GSE residential mortgage-backed securities	2,178		—		2,178		—
Asset backed securities	3,750		—		3,750		—
Pooled trust preferred securities	16,227		—		—		16,227

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			Fair Value Measurements at  December 31, 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	$	17,363	$	—	$	17,363	$	—
GSE securities	46,468		—		46,468		—
Collateralized mortgage obligations	67,066		—		67,066		—
Commercial mortgage-backed securities	46,429		—		46,429		—
GSE residential mortgage-backed securities	2,368		—		2,368		—
Asset backed securities	4,053		—		4,053		—
Pooled trust preferred securities	19,542		—		—		19,542
GSE preferred stock	1		1		—		—

Level 1 investment securities are valued using quoted prices in active markets for identical assets. The Company used Level 1 prices for its GSE preferred stock at December 31, 2012. The GSE preferred stock was sold for a $20,400 gain during the first quarter of 2013.

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. Two third-party pricing sources are used to compare the reasonableness of 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 providers 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.

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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 June 30, 2013 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 will be 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 condensed consolidated statements of condition using Level 3 inputs:

	Pooled Trust Preferred Securities
	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
	(Dollars in thousands)
Beginning balance	$	18,636		$	15,467		$	19,542		$	18,555
Total realized and unrealized gains (losses):
Included in accumulated other comprehensive income (loss)	(173		)	469			(372		)	(2,062		)
Principal repayments	(2,495		)	(1,141		)	(3,330		)	(1,810		)
Discount accretion	259			151			387			263
Ending balance	$	16,227		$	14,946		$	16,227		$	14,946

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 June 30, 2013
	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)	$	36,373	$	—	$	—	$	37,266
Other real estate owned	807		—		—		434

			Fair Value Measurements at December 31, 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)	$	10,292	$	—	$	—	$	10,292
Other real estate owned	2,492		—		—		2,492

Loans for which it is probable that the Company will not collect all principal and interest due according to 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.

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When the Company 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 second quarter of 2013. 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 $4.7 million and $880,000 for the three months ended June 30, 2013 and 2012, respectively, and $5.1 million and $1.7 million, respectively, for the six months ended June 30, 2013 and 2012. 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 $55,000 and $199,000, respectively, for the three months ended June 30, 2013 and 2012 and $164,000 and $684,000, respectively, for the six months ended June 30, 2013 and 2012. The changes were recorded as adjustments to current earnings through other real estate owned related expenses.

The following tables set forth quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements at the dates indicated:

	June 30, 2013
	Fair Value		Valuation Technique	Unobservable Inputs	Range (Weighted Averages)
	(Dollars in thousands)
Pooled trust preferred securities	$	16,227	Consensus pricing*	Default assumptions Discount rates	Varies by security 5.64% - 6.29% (5.76%)
Impaired loans (collateral-dependent)	36,373		Market comparable properties	Marketability discount	10%
Other real estate owned	807		Market comparable properties	Marketability discount	10%

	December 31, 2012
	Fair Value		Valuation Technique	Unobservable Inputs	Range (Weighted Averages)
	(Dollars in thousands)
Pooled trust preferred securities	$	19,542	Consensus pricing*	Default assumptions Discount rates	Varies by security 4.56% - 5.46% (4.74%)
Impaired loans (collateral-dependent)	10,292		Market comparable properties	Marketability discount	10%
Other real estate owned	2,492		Market comparable properties	Marketability discount	10%

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

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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 default assumptions and discount rates. 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 in the following tables 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.

	June 30, 2013
	Carrying Amount		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)
Financial Assets:
Cash and cash equivalents	$	149,626	$	149,626	$	149,626	$	—	$	—
Investment securities, available-for-sale	219,931		219,931		—		203,704		16,227
Investment securities, held-to-maturity	12,984		13,157		—		13,157		—
Loans receivable, net of allowance for loan losses	647,412		647,589		—		—		647,589
Loans held for sale	1,620		1,620		—		1,620		—
Federal Home Loan Bank stock	6,188		6,188		6,188		—		—
Interest receivable	2,470		2,470		—		2,470		—
Total financial assets	$	1,040,231	$	1,040,581	$	155,814	$	220,951	$	663,816
Financial Liabilities:
Deposits	$	961,945	$	963,508	$	657,314	$	—	$	306,194
Borrowed funds	49,306		51,368		—		51,368		—
Advance payments by borrowers	4,322		4,322		—		4,322		—
Interest payable	80		80		—		80		—
Total financial liabilities	$	1,015,653	$	1,019,278	$	657,314	$	55,770	$	306,194

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	December 31, 2012
	Carrying Amount		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)
Financial Assets:
Cash and cash equivalents	$	134,699	$	134,699	$	134,699	$	—	$	—
Investment securities, available-for-sale	203,290		203,290		1		183,747		19,542
Investment securities, held-to-maturity	15,458		15,722		—		15,722		—
Loans receivable, net of allowance for loan losses	680,082		681,550		—		—		681,550
Loans held for sale	1,509		1,509		—		1,509		—
Federal Home Loan Bank stock	6,188		6,188		6,188		—		—
Interest receivable	2,528		2,528		—		2,528		—
Total financial assets	$	1,043,754	$	1,045,486	$	140,888	$	203,506	$	701,092
Financial Liabilities:
Deposits	$	965,791	$	968,115	$	628,858	$	—	$	339,257
Borrowed funds	50,562		53,360		—		53,360		—
Advance payments by borrowers	4,734		4,734		—		4,734		—
Interest payable	68		68		—		68		—
Total financial liabilities	$	1,021,155	$	1,026,277	$	628,858	$	58,162	$	339,257

The carrying amount is the estimated fair value for cash and cash equivalents, accrued interest receivable and payable, and advance payments by borrowers. Investment security 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 Company 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 Company 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 tables.

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 condensed consolidated 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 2012 Annual Report on Form 10-K.

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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 June 30, 2013, shares available for future grants under the Equity Incentive Plan totaled 294,898 shares.

Restricted Stock

The following table presents the activity for restricted stock for the six months ended June 30, 2013:

	Number of Shares		Weighted- Average Grant-Date Fair Value
Unvested at December 31, 2012	120,737		$	4.72
Granted	67,430		7.66
Vested	(39,175	)	3.71
Forfeited	(43,969	)	5.75
Unvested at June 30, 2013	105,023		6.55

The compensation expense related to restricted stock for the three months ended June 30, 2013 and 2012 totaled $53,000 and $49,000, respectively. The compensation expense related to restricted stock for the six months ended June 30, 2013 totaled $39,000, net of a reversal of $52,000 for the unearned and forfeited 2012 grants. The compensation expense related to restricted stock for the six months ended June 30, 2012 was $70,000. At June 30, 2013, the remaining unamortized cost of the restricted stock awards was reflected as a reduction in additional paid-in capital and totaled $688,000. This cost is expected to be recognized over a weighted-average period of 3.4 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 six months ended June 30, 2013:

	Number of Options		Weighted- Average Exercise Price
Options outstanding at December 31, 2012	407,795		$	13.59
Granted	—		—
Exercised	—		—
Forfeited	—		—
Expired unexercised	(144,800	)	13.99
Options outstanding at June 30, 2013	262,995		13.38

For stock options outstanding at June 30, 2013, the range of exercise prices was $4.40 to $14.76, and the weighted-average remaining contractual term was 1.8 years. At June 30, 2013, 242,995 of the Company’s outstanding stock options were fully vested and out-of-the-money with no intrinsic value. Of the remaining 20,000 stock options, 5,000 were exercisable at June 30, 2013. All of the 20,000 options were in-the-money with an intrinsic value of $126,400, which represents the difference between the Company’s closing stock price on the last day of trading for the second quarter of 2013 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 months ended June 30, 2013 and 2012 was $3,000. Stock option expense for the six months ended June 30, 2013 and 2012 was $5,000 and $6,000, respectively. There were no stock options exercised during the three and six months ended June 30, 2013 and 2012. The Company reissues treasury shares, to the extent available, to satisfy option exercises.

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8. Pending Merger

In a joint press release dated May 13, 2013, First Merchants Corporation (First Merchants) and the Company announced First Merchants’ intent to acquire the Company in an all-stock transaction.  Under the terms of the merger agreement, shareholders of the Company will have the right to receive .65 shares of First Merchants common stock for each share of Company common stock held by them. The transaction is expected to close in the fourth quarter of 2013, subject to approval by the Company’s and First Merchants’ shareholders, regulatory approvals, and the satisfaction of customary conditions provided in the merger agreement.

Upon the closing of the merger, the Company will recognize a liability of approximately $1.9 million related to retention payments and the accelerated vesting of restricted shares and stock options of Company stock to certain executive officers of the Company.

9. Subsequent Event

On July 30, 2013, a putative class action lawsuit captioned Jay Orlando v. CFS Bancorp, Inc., et al., No. 13-CV-00261 was filed in U.S. District Court in the Northern District of Indiana against the Company, the individual directors of the Company, and First Merchants Corporation on behalf of the public shareholders of the Company. The complaint generally alleges various claims of federal securities law violations and that the directors of the Company breached their fiduciary duties by providing materially inadequate disclosures and material disclosure omissions with respect to the proposed merger with First Merchants Corporation. The plaintiffs seek (1) class certification, (2) to enjoin the merger or, in the event the merger is completed before entry of a final judgment, to rescind the merger or be awarded an unspecified amount of rescissory damages, (3) compensatory damages in an unspecified amount, and (4) costs and expenses, including attorneys’ fees. At this early stage of the litigation, it is not possible to assess the probability of a material adverse outcome or reasonably estimate any potential financial impact of the lawsuit on the Company. The Company believes the claim against it is without merit and intends to contest the matter vigorously.

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 United States 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. These forward-looking statements include, but are not limited to, statements regarding our ability to successfully execute our strategy and Strategic Growth and Diversification Plan, the level and sufficiency of the Bank’s current regulatory capital and equity ratios, our ability to continue to diversify the loan portfolio, efforts at deepening client relationships, increasing levels of core deposits, lowering non-performing asset levels, managing and reducing credit-related costs, increasing revenue growth and levels of earning assets, the effects of general economic and competitive conditions nationally and within our core market area, the ability to sell other real estate owned properties and mortgage loans held for sale, the sufficiency of the levels of provision for and the allowance for loan losses, amounts of charge-offs, levels of 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, the interest rate environment, and other risk factors identified in the filings we make with the SEC. In addition, these forward-looking statements include, but are not limited to, statements relating to the benefits of the proposed merger (the Merger) between First Merchants and us, including future financial and operating results and are subject to significant risks, assumptions, and uncertainties that may cause results to differ materially from those set forth in forward-looking statements, including, among other things: the risk that the businesses of First Merchants and us will not be integrated successfully or such integration may be more difficult, time-consuming, or costly than expected; expected revenue synergies and cost savings from the Merger may not be fully realized or realized within the expected time frame; revenues following the Merger may be lower than expected; client and employee relationships and business operations may be disrupted by the Merger; the ability to obtain required governmental and shareholder approvals; and the ability to complete the Merger in the expected timeframe.

You should not place undue reliance on any such forward-looking statements, which speak only as of the date made. The words “anticipate,” “believe,” “estimate,” “expect,” “indicate,” “intend,” “intend to,” “plan,” “project,” “should,” “will,” “would be,” or similar expressions, or the negative thereof, as well as statements that include future events, tense, or dates, or that are not historical or current facts, as they relate to us, our business, prospects, or our management, are intended to identify forward-looking statements. 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, 2012. Such forward-looking statements reflect our current views with respect to future events and are subject to certain risks, uncertainties, assumptions, and changes in circumstances. Forward-looking statements are not guarantees of future performance or outcomes, and actual results or events may differ materially from those included in these statements, including whether the merger is effectuated or not. We do not

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undertake, and specifically disclaim any obligation, to update any forward-looking statements to reflect occurrences, 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 Annual Report on Form 10-K for the year ended December 31, 2012. 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 on non-accrual status 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. These factors include for real estate properties the price at which an individual unit or unit(s) could be sold in the current market, the period of time over which the unit(s) would 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 450-20, Contingencies: Loss 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.

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During the second quarter of 2013, management revised its calculation methodology for the second component of the allowance for loan losses to segregate the historical losses on the Pre-1/1/08 and Post-1/1/08 loan portfolios (see “Loans Receivable” below in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussions about the Pre-1/1/08 and Post-1/1/08 loan portfolios.) The revised analysis first identifies the historical loss experience by the Pre-1/1/08 and Post-1/1/08 portfolios in order to better identify the losses associated with each of the portfolios. Management then segregates the Pre-1/1/08 and Post-1/1/08 portfolios by loan reporting category and loan risk rating including pass, special mention, substandard, and doubtful rated credits. The historical loss factors are then applied to the respective loan Pre-1/1/08 and Post-1/1/08 portfolios, loan categories, and risk ratings. Management will then factor in additional qualitative adjustments based on a subjective determination and review of the underlying trends in internal and external factors currently affecting the loan portfolio. The net impact of the changes in the allowance methodology was a $2.94 million reduction in the required allowance at June 30, 2013 which was primarily due to the higher historical loss factors being applied to the smaller amount of loans within the Pre-1/1/08 portfolio and the calculation of a separate historical loss factor for pass-rated credits for the Pre-1/1/08 and the Post-1/1/08 portfolios. At June 30, 2013, over 92% of our historical losses since January 1, 2008 related specifically to loans within the Pre-1/1/08 portfolio.

Loan losses are charged-off against the allowance for loan losses 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 on a quarterly basis and adjust the allowance by recording a provision for loan losses in an amount sufficient to maintain the allowance at a level we deem appropriate. The evaluation of the appropriateness of the allowance 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 carried at fair value, with the unrealized holding gains and losses, net of tax, reported in other comprehensive income and with no effect on earnings until realized. Investment in 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

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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 statement of condition 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. The tax planning strategies we considered in our deferred tax asset analysis include, but are not limited to, the termination of the bank-owned life insurance program, the sale/leaseback of our owned office properties, and the sale of our municipal securities with reinvestment of the proceeds in taxable securities. 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 June 30, 2013, 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 $12.4 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, seven years for the state of Indiana, and 12 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 tax 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 tax authority, assuming full knowledge of the position and all relevant facts. Differences between our position and the position of tax 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 consolidated financial statements at June 30, 2013.

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Results of Operations for the Three and Six Months Ended June 30, 2013 and 2012

Performance Overview

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

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
	(Dollars in thousands, except per share data)
Net income (loss)	$	(167	)	$	1,354		$	1,335		$	1,844
Diluted earnings (loss) per share	(.02		)	.13			.12			.17
Pre-tax, pre-provision earnings, as adjusted (1)	2,258			3,089			5,047			5,870
Return on average assets (2)	(.06		)%	.47		%	.24		%	.32		%
Return on average equity (2)	(.59		)	5.25			2.39			3.56
Average interest-earning assets	$	1,027,146		$	1,052,039		$	1,028,681		$	1,048,907
Net interest income	8,233			8,944			16,434			17,867
Net interest margin (2)	3.21		%	3.42		%	3.22		%	3.43		%
Non-interest income	$	1,806		$	2,643		$	4,660		$	5,467
Non-interest expense	9,464			8,542			17,919			18,749
Efficiency ratio (3)	96.11		%	75.71		%	86.49		%	82.92		%

	June 30, 2013			December 31, 2012			June 30, 2012
Book value per share	$	10.21		$	10.28		$	9.62
Shareholders’ equity to total assets	9.83		%	9.83		%	9.24		%
Bank Capital Ratios:
Tier 1 core capital ratio	9.08			8.81			8.56
Tier 1 risk-based capital ratio	14.06			12.81			12.10
Total risk-based capital ratio	15.31			14.06			13.35

(1) See “Non-U.S. GAAP Financial Information” on page 43.

(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 June 30, 2013 and results of operations for the three and six months ended June 30, 2013, and as compared to the same periods in the prior year. This discussion and analysis should be read in conjunction with our condensed consolidated financial statements and notes thereto included in this report.

We recorded a net loss of $(167,000), or $(.02) per share for the three months ended June 30, 2013, which represents a decrease of 112% from net income of $1.4 million, or $.13 per diluted share, for the comparable 2012 period. Our earnings were negatively impacted by lower net interest income, a loss on the sale of a large commercial participation other real estate owned property, and $971,000 of merger-related expenses. These merger-related expenses were primarily legal and investment banking fees for services rendered in connection with the merger with First Merchants Corporation announced in May 2013 and the preparation and review of the required regulatory filings. Non-interest expense increased by $922,000, or 10.8%, to $9.5 million for the second quarter of 2013 from $8.5 million for the second quarter of 2012 primarily due to $949,000 of professional fees in connection with the merger.

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Our problem asset resolution efforts continue, reducing our level of non-performing assets to $48.6 million at June 30, 2013, a decrease of 3.4% from $50.3 million at December 31, 2012. The ratio of non-performing assets to total assets decreased to 4.29% at June 30, 2013 from 4.42% at December 31, 2012. Driving the decrease in non-performing assets was a 6.3% decrease in other real estate owned to $21.9 million at June 30, 2013 from $23.3 million at December 31, 2012, which was partially offset by a 1.0% increase in non-performing loans. Our non-performing loans to total loans increased to 4.04% at June 30, 2013 from 3.89% at December 31, 2012, primarily due to the 4.7% decrease in total loans outstanding. Of the total non-performing loans at June 30, 2013, $7.3 million, or 27.2%, are current and performing in accordance with their loan agreements.

The targeted growth segments in our loan portfolio include commercial and industrial and owner occupied and multifamily commercial real estate, which in the aggregate comprised 60.3% of the commercial loan portfolio at June 30, 2013, compared to 59.2% at December 31, 2012 and 55.6% at June 30, 2012. In addition, our focus on deepening client relationships continues to emphasize core deposit growth. Total core deposits as a percentage of total deposits increased to 68.3% at June 30, 2013 from 65.1% at December 31, 2012 and 62.5% at June 30, 2012. The increase was primarily due to an increase in non-interest bearing accounts and the continued shrinkage in certificates of deposit in this low interest rate environment.

At June 30, 2013, our shareholders’ equity decreased slightly to $111.2 million, or 9.83% of assets, compared to $111.8 million, or 9.83% of assets, at December 31, 2012 and $104.6 million, or 9.24% of assets, at June 30, 2012. The decrease from December 31, 2012 was primarily due to net income of $1.3 million partially offset by a decrease in accumulated other comprehensive income, net of tax, of $1.9 million primarily due to higher interest rates and dividends declared of $219,000.

The Bank’s Tier 1 capital ratio increased 27 basis points to 9.08% at June 30, 2013 from 8.81% at December 31, 2012 and 52 basis points from 8.56% at June 30, 2012. The Bank’s total risk-based capital to risk-weighted assets ratio increased 125 basis points to 15.31% at June 30, 2013 from 14.06% at December 31, 2012 and 196 basis points from 13.35% at June 30, 2012. The increase in the capital ratios are primarily related to a decrease in risk-weighted assets. At June 30, 2013, the Bank was deemed to be “well-capitalized” and in excess of the individual minimum capital requirements established by the OCC in December 2012 of 8% for Tier 1 core capital and 12% for total risk-based capital to risk-weighted assets.

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.

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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 June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
	(Dollars in thousands)
Reconciliation of Income (Loss) Before Income Taxes to Pre-Tax, Pre-Provision Earnings, as adjusted:
Income (loss) before income taxes	$	(501	)	$	1,895		$	1,589		$	2,385
Provision for loan losses	1,076			1,150			1,586			2,200
Pre-tax, pre-provision earnings	575			3,045			3,175			4,585
Add back (subtract):
Net (gain) loss on sale of:
Investment securities	(192		)	(305		)	(376		)	(723		)
Other real estate owned	542			(86		)	532			(39		)
Merger-related expenses	971			—			971			—
Other real estate owned related expense, net	114			316			364			934
Loan collection expense	248			119			381			237
Severance and early retirement expense	—			—			—			876
Pre-tax, pre-provision earnings, as adjusted	$	2,258		$	3,089		$	5,047		$	5,870
Pre-tax, pre-provision earnings, as adjusted, to average assets (annualized)	.80		%	1.07		%	.89		%	1.02		%

Pre-tax, pre-provision earnings, as adjusted, decreased to $2.3 million for the second quarter of 2013 compared to $3.1 million for the second quarter of 2012 primarily as a result of lower gains on the sales of loans held for sale combined with a decrease in net interest income due to lower loan balances and our increased level of liquidity.

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Average Balances/Rates

The following table reflects 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 June 30,
	2013						2012
	Average Balance		Interest		Average Yield/Cost		Average Balance		Interest		Average Yield/Cost
	(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)	$	663,471	$	7,495	4.53	%	$	705,410	$	8,243	4.70	%
Investment securities (2)	246,277		1,731		2.78		252,698		2,186		3.42
Other interest-earning assets (3)	117,398		121		.41		93,931		103		.44
Total interest-earning assets	1,027,146		9,347		3.65		1,052,039		10,532		4.03
Non-interest earning assets	111,401						110,060
Total assets	$	1,138,547					$	1,162,099
Interest-bearing liabilities:
Deposits:
Checking accounts	$	193,637	$	52	.11	%	$	181,584	$	76	.17	%
Money market accounts	184,228		85		.19		195,382		139		.29
Savings accounts	161,690		73		.18		142,827		70		.20
Certificates of deposit	313,337		618		.79		371,021		1,009		1.09
Total deposits	852,892		828		.39		890,814		1,294		.58
Borrowed funds:
Other short-term borrowed funds	10,262		2		.08		10,810		4		.15
FHLB advances	39,410		284		2.85		39,774		290		2.88
Total borrowed funds	49,672		286		2.28		50,584		294		2.30
Total interest-bearing liabilities	902,564		1,114		.50		941,398		1,588		.68
Non-interest bearing deposits	112,141						105,927
Other non-interest bearing liabilities	10,823						10,947
Total liabilities	1,025,528						1,058,272
Shareholders’ equity	113,019						103,827
Total liabilities and shareholders’ equity	$	1,138,547					$	1,162,099
Net interest-earning assets	$	124,582					$	110,641
Net interest income / interest rate spread			$	8,233	3.15	%			$	8,944	3.35	%
Net interest margin					3.21	%					3.42	%
Ratio of average interest-earning assets to average interest-bearing liabilities					113.80	%					111.75	%

(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.

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	Six Months Ended June 30,
	2013						2012
	Average Balance		Interest		Average Yield/Cost		Average Balance		Interest		Average Yield/Cost
	(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)	$	669,791	$	15,195	4.57	%	$	707,061	$	16,629	4.73	%
Investment securities (2)	237,746		3,324		2.78		255,789		4,316		3.34
Other interest-earning assets (3)	121,144		245		.41		86,057		196		.46
Total interest-earning assets	1,028,681		18,764		3.68		1,048,907		21,141		4.05
Non-interest earning assets	111,315						111,737
Total assets	$	1,139,996					$	1,160,644
Interest-bearing liabilities:
Deposits:
Checking accounts	$	191,076	$	104	.11	%	$	179,977	$	159	.18	%
Money market accounts	183,277		178		.20		195,749		310		.32
Savings accounts	158,879		146		.19		139,468		137		.20
Certificates of deposit	322,120		1,331		.83		374,534		2,078		1.12
Total deposits	855,352		1,759		.41		889,728		2,684		.61
Borrowed funds:
Other short-term borrowed funds	10,658		5		.09		12,074		9		.15
FHLB advances	39,435		566		2.85		39,797		581		2.89
Total borrowed funds	50,093		571		2.27		51,871		590		2.25
Total interest-bearing liabilities	905,445		2,330		.52		941,599		3,274		.70
Non-interest bearing deposits	110,609						103,786
Other non-interest bearing liabilities	11,359						11,207
Total liabilities	1,027,413						1,056,592
Shareholders’ equity	112,583						104,052
Total liabilities and shareholders’ equity	$	1,139,996					$	1,160,644
Net interest-earning assets	$	123,236					$	107,308
Net interest income / interest rate spread			$	16,434	3.16	%			$	17,867	3.35	%
Net interest margin					3.22	%					3.43	%
Ratio of average interest-earning assets to average interest-bearing liabilities					113.61	%					111.40	%

(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.

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Rate/Volume Analysis

The following table shows 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 period 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 June 30,									Six Months Ended June 30,
	2013 Compared to 2012									2013 Compared to 2012
	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	$	(268	)	$	(480	)	$	(748	)	$	(576	)	$	(858	)	$	(1,434	)
Investment securities	(400		)	(55		)	(455		)	(703		)	(289		)	(992		)
Other interest-earning assets	(6		)	24			18			(24		)	73			49
Total interest income	(674		)	(511		)	(1,185		)	(1,303		)	(1,074		)	(2,377		)
Interest expense:
Deposits:
Checking accounts	(29		)	5			(24		)	(64		)	9			(55		)
Money market accounts	(46		)	(8		)	(54		)	(113		)	(19		)	(132		)
Savings accounts	(5		)	8			3			(9		)	18			9
Certificates of deposit	(250		)	(141		)	(391		)	(482		)	(265		)	(747		)
Total deposits	(330		)	(136		)	(466		)	(668		)	(257		)	(925		)
Borrowed funds:
Other short-term borrowed funds	(2		)	—			(2		)	(3		)	(1		)	(4		)
FHLB advances	(3		)	(3		)	(6		)	(10		)	(5		)	(15		)
Total borrowed funds	(5		)	(3		)	(8		)	(13		)	(6		)	(19		)
Total interest expense	(335		)	(139		)	(474		)	(681		)	(263		)	(944		)
Net change in net interest income	$	(339	)	$	(372	)	$	(711	)	$	(622	)	$	(811	)	$	(1,433	)

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Net Interest Income

Net Interest Income.Netinterest income decreased 7.9% to $8.2 million for the three months ended June 30, 2013 compared to $8.9 million for the three months ended June 30, 2012. Net interest income decreased 8.0% to $16.4 million for the six months ended June 30, 2013 compared to $17.9 million for the six months ended June 30, 2012. Thenet interest margin for the three and six months ended June 30, 2013 decreased 21 basis points to 3.21% and 3.22%, respectively, from 3.42% and 3.43%, respectively, for the comparable 2012 periods. Our net interest margin was negatively impacted by loans comprising a smaller proportion of interest-earning assets and the maintenance of a higher level of liquidity. We believe that higher levels of liquidity, modest loan demand, a reduced but still elevated level of non-performing assets, the continued low interest rate environment, and significant narrowing of spreads available on new investment security purchases will continue to pressure our net interest margin for the foreseeable future.

Interest Income. Interest income decreased 11.3% to $9.3 million for the three months ended June 30, 2013 from $10.5 million for the comparable 2012 period. For the six months ended June 30, 2013, interest income decreased 11.2% to $18.8 million from $21.1 million for the comparable 2012 period. The weighted-average rate on interest-earning assets decreased 38 and 37 basis points to 3.65% and 3.68%, respectively, for the three and six months ended June 30, 2013 from 4.03% and 4.05% for the comparable 2012 periods. The decreases are primarily related to the reinvestment of proceeds from sales and maturities of investment securities in lower-yielding investments, lower loan balances, 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 29.8% to $1.1 million for the three months ended June 30, 2013 from $1.6 million for the comparable 2012 period. The average cost of interest-bearing liabilities decreased 18 basis points to .50% for the three months ended June 30, 2013 from .68% for the 2012 period. For the six months ended June 30, 2013, interest expense decreased 28.8% to $2.3 million from $3.3 million for the comparable 2012 period. The average cost of interest-bearing liabilities decreased 18 basis points to .52% for the six months ended June 30, 2013 from .70% for the 2012 period. 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 contributed to the decreases in interest expense during the 2013 periods.

Interest expense on interest-bearing deposits decreased 36.0% to $828,000 for the three months ended June 30, 2013 from $1.3 million for the comparable 2012 period. The weighted-average cost of interest-bearing deposits decreased 19 basis points to .39% for the three months ended June 30, 2013 from .58% for the comparable 2012 period. For the six months ended June 30, 2013, interest expense on interest-bearing deposits decreased 34.5% to $1.8 million from $2.7 million for the comparable 2012 period and the weighted-average cost of interest-bearing deposits decreased 20 basis points to .41% for the six months ended June 30, 2013 from .61% for the comparable 2012 period. The decreases are primarily the result of lower rates on increased balances of core deposits and the repricing of maturing certificates of deposit at lower interest rates.

Interest expense on borrowed funds decreased 2.7% to $286,000 for the three months ended June 30, 2013 from $294,000 for the comparable 2012 period and 3.2% to $571,000 for the six months ended June 30, 2013 from $590,000 for the comparable 2012 period. The decreases in interest expense on borrowed funds were primarily due to lower average balances on borrowed funds during the 2013 periods. The weighted-average cost of borrowed funds decreased two basis points to 2.28% for the three months ended June 30, 2013 compared to 2.30% for the 2012 period as a result of lower average balances on lower-cost other short-term borrowed funds and increased two basis points to 2.27% for the six months ended June 30, 2013 compared to 2.25% for the 2012 period. The fluctuations in the weighted-average cost of borrowed funds are largely impacted by the average balances of the lower cost other short-term borrowed funds.

Provision for Loan Losses

The Company’s provision for loan losses was $1.08 million for the three months ended June 30, 2013 compared to $1.15 million for the 2012 period. The provision for loan losses was $1.59 million compared to $2.20 million, respectively, for the six months ended June 30, 2013 and 2012. 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.”

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Non-Interest Income

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

	Three Months Ended June 30,
	2013			2012		$ Change			% Change
	(Dollars in thousands)
Deposit related fees	$	1,648		$	1,578	$	70		4.4	%
Income from bank-owned life insurance	134			162		(28		)	(17.3	)
Other income	268			312		(44		)	(14.1	)
Subtotal	2,050			2,052		(2		)	(.1	)
Net gain (loss) on sale of:
Investment securities	192			305		(113		)	(37.0	)
Loans held for sale	106			200		(94		)	(47.0	)
Other real estate owned	(542		)	86		(628		)	(730.2	)
Subtotal	(244		)	591		(835		)	(141.3	)
Total non-interest income	$	1,806		$	2,643	$	(837	)	(31.7	)

	Six Months Ended June 30,
	2013			2012		$ Change			% Change
	(Dollars in thousands)
Deposit related fees	$	3,168		$	3,047	$	121		4.0	%
Income from bank-owned life insurance	464			702		(238		)	(33.9	)
Other income	615			597		18			3.0
Subtotal	4,247			4,346		(99		)	(2.3	)
Net gain (loss) on sale of:
Investment securities	376			723		(347		)	(48.0	)
Loans held for sale	569			359		210			58.5
Other real estate owned	(532		)	39		(571		)	(1,464.1	)
Subtotal	413			1,121		(708		)	(63.2	)
Total non-interest income	$	4,660		$	5,467	$	(807	)	(14.8	)

Deposit related fees include service charges, card-based fees, and other fees related to deposit accounts. Deposit related fees increased for the three and six months ended June 30, 2013 from the 2012 comparable periods due to a modest increase in card-based fees due to the success of the High Performance Checking (HPC) program in growing the number of checking accounts in a younger demographic that is more inclined to debit card usage. Income from bank-owned life insurance for the 2013 periods decreased from the comparable 2012 periods due to lower amounts received in 2013 from the death of insured persons. The decrease in net gains on sales of investment securities was primarily due to a decrease in the amount of securities sold during the 2013 periods compared to the 2012 periods. The decrease in gains on sales of loans held for sale during the three months ended June 30, 2013 from the comparable period in 2012 was primarily a result of lower gain on sale margins as a result of more aggressive competitor pricing as mortgage rates rose 100 basis points during the second quarter of 2013. The increase in gains on sales of loans held for sale during the six months ended June 30, 2013 was primarily related to a higher volume of loans sold during the 2013 period. The loss on the sale of other real estate owned during the 2013 periods was due to the sale of a large commercial participation property sold at a deep discount to appraised value by the participant bank.

49

Non-Interest Expense

The following table identifies changes in our non-interest expense for the periods presented:

	Three Months Ended June 30,
	2013		2012		$ Change			% Change
	(Dollars in thousands)
Compensation and mandatory benefits	$	3,712	$	3,716	$	(4	)	(.1	)%
Retirement and stock related compensation	306		309		(3		)	(1.0	)
Medical and life benefits	386		425		(39		)	(9.2	)
Other employee benefits	14		17		(3		)	(17.6	)
Subtotal compensation and employee benefits	4,418		4,467		(49		)	(1.1	)
Professional fees	1,141		198		943			476.3
Net occupancy expense	625		679		(54		)	(8.0	)
Data processing expense	544		445		99			22.2
FDIC insurance premiums and regulatory assessments	479		490		(11		)	(2.2	)
Furniture and equipment expense	398		468		(70		)	(15.0	)
Marketing	315		322		(7		)	(2.2	)
Other real estate owned related expense, net	114		316		(202		)	(63.9	)
Loan collection expense	248		119		129			108.4
Severance and early retirement expense	—		—		—			—
Other general and administrative expenses	1,182		1,038		144			13.9
Total non-interest expense	$	9,464	$	8,542	$	922		10.8

	Six Months Ended June 30,
	2013		2012		$ Change			% Change
	(Dollars in thousands)
Compensation and mandatory benefits	$	7,464	$	7,719	$	(255	)	(3.3	)%
Retirement and stock related compensation	543		581		(38		)	(6.5	)
Medical and life benefits	746		850		(104		)	(12.2	)
Other employee benefits	35		30		5			16.7
Subtotal compensation and employee benefits	8,788		9,180		(392		)	(4.3	)
Professional fees	1,469		451		1,018			225.7
Net occupancy expense	1,319		1,387		(68		)	(4.9	)
Data processing expense	1,057		883		174			19.7
FDIC insurance premiums and regulatory assessments	960		978		(18		)	(1.8	)
Furniture and equipment expense	801		925		(124		)	(13.4	)
Marketing	584		726		(142		)	(19.6	)
Other real estate owned related expense, net	364		934		(570		)	(61.0	)
Loan collection expense	381		237		144			60.8
Severance and early retirement expense	—		876		(876		)	(100.0	)
Other general and administrative expenses	2,196		2,172		24			1.1
Total non-interest expense	$	17,919	$	18,749	$	(830	)	(4.4	)

50

Total non-interest expense increased $922,000, or 10.8%, for the three months ended June 30, 2013 from the comparable 2012 period primarily due to increased professional fees, including legal and investment banking fees, related to the merger with First Merchants Corporation. Total non-interest expense decreased $830,000, or 4.4%, for the six months ended June 30, 2013 from the comparable 2012 period primarily due to decreased compensation and employee benefits expense and severance and early retirement expense as a result of our Voluntary Early Retirement Offering (VERO) program, branch closings, and outsourcing during the first quarter of 2012. Medical and life benefits were lower during the 2013 periods due to lower self-insurance claims. Marketing expense decreased during the six months ended June 30, 2013 due to the absence of the start-up costs related to the implementation of the HPC program during the first quarter of 2012. Other real estate owned expense, net decreased during the 2013 periods due to lower writedowns on properties held combined with lower holding costs, including real estate taxes, attorney fees, maintenance expense, and management fees. Partially offsetting these decreases was an increase in data processing expense during the 2013 periods as we added new or improved technology, including mobile banking, to our line of services offered to our retail and business clients. In addition, loan collection expense increased as we continue to work through problem loans.

Income Tax Expense

For the three months ended June 30, 2013, we recorded an income tax benefit of $334,000 as a result of our pre-tax loss compared to income tax expense of $541,000, or an effective tax rate of 28.5%, for comparable 2012 period. Our income tax expense totaled $254,000 and $541,000, respectively, for the six months ended June 30, 2013 and 2012 and represents effective tax rates of 16.0% and 22.7%, respectively. Our tax rates continue to be affected by the tax sheltering impacts of income from bank-owned life insurance and other tax credits.

Changes in Financial Condition

Our total assets were stable at $1.13 billion at June 30, 2013 compared to $1.14 billion at December 31, 2012, with higher levels of cash and investment securities available-for-sale offset by lower loan balances.

	June 30, 2013		December 31, 2012		$ Change			% Change
	(Dollars in thousands)
Assets:
Cash and cash equivalents	$	149,626	$	134,699	$	14,927		11.1	%
Investment securities available-for-sale, at fair value	219,931		203,290		16,641			8.2
Investment securities held-to-maturity, at cost	12,984		15,458		(2,474		)	(16.0	)
Net loans	647,412		680,082		(32,670		)	(4.8	)
Federal Home Loan Bank stock, at cost	6,188		6,188		—			—
Bank-owned life insurance	36,367		36,604		(237		)	(.6	)
Other real estate owned	21,878		23,347		(1,469		)	(6.3	)
Other	37,162		38,441		(1,279		)	(3.3	)
Total assets	$	1,131,548	$	1,138,109	$	(6,561	)	(.6	)
Liabilities and Shareholders’ Equity:
Deposits	$	961,945	$	965,791	$	(3,846	)	(.4	)%
Borrowed funds	49,306		50,562		(1,256		)	(2.5	)
Other	9,085		9,934		(849		)	(8.5	)
Total liabilities	1,020,336		1,026,287		(5,951		)	(.6	)
Shareholders’ equity	111,212		111,822		(610		)	(.5	)
Total liabilities and shareholders’ equity	$	1,131,548	$	1,138,109	$	(6,561	)	(.6	)

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Loans Receivable

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

	June 30, 2013					December 31, 2012
	Amount			% of Total		Amount			% of Total		% Change
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	95,675		14.5	%	$	102,628		14.8	%	(6.8	)%
Commercial real estate:
Owner occupied	97,906			14.8		98,046			14.2		(.1	)
Non-owner occupied	157,517			23.9		164,392			23.7		(4.2	)
Multifamily	72,806			11.0		75,228			10.9		(3.2	)
Commercial construction and land development	14,166			2.1		20,228			2.9		(30.0	)
Commercial participations	3,661			.6		5,311			.8		(31.1	)
Total commercial loans	441,731			66.9		465,833			67.3		(5.2	)
Retail loans:
One-to-four family residential	170,879			25.9		175,943			25.4		(2.9	)
Home equity lines of credit	44,026			6.7		46,477			6.7		(5.3	)
Retail construction	913			.1		1,176			.2		(22.4	)
Consumer	3,232			.5		3,305			.5		(2.2	)
Total retail loans	219,050			33.2		226,901			32.8		(3.5	)
Total loans receivable	660,781			100.1		692,734			100.1		(4.6	)
Net deferred loan fees	(709		)	(.1	)	(467		)	(.1	)	51.8
Total loans receivable, net of deferred loan fees	$	660,072		100.0	%	$	692,267		100.0	%	(4.7	)

 Total loans receivable, net of deferred loan fees, decreased $32.2 million, or 4.7%, at June 30, 2013 from December 31, 2012 primarily due to loan payoffs and repayments totaling $45.6 million, including $6.4 million of lower commercial and industrial lines of credit net paydowns; sales of one-to-four family loans totaling $24.9 million; transfers to other real estate owned totaling $2.3 million; and gross loan charge-offs totaling $2.4 million. Partially offsetting these decreases, loan fundings during the six months ended June 30, 2013 totaled $42.6 million, down 33.1% from $63.7 million for the six months ended June 30, 2012. The decrease in loan fundings is primarily due to the competitive market for loans as well as the decrease in commercial clients utilizing lines of credit.

Commercial and industrial loans decreased $7.0 million, or 6.8%, during 2013 primarily due to net paydowns of $6.4 million of commercial lines of credit. In addition, non-owner occupied commercial real estate loans decreased $6.9 million, or 4.2%, primarily due to four large loan payoffs totaling $4.5 million, transfers to other real estate owned totaling $649,000, and gross loan charge-offs of $1.4 million. Multifamily loans decreased $2.4 million, or 3.2%, due to three large loan payoffs totaling $2.2 million and transfers to other real estate owned totaling $1.4 million. Commercial construction and land development loans decreased $6.1 million, or 30.0%, due to two loans totaling $4.6 million completing the construction phase and transferring to amortizing owner occupied commercial real estate loans. Commercial participation loans decreased $1.7 million, or 31.1%, primarily due to repayments totaling $2.0 million.

As more fully discussed in our Annual Report on Form 10-K for the year ended December 31, 2012, 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 60.3% of the commercial loan portfolio at June 30, 2013 compared to 59.2% at December 31, 2012 and 55.6% at June 30, 2012. Over 85% of the loans outstanding at June 30, 2013 in these growth categories were originated after January 1, 2008 (Post-1/1/08). During the first six months of 2013, these targeted growth categories decreased by $9.5 million due to $25.2 million in loan repayments which were partially offset by $13.2 million in new fundings. At June 30, 2013, our total commercial

52

loans outstanding originated prior to January 1, 2008 (Pre-1/1/08) decreased $17.0 million, or 11.2%, to $135.4 million, or 30.7% of our total commercial loan portfolio, primarily due to normal amortization, charge-offs, and repayments.

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 highlight the shift in our lending focus to those growth categories in accordance with our strategic plan:

	June 30, 2013
	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	$	6,419	$	89,256	$	95,675	6.7	%
Commercial real estate:
Owner occupied	29,488		68,418		97,906		30.1
Non-owner occupied	91,878		65,639		157,517		58.3
Multifamily	3,373		69,433		72,806		4.6
Commercial construction and land development	2,297		11,869		14,166		16.2
Commercial participations	1,942		1,719		3,661		53.0
Total commercial loans	$	135,397	$	306,334	$	441,731	30.7

	December 31, 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	$	7,233	$	95,395	$	102,628	7.0	%
Commercial real estate:
Owner occupied	34,193		63,853		98,046		34.9
Non-owner occupied	97,019		67,373		164,392		59.0
Multifamily	6,704		68,524		75,228		8.9
Commercial construction and land development	3,316		16,912		20,228		16.4
Commercial participations	3,973		1,338		5,311		74.8
Total commercial loans	$	152,438	$	313,395	$	465,833	32.7

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

	June 30, 2013				December 31, 2012
	Amount		% of Total		Amount		% of Total		% Change
	(Dollars in thousands)
Commercial and industrial	$	1,235	33.7	%	$	1,333	25.1	%	(7.4	)%
Commercial real estate:
Owner occupied	484		13.2		97		1.8		399.0
Non-owner occupied	1,942		53.1		3,636		68.5		(46.6	)
Commercial construction and land development	—		—		245		4.6		(100.0	)
Total commercial participations	$	3,661	100.0	%	$	5,311	100.0	%	(31.1	)

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	June 30, 2013				December 31, 2012
	Amount		% of Total		Amount		% of Total		% Change
	(Dollars in thousands)
Illinois	$	1,073	29.3	%	$	1,085	20.4	%	(1.1	)%
Indiana	817		22.3		530		10.0		54.2
Michigan	1,235		33.7		1,241		23.4		(.5	)
Florida	—		—		245		4.6		(100.0	)
Colorado	536		14.7		909		17.1		(41.0	)
Texas	—		—		1,301		24.5		(100.0	)
Total commercial participations	$	3,661	100.0	%	$	5,311	100.0	%	(31.1	)

Asset Quality and Allowance for Loan Losses

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

	June 30, 2013			March 31, 2013			December 31, 2012
	(Dollars in thousands)
Non-performing loans:
Commercial loans:
Commercial and industrial	$	1,499		1,532			$	449
Commercial real estate:
Owner occupied	5,815			5,484			5,417
Non-owner occupied	7,241			7,698			9,083
Multifamily	2,357			1,314			2,775
Commercial construction and land development	2,324			2,357			2,366
Commercial participations	1,235			339			339
Total commercial loans	20,471			18,724			20,429
Retail loans:
One-to-four family residential	5,451			5,557			5,671
Home equity lines of credit	667			675			683
Retail construction	85			85			150
Consumer	—			7			—
Total retail loans	6,203			6,324			6,504
Total non-performing loans	26,674			25,048			26,933
Other real estate owned:
Commercial	21,172			22,793			22,595
Retail	706			905			752
Total other real estate owned	21,878			23,698			23,347
Total non-performing assets	48,552			48,746			50,280
90 days past due loans still accruing interest	—			917			—
Total non-performing assets plus 90 days past due loans still accruing interest	$	48,552		$	49,663		$	50,280
Accruing troubled debt restructurings	$	19,402		$	7,332		$	17,616
Non-performing assets to total assets	4.29		%	4.25		%	4.42		%
Non-performing loans to total loans, net of deferred fees	4.04			3.77			3.89

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 Total non-performing loans increased $1.6 million, or 6.5%, to $26.7 million at June 30, 2013 from $25.0 million at March 31, 2013 and was relatively stable with $26.9 million at December 31, 2012. The increase during the second quarter of 2013 was primarily due to the transfer to non-accrual status of one commercial real estate owner occupied loan totaling $1.1 million, one commercial and industrial participation loan totaling $1.2 million, one commercial real estate multifamily loan totaling $594,000, and two commercial real estate non-owner occupied loan relationships totaling $802,000. These increases were partially offset by gross loan charge-offs on non-performing loans totaling $1.6 million and repayments totaling $1.1 million. Of the total non-performing loans at June 30, 2013, $7.3 million, or 27.2% were current and performing in accordance with their loan agreements.

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:

	June 30, 2013			December 31, 2012			% change
	(Dollars in thousands)
Commercial and industrial	$	1,235		$	—		100.0	%
Commercial real estate – non-owner occupied	—			93			(100.0	)
Commercial construction and land development	—			246			(100.0	)
Total non-performing commercial participations	$	1,235		$	339		264.3
Indiana	—			93			(100.0	)%
Florida	—			246			(100.0	)
Michigan	1,235			—			100.0
Total non-performing commercial participations	$	1,235		$	339		264.3
Percentage of total non-performing loans	4.63		%	1.26		%
Percentage of total commercial participations	33.73			6.38

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

	June 30, 2013
	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	$	1,654	$	80	$	75	$	1,499	$	—	$	1,499	90.6	%
Commercial real estate:
Owner occupied	8,284		2,321		148		5,815		363		5,452		70.2
Non-owner occupied	10,154		2,461		452		7,241		3,201		4,040		71.3
Multifamily	2,460		—		103		2,357		—		2,357		95.8
Commercial construction and land development	2,467		93		50		2,324		207		2,117		94.2
Commercial participations	1,235		—		—		1,235		—		1,235		100.0
Total commercial loans	26,254		4,955		828		20,471		3,771		16,700		78.0
Retail loans:
One-to-four family residential	5,607		156		—		5,451		—		5,451		97.2
Home equity lines of credit	784		117		—		667		—		667		85.1
Retail construction	150		65		—		85		—		85		56.7
Total retail loans	6,541		338		—		6,203		—		6,203		94.8
Total non-performing loans	$	32,795	$	5,293	$	828	$	26,674	$	3,771	$	22,903	81.3

	December 31, 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	$	946	$	423	$	74	$	449	$	—	$	449	47.5	%
Commercial real estate:
Owner occupied	9,262		3,160		685		5,417		—		5,417		58.5
Non-owner occupied	11,184		1,740		361		9,083		217		8,866		81.2
Multifamily	3,403		532		96		2,775		—		2,775		81.5
Commercial construction and land development	2,467		61		40		2,366		180		2,186		95.9
Commercial participations	5,583		5,103		141		339		—		339		6.1
Total commercial loans	32,845		11,019		1,397		20,429		397		20,032		62.2
Retail loans:
One-to-four family residential	5,836		165		—		5,671		—		5,671		97.2
Home equity lines of credit	778		95		—		683		—		683		87.8
Retail construction	150		—		—		150		—		150		100.0
Total retail loans	6,764		260		—		6,504		—		6,504		96.2
Total non-performing loans	$	39,609	$	11,279	$	1,397	$	26,933	$	397	$	26,536	68.0

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Non-performing assets decreased $1.7 million, or 3.4%, to $48.6 million at June 30, 2013 from $50.3 million at December 31, 2012 primarily due to decreases in other real estate owned during 2013. During the six months ended June 30, 2013, we sold 15 other real estate owned properties totaling $3.4 million resulting in net losses on sales of $532,000, including the cash sale of one large commercial participation property that was sold at a deep discount to appraised value by the participant bank resulting in a $529,000 loss on sale. In addition, we transferred five relationships to other real estate owned totaling $2.3 million, including four multifamily properties from one owner occupied and multifamily commercial real estate loan relationship totaling $1.4 million.

The activity for the three and six months ended June 30, 2013 for our other real estate owned and the balance of our other real estate owned properties based on the loan category in which they were originated are set forth in the following tables:

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
	(Dollars in thousands)
Balance at beginning of period	$	23,698		$	19,429		$	23,347		$	19,091
Transfers to other real estate owned	115			1,174			2,337			2,719
Net repayments and improvements of properties	(213		)	8			(239		)	8
Sales of other real estate owned	(1,667		)	(1,189		)	(3,404		)	(1,911		)
Valuation allowances recorded for declines in net realizable value	(55		)	(199		)	(163		)	(684		)
Balance at end of period	$	21,878		$	19,223		$	21,878		$	19,223

	June 30, 2013		December 31, 2012		% Change
	(Dollars in thousands)
Commercial loans:
Commercial real estate:
Non-owner occupied	$	7,926	$	7,950	(.3	)%
Multifamily	1,599		340		370.3
Commercial construction and land development	6,359		7,416		(14.3	)
Commercial participations:
Commercial real estate – non-owner occupied	2,357		2,361		(.2	)
Commercial construction and land development	2,930		4,528		(35.3	)
Total commercial loans	21,171		22,595		(6.3	)
Retail loans:
One-to-four family residential	531		500		6.2
Home equity lines of credit	—		63		(100.0	)
Retail construction	176		189		(6.9	)
Total retail loans	707		752		(6.0	)
Total other real estate owned	$	21,878	$	23,347	(6.3	)

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As more fully discussed in our Annual Report on Form 10-K for the year ended December 31, 2012, 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 six years. Since January 1, 2008, $51.4 million, or 91.3%, 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, 46.6% of our non-performing commercial loans and 89.0% of our commercial other real estate owned portfolio at June 30, 2013 were originated Pre-1/1/08:

	June 30, 2013
	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	$	372		$	1,127		$	1,499		24.8	%
Commercial real estate:
Owner occupied	3,297			2,518			5,815			56.7
Non-owner occupied	4,548			2,693			7,241			62.8
Multifamily	657			1,700			2,357			27.9
Commercial construction and land development	674			1,650			2,324			29.0
Commercial participations	—			1,235			1,235			—
Total non-performing commercial loans	$	9,548		$	10,923		$	20,471		46.6
Total commercial loans outstanding at June 30, 2013	$	135,397		$	306,334		$	441,731
Non-performing commercial loans to total commercial loans	7.05		%	3.57		%	4.63		%

	June 30, 2013
	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	$	6,710	$	1,216	$	7,926	84.7	%
Multifamily	483		1,116		1,599		30.2
Commercial construction and land development	6,359		—		6,359		100.0
Commercial participations:
Commercial real estate – non-owner occupied	2,357		—		2,357		100.0
Commercial construction and land development	2,930		—		2,930		100.0
Total other real estate owned – commercial	$	18,839	$	2,332	$	21,171	89.0

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During 2013, we recorded gross loan charge-offs and net other real estate owned writedowns related to our commercial loan portfolio totaling $2.1 million, of which $1.0 million, or 49.5%, were related to loans originated Pre-1/1/08. The breakdown of the commercial loans gross charge-offs and other real estate owned writedowns on commercial properties are identified in the following table:

	Six Months Ended June 30, 2013
	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	$	—		$	80	$	80		—	%
Commercial real estate:
Owner occupied	—			287		287			—
Non-owner occupied	859			530		1,389			61.8
Multifamily	—			161		161			—
Commercial construction and land development	33			—		33			100.0
Total commercial loan charge-offs	892			1,058		1,950			45.7
Writedowns on other real estate owned – commercial properties:
Commercial real estate:
Non-owner occupied	57			—		57			100.0
Multifamily	121			—		121			100.0
Commercial construction and land development	(142		)	—		(142		)	100.0
Commercial participations – construction and land development	108			—		108			100.0
Total writedowns on other real estate owned – commercial properties	144			—		144			100.0
Total commercial loan charge-offs and writedowns on  other real estate owned	$	1,036		$	1,058	$	2,094		49.5

Potential Problem Assets.Potential problem assets, defined as loans classified as substandard pursuant to our internal loan grading system that do not meet the definition of a non-performing loan, increased to $39.5 million at June 30, 2013 from $5.7 million at December 31, 2012. This increase is due to the substandard classification of four non-owner occupied commercial real estate relationships totaling $23.6 million, two commercial and industrial loan relationships totaling $5.5 million, and three owner occupied commercial real estate relationships totaling $897,000. These loan relationships were classified as substandard due to changes in the borrowers’ financial condition and all but one owner occupied commercial real estate loan totaling $18,000 were current at June 30, 2013. Partially offsetting these increases was the transfer to non-accrual status of one commercial and industrial and owner occupied commercial real estate relationship totaling $1.4 million, one owner occupied commercial real estate loan totaling $1.1 million, and three retail loans totaling $289,000, all of which were previously considered potential problem assets. In addition, a non-owner occupied commercial real estate previously identified potential problem asset totaling $933,000 was repaid in full during the first quarter of 2013.

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

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
	(Dollars in thousands)
Balance at beginning of period	$	12,024		$	11,768		$	12,185		$	12,424
Loan charge-offs:
Current period loan charge-offs	(1,514		)	(892		)	(2,392		)	(1,933		)
Previously established specific reserves	(55		)	—			(55		)	(718		)
Total loan charge-offs	(1,569		)	(892		)	(2,447		)	(2,651		)
Recoveries of loans previously charged-off	1,129			36			1,336			89
Net loan charge-offs	(440		)	(856		)	(1,111		)	(2,562		)
Provision for loan losses	1,076			1,150			1,586			2,200
Balance at end of period	$	12,660		$	12,062		$	12,660		$	12,062

	June 30, 2013			December 31, 2012			June 30, 2012
	(Dollars in thousands)
Allowance for loan losses	$	12,660		$	12,185		$	12,062
Total loans receivable, net of unearned fees	660,072			692,267			713,596
Allowance for loan losses to total loans	1.92		%	1.76		%	1.69		%
Allowance for loan losses to non-performing loans	47.46			45.24			23.26
Ratio of net loans charged-off to average loans outstanding for the quarter ended, annualized	.27			.58			.49

The allowance for loan losses increased 3.9% to $12.7 million at June 30, 2013 from $12.2 million at December 31, 2012 and increased 5.0% from $12.1 million at June 30, 2012. The ratio of the allowance for loan losses to total loans increased to 1.92% at June 30, 2013 from 1.76% at December 31, 2012 and 1.69% at June 30, 2012 as a result of the increase in the allowance balance combined with a decrease in total loans.

During the second quarter of 2013, management revised its calculation methodology for the second component of the allowance for loan losses to segregate the historical losses on the Pre-1/1/08 and Post-1/1/08 loan portfolios. The revised analysis first identifies the historical loss experience by the Pre-1/1/08 and Post-1/1/08 portfolios in order to better identify the losses associated with each of the portfolios. Management then segregates the Pre-1/1/08 and Post-1/1/08 portfolios by loan reporting category and loan risk rating including pass, special mention, substandard, and doubtful rated credits. The historical loss factors are then applied to the respective loan Pre-1/1/08 and Post-1/1/08 portfolios, loan categories, and risk ratings. Management will then factor in additional qualitative adjustments based on a subjective determination and review of the underlying trends in internal and external factors currently affecting the loan portfolio. The net impact of the changes in the allowance methodology was a $2.94 million reduction in the required allowance at June 30, 2013 which was primarily due to the higher historical loss factors being applied to the smaller amount of loans within the Pre-1/1/08 portfolio and the calculation of a separate historical loss factor for pass-rated credits. At June 30, 2013, over 92% of our historical losses since January 1, 2008 related specifically to loans within the Pre-1/1/08 portfolio.

The provision for loan losses decreased 6.4% to $1.08 million for the second quarter of 2013 from $1.15 million for the comparable 2012 period. The provision for the quarter was impacted by a $2.8 million specific reserve established for a $13.1 million commercial real estate non-owner occupied loan deemed a troubled debt restructuring during the second quarter of 2013 and $1.6 million of gross charge-offs, which were partially offset by total recoveries during the quarter of $1.1 million and the above mentioned $2.94 million decrease in the required allowance.

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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 $4.9 million recorded through June 30, 2013 on $7.3 million (net of charge-offs) of non-performing collateral-dependent loans. At June 30, 2013, the ratio of the allowance for loan losses to non-performing loans, excluding the $7.3 million of non-performing collateral-dependent loans with partial charge-offs, was 65.2%.

Investment Securities

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

	June 30, 2013
	Par  Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair  Value
	(Dollars in thousands)
Available-for-sale investment securities:
U.S. Treasury securities	$	61,000	$	61,395	$	324	$	(535	)	$	61,184
Government sponsored entity (GSE) securities	23,000		23,477		354		(277		)	23,554
Collateralized mortgage obligations	64,285		60,680		3,013		(24		)	63,669
Commercial mortgage-backed securities	47,104		48,683		706		(20		)	49,369
GSE residential mortgage-backed securities	2,201		2,368		—		(190		)	2,178
Asset backed securities	3,818		3,569		181		—			3,750
Pooled trust preferred securities	21,178		19,466		—		(3,239		)	16,227
Total available-for-sale investment securities	$	222,586	$	219,638	$	4,578	$	(4,285	)	$	219,931
Held-to-maturity investment securities:
Asset backed securities	$	5,526	$	5,604	$	160	$	—		$	5,764
Municipal securities	7,380		7,380		23		(10		)	7,393
Total held-to-maturity investment securities	$	12,906	$	12,984	$	183	$	(10	)	$	13,157

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	December 31, 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	$	17,000	$	16,964	$	405	$	(6	)	$	17,363
Government sponsored entity (GSE) securities	45,000		45,628		848		(8		)	46,468
Collateralized mortgage obligations	67,902		63,367		3,735		(36		)	67,066
Commercial mortgage-backed securities	44,267		45,178		1,251		—			46,429
GSE residential mortgage-backed securities	2,224		2,400		—		(32		)	2,368
Asset backed securities	4,182		3,876		177		—			4,053
Pooled trust preferred securities	24,508		22,409		—		(2,867		)	19,542
GSE preferred stock	200		—		1		—			1
Total available-for-sale investment securities	$	205,283	$	199,822	$	6,417	$	(2,949	)	$	203,290
Held-to-maturity investment securities:
Asset backed securities	$	6,446	$	6,578	$	219	$	—		$	6,797
Municipal securities	8,880		8,880		45		—			8,925
Total held-to-maturity investment securities	$	15,326	$	15,458	$	264	$	—		$	15,722

At June 30, 2013, the amortized cost of our collateralized mortgage obligation portfolio totaled $60.7 million, with 82% of the portfolio maintaining a lowest credit rating of A or higher. The composition of this portfolio includes $10.1 million backed by Ginnie Mae and $50.6 million of non-agency securities mainly backed by both floating- and fixed-rate residential mortgages originated prior to 2006. In addition, $53.3 million within this portfolio are floating-rate bonds indexed to 30 day LIBOR with unaccreted discounts totaling $3.6 million at June 30, 2013.

Our commercial mortgage-backed investment securities portfolio consists mainly of short-term, fixed-rate, senior tranches of seasoned issues with extensive subordination and limited balloon risk. All bonds in this portfolio are AAA-rated with the exception of a single bond with a AA+ rating since 100% of the underlying collateral has been replaced with U.S. Treasuries.  

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 on the underlying collateral. Credit ratings were also negatively affected in 2009, and all of the pooled trust preferred investments in our portfolio have 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 related to pooled trust preferred securities. Rating agencies are also increasingly analyzing deferring issuers for probability of default instead of treating all, or nearly all, deferring issuers as defaulted issuers. In addition, one rating agency has recently noted the large spread between the underlying collateral and the coupons on the pooled trust preferred securities and plans to add this assumption into their future risk analyses. Should they make this change, we would expect further upgrades on the pooled trust preferred investments. Three of our investments, representing approximately 72% of our total pooled trust preferred investments, currently have composite investment-grade ratings.

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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 June 30, 2013 currently projects no loss of principal or interest on any of our pooled trust preferred investments.

All of our pooled trust preferred investments are floating rate “Super Senior” tranches indexed to 90 day LIBOR with unaccreted discounts of $1.7 million at June 30, 2013. The “Super Senior” tranches are the most senior tranches. Due to the structure of the investments, 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 own 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. During the second quarter of 2013, the annualized principal pay down rate on these investments was 42.6% and has averaged 18.2% for the past four quarters. Management expects additional cure and redemption announcements in the near term.

Management is expecting redemption activity to remain strong over the near term as call windows are now open on all of the Company’s pooled trust preferred investments, certain issuers evaluate 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 environment.

Due to recently updated regulations on the methodology for determining the classification of structured securities, all of the Company’s pooled trust preferred investments are no longer classified as substandard assets.

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:

	June 30, 2013				December 31, 2012
	Amount		% of Total		Amount		% of Total		% Change
	(Dollars in thousands)
Checking accounts:
Non-interest bearing	$	110,724	11.5	%	$	107,670	11.1	%	2.8	%
Interest-bearing	202,399		21.0		185,388		19.2		9.2
Money market accounts	181,484		18.9		182,001		18.9		(.3	)
Savings accounts	162,707		16.9		153,799		15.9		5.8
Core deposits	657,314		68.3		628,858		65.1		4.5
Certificates of deposit accounts	304,631		31.7		336,933		34.9		(9.6	)
Total deposits	$	961,945	100.0	%	$	965,791	100.0	%	(.4	)

Total deposits decreased $3.8 million, or .4%, to $961.9 million at June 30, 2013 from $965.8 million at December 31, 2012. This decrease was primarily due to a $32.3 million, or 9.6%, decrease in certificates of deposit partially offset by a $28.5 million, or 4.5%, increase in core deposits. The increase in core deposits is primarily due to the implementation of our HPC deposit acquisition marketing program that targets both retail and business clients. This direct mail marketing program is designed to attract a younger demographic and enhance growth in the number of checking accounts, core deposits, and related fee income as well as to provide additional cross-selling opportunities. In addition, core deposits continue to benefit due in part to our disciplined pricing strategies which led to clients moving maturing certificates of deposit into money market and savings accounts due to the current low interest rate environment.

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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 June 30, 2013, we had $9.9 million in Repo Sweeps compared to $11.1 million at December 31, 2012. 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:

	June 30, 2013				December 31, 2012
	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		1,038		6.71
2015	15,000		1.42		15,000		1.42
2018 (1)	2,360		5.54		2,360		5.54
2019 (1)	6,005		6.29		6,111		6.29
Total FHLB advances	39,403		2.85		39,509		2.86
Short-term variable-rate borrowed funds - Repo Sweep accounts	9,903		.10		11,053		.10
Total borrowed funds	$	49,306	2.30		$	50,562	2.26

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

At June 30, 2013, the Bank had a borrowing relationship with the Federal Reserve Bank (FRB) discount window. This line was not utilized during the three and six months ended June 30, 2013 or 2012.

Shareholders’ Equity

Shareholders’ equity decreased slightly to $111.2 million, or 9.83% of total assets, for June 30, 2013 compared to $111.8 million, or 9.83% of total assets, at December 31, 2012. The decrease was primarily due to a decrease in accumulated other comprehensive income, net of tax, of $1.9 million primarily due to higher interest rates and dividends declared of $219,000 partially offset by net income of $1.3 million for the six months ended June 30, 2013.

64

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 June 30, 2013, we had cash and cash equivalents of $149.6 million, an increase of $14.9 million, or 11.1%, from $134.7 million at December 31, 2012. The increase was mainly the result of proceeds received from repayments and prepayments of loans totaling $27.4 million and proceeds received from sales, maturities, and paydowns of investment securities totaling $47.7 million. The cash inflows were partially offset by cash outflows related to $64.1 million of investment securities purchases.

We use our sources of funds primarily to meet our ongoing commitments; to fund loan commitments, maturing certificates of deposit, and savings withdrawals; and to 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 or incurring any debt at the parent company without the prior approval of the FRB under our informal regulatory agreement.

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 June 30, 2013, under current regulations, the Bank had no net earnings available for dividend declarations to the parent company. At June 30, 2013, the parent company had $1.5 million in cash and cash equivalents. We do not anticipate that these restrictions will have a material adverse impact on our liquidity or ability to continue to pay dividends.

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Contractual Obligations

The following table presents our contractual obligations to third parties at June 30, 2013 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	$	221,743	$	68,669	$	14,010	$	209	$	304,631
FHLB advances (1)	15,389		16,796		904		6,314		39,403
Short-term borrowed funds (2)	9,903		—		—		—		9,903
Service bureau contract	1,873		3,746		3,746		—		9,365
Operating leases	334		459		286		1,676		2,755
Dividends payable on common stock	109		—		—		—		109
	$	249,351	$	89,670	$	18,946	$	8,199	$	366,166

(1) Does not include interest expense at the weighted-average contractual rate of 2.85% for the periods presented.

(2) Does not include interest expense at the weighted-average contractual rate of .10% 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.

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The following table details the amounts and expected maturities of significant commitments at June 30, 2013:

	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	$	5,442	$	105	$	—	$	37	$	5,584
Commercial real estate:
Owner occupied	4,364		135		—		—		4,499
Non-owner occupied	4,284		—		—		—		4,284
Multifamily	1,550		—		—		—		1,550
Commercial construction and land development	2,654		204		—		—		2,858
Commercial participations	—		—		250		—		250
Retail	4,695		—		—		—		4,695
Commitments to fund unused:
Equity lines of credit	—		—		—		36,281		36,281
Commercial business lines	44,429		2,265		—		—		46,694
Construction loans	—		1,055		—		—		1,055
Commercial real estate - owner occupied lines	33		—		—		—		33
Commercial real estate - multifamily lines	—		182		—		—		182
Consumer overdraft lines	116		80		—		—		196
Credit enhancements	2,075		—		7,699		5,062		14,836
Letters of credit	1,259		21		5		—		1,285
	$	70,901	$	4,047	$	7,954	$	41,380	$	124,282

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 2016.

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 one year. 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.

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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. In addition, in accordance with its most recent examination, the OCC established higher individual minimum capital ratios for the Bank. Specifically, the Bank must maintain a Tier 1 capital to adjusted total assets ratio of at least 8% and a total risk-based capital to risk-weighted assets ratio of at least 12%. At June 30, 2013 and December 31, 2012, the Bank was deemed to be “well-capitalized” and in excess of the higher individual minimum capital requirements established for the Bank by the OCC.

The total amount of deferred tax assets not included for regulatory capital purposes was $8.3 million and $9.0 million, respectively, at June 30, 2013 and December 31, 2012. 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, available tax planning strategies, and OCC limitations. Using all information available to us 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 June 30, 2013 and December 31, 2012 are presented in the following table. There are no conditions or events that have occurred since June 30, 2013 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 June 30, 2013:
Tangible capital to adjusted total assets	$	101,959	9.08	%	$	16,839	>=	1.5	%	$	22,452	>=	2.0	%
Tier 1 (core) capital to adjusted total assets	101,959		9.08		44,905		>=	4.0		56,131		>=	5.0
Tier 1 (core) capital to risk-weighted assets	101,959		14.06		29,011		>=	4.0		43,517		>=	6.0
Total risk-based capital to risk-weighted assets	111,070		15.31		58,023		>=	8.0		72,529		>=	10.0
At December 31, 2012:
Tangible capital to adjusted total assets	$	99,279	8.81	%	$	16,896	>=	1.5	%	$	22,527	>=	2.0	%
Tier 1 (core) capital to adjusted total assets	99,279		8.81		45,055		>=	4.0		56,319		>=	5.0
Tier 1 (core) capital to risk-weighted assets	99,279		12.81		31,008		>=	4.0		46,512		>=	6.0
Total risk-based capital to risk-weighted assets	109,000		14.06		62,016		>=	8.0		77,520		>=	10.0

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The following table reflects the adjustments required to reconcile the Bank’s shareholders’ equity to the Bank’s regulatory capital at June 30, 2013:

	Tangible			Core			Risk-Based
	(Dollars in thousands)
Shareholders’ equity of the Bank	$	111,319		$	111,319		$	111,319
Disallowed deferred tax asset	(8,341		)	(8,341		)	(8,341		)
Adjustment for unrealized gains on certain available-for-sale securities	(181		)	(181		)	(181		)
Other	(838		)	(838		)	(838		)
General allowance for loan losses	—			—			9,111
Regulatory capital of the Bank	$	101,959		$	101,959		$	111,070
Total adjusted assets for Tangible and Tier 1 (core) capital purposes	$	1,122,617		$	1,122,617
Total risk-weighted assets for risk-based capital purposes							$	725,285

The increase in the Bank’s regulatory capital ratios from December 31, 2012 is primarily a result of a decrease in total risk-weighted assets due to a decrease in 100% risk-weighted loans and an increase in 0% risk-weighted U.S. Treasury securities.

In July 2013, the FRB and the OCC approved a final rulemaking and the FDIC approved an interim final rulemaking on capital that, together, were initially proposed in June 2012 through three joint notices of proposed rulemakings (Basel III). The final rulemakings revise each agency’s risk-based and leverage capital requirements consistent with agreements reached by the Basel Committee on Banking Supervision, including implementation of a new common equity Tier 1 minimum capital requirement and a higher minimum Tier 1 capital requirement. In addition, the Basel III rulemakings apply limits on a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a specified “buffer” of common equity Tier 1 capital in addition to the minimum risk-based capital requirements. The Basel III rulemakings also revise the agencies’ prompt corrective action framework by incorporating the new regulatory capital minimums and updating the definition of tangible equity. In addition, the Basel III rulemakings place new constraints on the inclusion of minority interests, mortgage-servicing assets, and deferred tax assets in regulatory capital. The final rulemakings contain three key changes from the June 2012 proposals to help reduce the burden on smaller banking organizations while still promoting a better capitalized banking system. The final rulemakings i) do not change the current treatment of residential mortgage exposures, ii) allow banking organizations that are not subject to the advanced approaches capital rules as outlined in the Basel III rulemakings to opt not to incorporate most amounts reported as accumulated other comprehensive income in the calculation of regulatory capital, and iii) allow depository institution holding companies with less than $15 billion in total consolidated assets as of December 31, 2009, and certain mutual holding companies to continue to count as Tier 1 capital certain existing Trust Preferred Securities that were issued prior to May 19, 2010 rather than phasing such securities out of regulatory capital. Most banking organizations are required to apply the new capital rules on January 1, 2015, with the largest internationally active banking organizations required to apply the provisions on January 1, 2014. We are currently reviewing the impact the final rules will have upon the financial condition or results of operations of 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 rate jump features in certain of our certificates of deposit. Management’s goal, through policies established by the Asset/Liability Management Committee of the Bank’s 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 comprehensive integrated Asset/Liability Management Policy that establishes written guidelines for the asset/liability management function, including the management of net interest margin, interest rate risk, investment security purchases, liquidity, and contingency funding plans. 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 interest rate risk, verify compliance with Board approved interest rate risk tolerance limits, take appropriate actions to mitigate those risks, monitor and discuss the status and

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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 interest rate risk exposure using Net Present Value analysis and net interest income-at-risk analysis.

We use Net Portfolio Value Analysis as the primary measurement of our interest rate risk. We measure our interest rate risk 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 interest rate risk 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.

At June 30, 2013, we are reporting interest rate risk (IRR) results based on output from our internal IRR model implemented during 2012. The goals of bringing the third-party IRR model in-house were: 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 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 June 30, 2013 and December 31, 2012:

		Net Portfolio Value
		At June 30, 2013							At December 31, 2012
		$ Amount		$ Change			% Change		$ Amount		$ Change			% Change
		(Dollars in thousands)
Assumed Change in Interest Rates  (Basis Points):
+	300	$	135,427	$	4,243		3.2	%	$	128,789	$	7,244		6.0	%
+	200	134,889		3,705			2.8		127,834		6,289			5.2
+	100	134,215		3,031			2.3		125,419		3,874			3.2
	0	131,184		—			—		121,545		—			—
-	100	123,872		(7,312		)	(5.6	)	117,995		(3,550		)	(2.9	)

The increase in the base NPV from December 31, 2012 to June 30, 2013 was caused mainly by the effect of the steepening yield curve on the NPVs of 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 June 30, 2013 and December 31, 2012, respectively:

		Change in Net Interest Income Over a Twelve-Month Period
		June 30, 2013					December 31, 2012
		$ Change			% Change		$ Change		% Change
		(Dollars in thousands)
Assumed Change in Interest Rates (Basis Points):
+	300	$	3,883		12.7	%	$	3,685	11.5	%
+	200	2,652			8.7		2,402		7.5
+	100	1,308			4.3		1,004		3.1
-	100	(30		)	(.1	)	39		.1

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The preceding table indicates that if interest rates were to move up 200 basis points, net interest income would be expected to increase 8.7% in year one; and if interest rates were to move down 100 basis points, net interest income would be expected to remain relatively stable 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 the rising interest rate scenarios have improved since December 31, 2012 as the Bank has maintained higher levels of liquid interest-earning deposits that reprice daily, a higher percentage of its investment portfolio in floating rate securities, a steeper yield curve, less long term fixed-rate one-to-four family residential mortgages, and $28.5 million of additional low-cost core deposits, which represents 68.3% of deposits at June 30, 2013 versus 65.1% at December 31, 2012. 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 table above 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 June 30, 2013, we were in compliance with all of our Board approved NPV and net interest income at risk tolerance limits.

The above 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 June 30, 2013 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

On July 30, 2013, a putative class action lawsuit captioned Jay Orlando v. CFS Bancorp, Inc., et al., No. 13-CV-00261 was filed in U.S. District Court in the Northern District of Indiana against the Company, the individual directors of the Company and First Merchants Corporation on behalf of the public shareholders of the Company. The complaint generally alleges various claims of federal securities law violations and that the directors of the Company breached their fiduciary duties by providing materially inadequate disclosures and material disclosure omissions with respect to the proposed merger with First Merchants Corporation. The plaintiffs seek (1) class certification, (2) to enjoin the merger or, in the event the merger is completed before entry of a final judgment, to rescind the merger or be awarded an unspecified amount of rescissory damages, (3) compensatory damages in an unspecified amount, and (4) costs and expenses, including attorneys’ fees. At this early stage of the litigation, it is not possible to assess the probability of a material adverse outcome or reasonably estimate any potential financial impact of the lawsuit on the Company. The Company believes the claim against it is without merit and intends to contest the matter vigorously.

Also, the Company is, from time to time, 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, 2012 (the 2012 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 2012 Form 10-K.

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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 June 30, 2013. 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 pursuant to an informal regulatory agreement with the FRB.

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).
2.1	Agreement of Reorganization and Merger Between First Merchants Corporation and CFS Bancorp, Inc. dated as of May 13, 2013 (1)
3.1	Articles of Incorporation of CFS Bancorp, Inc. (2)
3.2	Amended and Restated Bylaws of CFS Bancorp, Inc. (3)
4.0	Form of Stock Certificate of CFS Bancorp, Inc. (4)
10.1	Voting Agreement dated May 13, 2013, by and among First Merchants Corporation and Certain Shareholders of CFS Bancorp, Inc. (1)
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 June 30, 2013, filed on August 9, 2013, formatted in Extensive Business Reporting Language (XBRL): (i) condensed consolidated statements of condition, (ii) condensed consolidated statements of operations, (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 (5)

(1) Incorporated herein by reference to the Company’s Current Report on Form 8-K filed with the SEC on May 13, 2013.

(2) 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).

(3) Incorporated herein by reference to the Company’s Current Report on Form 8-K filed with the SEC on December 17, 2010.

(4) 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.

(5) 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 1933 and Section 18 of the Securities Exchange Act of 1934.

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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:	August 12, 2013	By:	/s/ Daryl D. Pomranke
			Daryl D. Pomranke President and Chief Executive Officer
Date:	August 12, 2013	By:	/s/ Jerry A. Weberling
			Jerry A. Weberling Executive Vice President and Chief Financial Officer

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