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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934

For the fiscal year ended December 31, 2012

Commission file number 0-12422

MAINSOURCE FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)

Indiana
(State or other jurisdiction
of incorporation or organization)
  35-1562245
(I.R.S. Employer
Identification No.)

2105 North State Road 3 Bypass
Greensburg, Indiana 47240
(Address of principal executive offices) (Zip code)

Registrant's telephone number, including area code: (812) 663-6734

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
Common shares, no par value

 

Name of each exchange on which registered
The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act:
None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o    No ý

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o    No ý

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 ý    No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the previous 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý    No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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 definitions of "large accelerated filer", "accelerated filer", and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No ý

The aggregate market value (not necessarily a reliable indication of the price at which more than a limited number of shares would trade) of the voting stock held by non-affiliates of the registrant was $239,915,062 as of June 30, 2012.

As of March 14, 2013, there were outstanding 20,326,725 common shares, without par value, of the registrant.

DOCUMENTS INCORPORATED BY REFERENCE

Documents
 
Part of Form 10-K
Into Which Incorporated
Definitive Proxy Statement for Annual
Meeting of Shareholders to be held
April 23, 2013
  Part III (Items 10 through 14)



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FORM 10-K

TABLE OF CONTENTS

PART I

  Page

Item 1

 

Business

 

3
Item 1A   Risk Factors   9
Item 1B   Unresolved Staff Comments   14
Item 2   Properties   14
Item 3   Legal Proceedings   14
Item 4   Mine Safety Disclosures   14

 

 

 

 

 

PART II

   

Item 5

 

Market For Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

15
Item 6   Selected Financial Data   17
Item 7   Management's Discussion and Analysis of Financial Condition and Results of Operations   18
Item 7A   Quantitative and Qualitative Disclosures About Market Risk   30
Item 8   Financial Statements and Supplementary Data   31
Item 9   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   72
Item 9A   Controls and Procedures   72
Item 9B   Other Information   72

 

 

 

 

 

PART III

   

Item 10

 

Directors, Executive Officers and Corporate Governance

 

See below
Item 11   Executive Compensation   See below
Item 12   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   See below
Item 13   Certain Relationships and Related Transactions and Director Independence   See below
Item 14   Principal Accounting Fees and Services   See below

 

 

 

 

 

PART IV

   

Item 15

 

Exhibits, Financial Statement Schedules

 

73

        Pursuant to General Instruction G, the information called for by Items 10-14 is omitted by MainSource Financial Group, Inc. since MainSource Financial Group, Inc. will file with the Commission a definitive proxy statement for its 2013 Annual Meeting of Shareholders pursuant to Regulation 14A not later than 120 days after the close of the fiscal year containing the information required by Items 10-14.

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PART I.

(Dollar amounts in thousands except per share data)

ITEM 1.   BUSINESS

General

        MainSource Financial Group, Inc. ("MainSource" or the "Company") is an Indiana corporation and bank holding company, within the meaning of the Bank Holding Company Act of 1956, as amended (the "BHC Act"), that has elected to become a financial holding company ("FHC"). The Company is based in Greensburg, Indiana. As of December 31, 2012, the Company operated one banking subsidiary: MainSource Bank ("the Bank"), an Indiana state chartered bank. Through its non-bank affiliates, the Company provides services incidental to the business of banking. Since its formation in 1982, the Company has acquired and established various institutions and financial services companies and may acquire additional financial institutions and financial services companies in the future. For further discussion of the business of the Company see Management's Discussion and Analysis in Part II, Item 7.

        As of December 31, 2012, the Company operated 78 branch banking offices in Indiana, Illinois, Ohio and Kentucky. As of December 31, 2012, the Company had consolidated assets of $2,769,288, consolidated deposits of $2,185,054 and shareholders' equity of $323,751.

        Through the Bank, the Company offers a broad range of financial services, including: accepting time and transaction deposits; making consumer, commercial, agribusiness and real estate mortgage loans; renting safe deposit facilities; providing personal and corporate trust services; and providing other corporate services such as letters of credit and repurchase agreements.

        The lending activities of the Bank are separated into primarily the categories of commercial, commercial real estate, residential, and consumer. Loans are originated by the lending officers of the Bank subject to limitations set forth in lending policies. The Board of Directors of the Bank monitors concentrations of credit, problem and past due loans and charge-offs of uncollectible loans and approves loan policy. The Bank maintains conservative loan policies and underwriting practices in order to address and manage loan risks. These policies and practices include granting loans on a sound and collectible basis, serving the legitimate needs of the community and the general market area while obtaining a balance between maximum yield and minimum risk, ensuring that primary and secondary sources of repayment are adequate in relation to the amount of the loan, developing and maintaining adequate diversification of the loan portfolio as a whole and of the loans within each category and developing and applying adequate collection policies.

        Commercial loans include secured and unsecured loans, including real estate loans, to individuals and companies and to governmental units predominantly within the market area of the Bank for a myriad of business purposes.

        Agricultural loans are generated in the Bank's markets. Most of the loans are real estate loans on farm properties. Loans are also made for agricultural production and such loans are generally reviewed annually.

        Residential real estate lending has been the largest component of the loan portfolio for many years. The Bank generates residential mortgages for its own portfolio. However, the Company elects to sell the majority of its fixed rate mortgages into the secondary market while maintaining the servicing of such loans. At December 31, 2012, the Company was servicing a $758 million residential real estate loan portfolio. By originating loans for sale in the secondary market, the Company can more fully satisfy customer demand for fixed rate residential mortgages and increase fee income, while reducing the risk of loss caused by rising interest rates.

        The principal source of revenues for the Company is interest and fees on loans, which accounted for 55.0% of total revenues in 2012, 55.7% in 2011 and 59.8% in 2010. While the Company's chief decision makers monitor the revenue streams of the various Company products and services, the identifiable segments are not material and operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company's financial service operations are considered by management to be aggregated in one reportable operating segment.

        The Company's investment securities portfolio is primarily comprised of state and municipal bonds; U. S. government sponsored entity's mortgage-backed securities and collateralized mortgage obligations; and corporate securities. The Company has classified its entire investment portfolio as available for sale, with fair value changes reported separately in shareholders' equity. Funds invested in the investment portfolio generally represent funds not immediately required to meet loan demand. Income related to the Company's investment portfolio accounted for 16.2% of total revenues in 2012, 17.0% in 2011 and 16.6% in 2010. As of December 31, 2012, the Company had not identified any securities as being "high risk" as defined by the FFIEC Supervisory Policy Statement on Securities Activities.

        The primary source of funds for the Bank is deposits generated in local market areas. To attract and retain stable depositors, the Bank markets various programs for demand, savings and time deposit accounts. These programs include interest and non-interest bearing demand and individual retirement accounts.

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        Currently, national retailing and manufacturing subsidiaries, brokerage and insurance firms and credit unions are fierce competitors within the financial services industry. Mergers between financial institutions within Indiana and neighboring states, which became permissible under the Interstate Banking and Branching Efficiency Act of 1994, have also added competitive pressure.

        The branches of the Bank are predominantly located in non-metropolitan areas and the Bank's business is centered in loans and deposits generated within markets considered largely rural in nature. In addition to competing vigorously with other banks, thrift institutions, credit unions and finance companies located within their service areas, we also compete, directly and indirectly, with all providers of financial services.

Employees

        As of December 31, 2012, the Company and its subsidiaries had 808 full-time equivalent employees to whom they provide a variety of benefits and with whom they enjoy excellent relations. None of our employees are subject to collective bargaining agreements.

Regulation and Supervision

        The Company is a financial holding company ("FHC") within the meaning of the Bank Holding Company Act of 1956, as amended. As a FHC, the Company is subject to regulation by the Federal Reserve Board ("FRB"). The Bank is an Indiana state chartered bank subject to supervision and regulation by the Federal Deposit Insurance Corporation ("FDIC") and the Indiana Department of Financial Institutions. The following is a discussion of material statutes and regulations affecting the Company and the Bank. The discussion is qualified in its entirety by reference to such statutes and regulations.

    Bank Holding Company Act of 1956, as amended

        Generally, the BHC Act governs the acquisition and control of banks and nonbanking companies by bank holding companies. A bank holding company is subject to regulation by and is required to register with the FRB under the BHC Act. The BHC Act requires a bank holding company to file an annual report of its operations and such additional information as the FRB may require. The FRB has issued regulations under the BHC Act requiring a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. It is the policy of the FRB that, pursuant to this requirement, a bank holding company should stand ready to use its resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity.

        The acquisition of 5% or more of the voting shares of any bank or bank holding company generally requires the prior approval of the FRB and is subject to applicable federal and state law, including the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 ("Riegle-Neal") for interstate transactions. The FRB evaluates acquisition applications based on, among other things, competitive factors, supervisory factors, adequacy of financial and managerial resources, and banking and community needs considerations.

        The BHC Act also prohibits, with certain exceptions, a bank holding company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any "nonbanking" company unless the nonbanking activities are found by the FRB to be "so closely related to banking…as to be a proper incident thereto." Under current regulations of the FRB, a bank holding company and its nonbank subsidiaries are permitted, among other activities, to engage in such banking-related business ventures as consumer finance, equipment leasing, data processing, mortgage banking, financial and investment advice, and securities brokerage services. The BHC Act does not place territorial restrictions on the activities of a bank holding company or its nonbank subsidiaries.

        Federal law prohibits acquisition of "control" of a bank or bank holding company without prior notice to certain federal bank regulators. "Control" is defined in certain cases as the acquisition of as little as 10% of the outstanding shares of any class of voting stock. Furthermore, under certain circumstances, a bank holding company may not be able to purchase its own stock, where the gross consideration will equal 10% or more of the company's net worth, without obtaining approval of the FRB. Under the Federal Reserve Act, banks and their affiliates are subject to certain requirements and restrictions when dealing with each other (affiliate transactions include transactions between a bank and its bank holding company).

    Gramm-Leach-Bliley Financial Modernization Act of 1999.

        The Gramm-Leach-Bliley Financial Modernization Act of 1999 (the "Modernization Act") was enacted on November 12, 1999. The Modernization Act, which amended the BHC Act, provides the following:

    it allows bank holding companies that qualify as "financial holding companies" to engage in a broad range of financial and related activities;

    it allows insurers and other financial services companies to acquire banks;

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    it removes various restrictions that applied to bank holding company ownership of securities firms and mutual fund advisory companies; and

    it establishes the overall regulatory structure applicable to bank holding companies that also engage in insurance and securities operations.

        The Company initially qualified as a financial holding company in December, 2004. Thus the Company is authorized to operate as a financial holding company and is eligible to engage in, or acquire companies engaged in, the broader range of activities that are permitted by the Modernization Act. These activities include those that are determined to be "financial in nature," including insurance underwriting, securities underwriting and dealing, and making merchant banking investments in commercial and financial companies. If a banking subsidiary ceases to be "well capitalized" or "well managed" under applicable regulatory standards, the FRB may, among other things, place limitations on our ability to conduct these broader financial activities or, if the deficiencies persist, require us to divest the banking subsidiary. In addition, if a banking subsidiary receives a rating of less than satisfactory under the Community Reinvestment Act of 1977 ("CRA"), we would be prohibited from engaging in any additional activities other than those permissible for bank holding companies that are not financial holding companies.

    Bank Secrecy Act and USA Patriot Act

        In 1970, Congress enacted the Currency and Foreign Transactions Reporting Act, commonly known as the Bank Secrecy Act (the "BSA"). The BSA requires financial institutions to maintain records of certain customers and currency transactions and to report certain domestic and foreign currency transactions, which may have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings. Under this law, financial institutions are required to develop a BSA compliance program.

        In 2001, the President signed into law comprehensive anti-terrorism legislation known as the USA Patriot Act. Title III of the USA Patriot Act requires financial institutions, including the Company and the Bank, to help prevent and detect international money laundering and the financing of terrorism and prosecute those involved in such activities. The Department of the Treasury has adopted additional requirements to further implement Title III.

        Under these regulations, a mechanism has been established for law enforcement officials to communicate names of suspected terrorists and money launderers to financial institutions to enable financial institutions to promptly locate accounts and transactions involving those suspects. Financial institutions receiving names of suspects must search their account and transaction records for potential matches and report positive results to the U.S. Department of the Treasury Financial Crimes Enforcement Network ("FinCEN"). Each financial institution must designate a point of contact to receive information requests. These regulations outline how financial institutions can share information concerning suspected terrorist and money laundering activity with other financial institutions under the protection of a statutory safe harbor if each financial institution notifies FinCEN of its intent to share information. The Department of the Treasury has also adopted regulations intended to prevent money laundering and terrorist financing through correspondent accounts maintained by U.S. financial institutions on behalf of foreign banks. Financial institutions are required to take reasonable steps to ensure that they are not providing banking services directly or indirectly to foreign shell banks. In addition, banks must have procedures in place to verify the identity of the persons with whom they deal.

    FDIC Improvement Act of 1991

        The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") requires, among other things, federal bank regulatory authorities to take "prompt corrective action" with respect to banks which do not meet minimum capital requirements. For these purposes, FDICIA establishes five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The FDIC has adopted regulations to implement the prompt corrective action provisions of FDICIA.

        "Undercapitalized" banks are subject to growth limitations and are required to submit a capital restoration plan. A bank's compliance with such plan is required to be guaranteed by the bank's parent holding company. If an "undercapitalized" bank fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. "Significantly undercapitalized" banks are subject to one or more restrictions, including an order by the FDIC to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cease receipt of deposits from correspondent banks, and restrictions on compensation of executive officers. "Critically undercapitalized" institutions may not, beginning 60 days after becoming "critically undercapitalized," make any payment of principal or interest on certain subordinated debt or extend credit for a highly leveraged transaction or enter into any transaction outside the ordinary course of business. In addition, "critically undercapitalized" institutions are subject to appointment of a receiver or conservator.

        A "well capitalized" institution is one that has a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6%, a leverage ratio of at least 5% and is not subject to regulatory direction to maintain a specific level for any capital measure. An "adequately capitalized" institution is one that has ratios greater than 8%, 4% and 4%. An institution is "undercapitalized" if its respective ratios are less than 8%, 4% and 4%. "Significantly undercapitalized" institutions have ratios of

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less than 6%, 3% and 3%. An institution is deemed to be "critically undercapitalized" if it has a ratio of tangible equity to total assets that is 2% or less.

    The Sarbanes-Oxley Act

        The Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. Among other requirements, the Sarbanes-Oxley Act established: (i) requirements for audit committees of public companies, including independence and expertise standards; (ii) additional responsibilities regarding financial statements for the chief executive officers and chief financial officers of reporting companies; (iii) standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for reporting companies regarding various matters relating to corporate governance, and (v) new and increased civil and criminal penalties for violation of the securities laws.

    Deposit Insurance Fund

        The deposits of the Bank are insured to the maximum extent permitted by law by the Deposit Insurance Fund ("DIF") of the FDIC, which was created in 2006 as the result of the merger of the Bank Insurance Fund and the Savings Association Insurance Fund in accordance with the Federal Deposit Insurance Reform Act of 2005 (the "FDI Act"). The FDIC maintains the DIF by assessing depository institutions an insurance premium. Pursuant to the Dodd-Frank Act, the FDIC is required to set a DIF reserve ratio of 1.35% of estimated insured deposits and is required to achieve this ratio by September 30, 2020. Also, the Dodd-Frank Act has eliminated the 1.50% ceiling on the reserve ratio and provides that the FDIC is no longer required to refund amounts in the DIF that exceed 1.50% of insured deposits.

        Under the FDIC's risk-based assessment system, insured institutions are required to pay deposit insurance premiums based on the risk that each institution poses to the DIF. An institution's risk to the DIF is measured by its regulatory capital levels, supervisory evaluations, and certain other factors. An institution's assessment rate depends upon the risk category to which it is assigned. As noted above, pursuant to the Dodd-Frank Act, the FDIC will calculate an institution's assessment level based on its total average consolidated assets during the assessment period less average tangible equity (i.e., Tier 1 capital) as opposed to an institution's deposit level which was the previous basis for calculating insurance assessments. Pursuant to the Dodd-Frank Act, institutions will be placed into one of four risk categories for purposes of determining the institution's actual assessment rate. The FDIC will determine the risk category based on the institution's capital position (well capitalized, adequately capitalized, or undercapitalized) and supervisory condition (based on exam reports and related information provided by the institution's primary federal regulator).

    Dividends

        The Company is a legal entity separate and distinct from the Bank. There are various legal limitations on the extent to which the Bank can supply funds to the Company. The principal source of the Company's funds consists of dividends from the Bank. State and Federal law restricts the amount of dividends that may be paid by banks. In addition, the Bank is subject to certain restrictions on extensions of credit to the Company, on investments in the stock or other securities of the Company and in taking such stock or securities as collateral for loans.

    Community Reinvestment Act

        The Community Reinvestment Act requires that the federal banking regulators evaluate the records of a financial institution in meeting the credit needs of its local community, including low and moderate income neighborhoods. These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. Failure to adequately meet these criteria could result in the imposition of additional requirements and limitations on the Bank.

    Capital Requirements

        As discussed above, the Company and the Bank must meet certain minimum capital requirements mandated by each of their state or federal regulators. These regulatory agencies require BHCs and banks to maintain certain minimum ratios of primary capital to total assets and total capital to total assets. The FRB requires BHCs to maintain a minimum Tier 1 leverage ratio of 3% capital to total assets; however, for all but the most highly rated institutions which do not anticipate significant growth, the minimum Tier 1 leverage ratio is 3% plus an additional cushion of 100 to 200 basis points. As of December 31, 2012, the Company's leverage ratio of capital to total assets was 10.4%. The FRB and FDIC each have approved the imposition of "risk-adjusted" capital ratios on BHCs and financial institutions. The Company's Tier 1 Capital to Risk-Weighted Assets Ratio was 16.5% and its Total Capital to Risk-Weighted Assets Ratio was 17.8% at December 31, 2012. The Bank had capital to asset ratios and risk- adjusted capital ratios at December 31, 2012, in excess of the applicable minimum regulatory requirements.

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    Emergency Economic Stabilization Act of 2008

        In October 2008, the Emergency Economic Stabilization Act of 2008 ("EESA") was enacted. The EESA authorized Treasury to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage- related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in a troubled asset relief program ("TARP"). The purpose of TARP was to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. EESA also increased the amount of deposit insurance provided by the FDIC.

        The U.S. Department of the Treasury ("Treasury"), working with the Federal Reserve Board, established late in 2008 the TARP Capital Purchase Program ("CPP"), which was intended to stabilize the financial services industry. One of the components of the CPP included a $250 billion voluntary capital purchase program for certain qualified and healthy banking institutions. Pursuant to the CPP, Treasury purchased from the Company 57,000 shares of $1,000 par value senior perpetual preferred securities at a price of $57 million equal to approximately 3.0% of the Company's then risk-weighted assets. Such preferred shares pay a dividend of 5% for the first five years and will increase to 9% thereafter. In connection with the Company's participation in the CPP, Treasury also received a warrant for the purchase of common stock in the amount of 571,906 shares at a strike price of $14.95 per share. The warrant expires on January 16, 2019. During 2012, Treasury auctioned off the Company's preferred shares to third parties. The Company was successful in repurchasing some of these shares and on two separate occasions during 2012, repurchased some additional shares from third parties. As of December 31, 2012, 15,100 shares of Series A preferred stock remained outstanding. See Note 2 in the Consolidated Financial Statements for further discussion of the preferred shares.

    American Recovery and Reinvestment Act of 2009

        On February 17, 2009, President Barack Obama signed the American Recovery and Reinvestment Act of 2009 ("ARRA"), more commonly known as the economic stimulus or economic recovery package. ARRA included a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health and education needs. In addition, ARRA imposed new executive compensation and corporate governance limits on current and future participants in the CPP, including the Company, which are in addition to those previously announced by Treasury. These limits remain in place until the participant has redeemed the preferred stock sold to Treasury, which is now permitted under ARRA without penalty and without the need to raise new capital, subject to Treasury's consultation with the recipient's appropriate federal regulator. On June 10, 2009, Treasury released an interim final rule, effective June 15, 2009, that provided guidance on the compensation and governance standards for participants in the CPP, and promulgated regulations to implement the restrictions and standards set forth in ARRA. Among other things, Treasury's final rule and ARRA significantly expanded the executive compensation restrictions previously imposed by EESA. As of April 3, 2012, the date the U.S. Treasury no longer held any shares of the Company's preferred stock issued under the CPP, the Company was no longer subject to the ARRA or EESA restrictions.

    The Dodd-Frank Wall Street Reform and Consumer Protection Act

        On July 21, 2010, President Obama signed into law the sweeping financial regulatory reform act entitled the "Dodd-Frank Wall Street Reform and Consumer Protection Act" (Dodd-Frank Act). The Dodd-Frank Act implements far-reaching changes to the regulation of the financial services industry, including provisions that, among other things will:

    centralize responsibility for consumer financial protection by creating a new agency (the Consumer Financial Protection Bureau) responsible for implementing, examining and enforcing compliance with federal consumer financial laws with broad rulemaking, supervision and enforcement authority for a wide range of consumer protection laws that would apply to all banks and thrifts; smaller financial institutions, including the Company, will be subject to the supervision and enforcement of their primary federal banking regulator with respect to the federal consumer financial protection laws;

    require the FDIC to seek to make its capital requirements for banks countercyclical so that the amount of capital required to be maintained increases in times of economic expansion and decreases in times of economic contraction;

    change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital;

    implement corporate governance revisions, including with regard to executive compensation and proxy access by stockholders, that apply to all public companies, not just financial institutions;

    make permanent the $250,000 limit for federal deposit insurance and increase the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000, and provide unlimited federal deposit insurance until January 1, 2013, for non-interest bearing demand transaction accounts at all insured depository institutions;

    repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts starting July 2011; and

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    increase the authority of the Federal Reserve to examine the Company and its non-bank subsidiaries.

        The Dodd-Frank Act includes certain provisions concerning the capital regulations of the United States banking regulators, which are often referred to as the "Collins Amendment." These provisions are intended to subject bank holding companies to the same capital requirements as their bank subsidiaries and to eliminate or significantly reduce the use of hybrid capital instruments, especially trust preferred securities, as regulatory capital. Under the Collins Amendment, trust preferred securities issued by a company, such as the Company, with total consolidated assets of less than $15 billion before May 19, 2010 and treated as regulatory capital are grandfathered, but any such securities issued later are not eligible as regulatory capital. The banking regulators must develop regulations setting minimum risk-based and leverage capital requirements for holding companies and banks on a consolidated basis that are no less stringent than the generally applicable requirements in effect for depository institutions under prompt corrective action regulations. The banking regulators also must seek to make capital standards countercyclical so that the required levels of capital increase in times of economic expansion and decrease in times of economic contraction.

        Many aspects of the act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company, its customers or the financial industry more generally. Provisions in the legislation that affect deposit insurance assessments and payment of interest on demand deposits could increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate.

    S.A.F.E. Act Requirements

        Regulations issued under the Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (the "S.A.F.E. Act") require residential mortgage loan originators who are employees of institutions regulated by the foregoing agencies, including national banks, to meet the registration requirements of the S.A.F.E. Act. The S.A.F.E. Act requires residential mortgage loan originators who are employees of regulated financial institutions to be registered with the Nationwide Mortgage Licensing System and Registry, a database created by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators to support the licensing of mortgage loan originators by the states. Employees of regulated financial institutions are generally prohibited from originating residential mortgage loans unless they are registered.

    Basel III

        In December 2010, the Basel Committee released its final framework for strengthening international capital and liquidity regulation, officially identified by the Basel Committee as "Basel III". In June 2012, the Federal Reserve Board, OCC, and FDIC (collectively, the "Agencies") each issued Notices of Proposed Rulemaking ("NPRs") that would revise and replace the Agencies' current capital rules to align with the BASEL III capital standards and meet certain requirements of the Dodd-Frank Act. The comment period for the NPRs ended October 22, 2012, and comments received by such deadline are currently being evaluated by the Agencies.

        The standards set forth in the NPRs, when implemented by the Agencies and fully phased-in, will require bank holding companies and their bank subsidiaries to maintain substantially more capital, with a greater emphasis on common equity.

        As set forth in the NPRs, the new capital rules would, among other things:

    Narrow the types of instruments that can be included in Tier 1 Capital (including removing trust preferred securities from such definition);

    Introduce a new Common Equity Tier 1 Capital Ratio of 6.5% (to be well-capitalized);

    Increase the Tier 1 Capital Ratio from 4% to 6%; and

    Introduce a capital conservation buffer of an additional 2.5% of common equity to risk-weighted assets.

        The timing for the Agencies' adoption and implementation of final rules to implement the Basel III/Dodd-Frank Act capital framework is uncertain. Accordingly, the regulations ultimately applicable to the Company and the Bank may be substantially different from the Basel III final framework as published in December 2010 (and updated in 2011) or the NPRs. The requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Company's financial results.

    Future Legislation

        In addition to the specific legislation described above, various additional legislation is currently being considered by Congress. This legislation may change banking statutes and the Company's operating environment in substantial and unpredictable ways and may increase reporting requirements and governance. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities, or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. The Company cannot predict whether any potential legislation will be enacted and, if enacted, the effect that it, or any implementing regulations, would have on its business, results of operations, or financial condition.

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ITEM 1A.    RISK FACTORS

        In addition to the other information contained in this report, the following risks may affect us. If any of these risks actually occur, our business, financial condition or results of operations may suffer. As a result, the price of our common shares could decline.

Risks Related to the Company's Business

Difficult conditions in the capital markets and the economy generally have affected and may continue to materially adversely affect our business and results of operations.

        From 2007 through 2009, the U.S. economy was in recession. Business activity across a wide range of industries and regions in the U.S. was greatly reduced. Although economic conditions have begun to improve, certain sectors, such as real estate, remain weak and unemployment remains high. Local governments and many businesses are still in serious difficulty due to lower consumer spending and the lack of liquidity in the credit markets.

        Market conditions also led to the failure or merger of several prominent financial institutions and numerous regional and community-based financial institutions. These failures, as well as projected future failures, have had a significant negative impact on the capitalization level of the deposit insurance fund of the FDIC, which, in turn, has led to a significant increase in deposit insurance premiums paid by financial institutions.

        The Company's financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services that the Company offers, is highly dependent upon the business environment in the markets where the Company operates and in the United States as a whole. A favorable business environment is generally characterized by, among other factors, economic growth, efficient capital markets, low inflation, low unemployment, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters, or a combination of these or other factors.

        During 2011 and 2012, the business environment continued to be adverse for many households and businesses in the United States and worldwide. While economic conditions in the United States and worldwide have begun to improve, there can be no assurance that this improvement will continue. Such conditions have affected, and could continue to adversely affect, the credit quality of the Company's loans, results of operations and financial condition.

Recently enacted and potential further financial regulatory reforms could have a significant impact on our business, financial condition and results of operations.

        On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") into law. The Dodd-Frank Act is expected to have a broad impact on the financial services industry, including significant regulatory and compliance changes. Many of the requirements called for in the Dodd-Frank Act will be implemented over time and most will be subject to implementing regulations over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on our operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of business activities, require changes to certain business practices, impose more stringent capital, liquidity and leverage requirements or otherwise adversely affect our business. In particular, the potential impact of the Dodd-Frank Act on our operations and activities, both currently and prospectively, include, among others:

    a reduction in the ability to generate or originate revenue-producing assets as a result of compliance with heightened capital standards;

    increased cost of operations due to greater regulatory oversight, supervision and examination of banks and bank holding companies, and higher deposit insurance premiums;

    the limitation on the ability to raise new capital through the use of trust preferred securities, as any new issuances of these securities will no longer be included as Tier 1 capital going forward;

    a potential reduction in fee income due to limits on interchange fees applicable to larger institutions which could effectively reduce the fees we can charge; and

    the limitation on the ability to expand consumer product and service offerings due to anticipated stricter consumer protection laws and regulations.

        Further, we may be required to invest significant management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements under the Dodd-Frank Act, which may negatively impact results of operations and financial condition.

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        We cannot predict whether there will be additional proposed laws or reforms that would affect the U.S. financial system or financial institutions, whether or when such changes may be adopted, how such changes may be interpreted and enforced or how such changes may affect us. However, the costs of complying with any additional laws or regulations could have a material adverse effect on our financial condition and results of operations.

The new Basel III capital rules proposed in August 2012 by the Federal Reserve and the FDIC to implement the Basel III capital guidelines may adversely affect the Company's and the Bank's capital adequacy and the costs of conducting its business.

        If adopted and effective in their current form, many of these proposals will be applicable to the Company and the Bank, and will include several significant changes, including changes to the definition of "capital" for regulatory purposes, the types and minimum levels of capital required under the prompt corrective action rules and for other regulatory purposes and the risk-weighting of various assets. In addition, among other things, for bank holding companies with under $15 billion in assets, trust preferred securities will be phased out as Tier 1 capital over 10 years. Based on the current components and levels of our capital and assets, we believe that we would be in compliance with the requirements in the proposed rules if they were currently in effect. There is no assurance that the Basel III proposals will be adopted in their current form, what changes may be made prior to adoption, or when the final rules will be effective. Until the proposals are finalized and the timing of implementation of the new rules is determined, some uncertainty will exist with respect to the impact of the rules on us and the banking industry generally.

Like most banking organizations, a significant portion of our assets consists of loans, which if not repaid could result in losses to the Company.

        As a lender, we are exposed to the risk that our customers will be unable to repay their loans according to their terms and that the collateral securing the payment of their loans (if any) may not be sufficient to assure repayment. Credit losses could have a material adverse effect on our operating results.

        As of December 31, 2012, our total loan portfolio was approximately $1,553,383 or 56% of our total assets. Three major components of the loan portfolio are loans principally secured by real estate, approximately $1,345,354 or 87% of total loans; other commercial loans, approximately $159,734 or 10% of total loans; and consumer loans, approximately $48,295 or 3% of total loans. Our credit risk with respect to our consumer installment loan portfolio and commercial loan portfolio relates principally to the general creditworthiness of individuals and businesses within our local market area. Our credit risk with respect to our residential and commercial real estate mortgage and construction loan portfolio relates principally to the general creditworthiness of individuals and businesses and the value of real estate serving as security for the repayment of the loans. A related risk in connection with loans secured by commercial real estate is the effect of unknown or unexpected environmental contamination, which could make the real estate effectively unmarketable or otherwise significantly reduce its value as security. Continued or worsening declines in the economy could cause additional credit issues, particularly within our residential and commercial real estate mortgage and construction loan portfolio.

Our allowance for loan losses may not be sufficient to cover actual loan losses, which could adversely affect our earnings.

        We maintain an allowance for loan losses at a level estimated by management to be sufficient to cover probable incurred loan losses in our loan portfolio. Loan losses will likely occur in the future and may occur at a rate greater than we have experienced to date. In determining the size of the allowance, our management makes various assumptions and judgments about the collectability of our loan portfolio, including the diversification by industry of our commercial loan portfolio, the effect of changes in the local real estate markets on collateral values, the results of recent regulatory examinations, the effects on the loan portfolio of current economic indicators and their probable impact on borrowers, the amount of charge-offs for the period, the amount of nonperforming loans and related collateral security, and the evaluation of our loan portfolio by an external loan review. If our assumptions and judgments prove to be incorrect, our current allowance may not be sufficient and adjustments may be necessary to allow for different economic conditions or adverse developments in our loan portfolio. Additionally, continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside the Company's control, may require an increase in the allowance for loan losses. Federal and state regulators also periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in our allowance for loan losses or loan charge-offs could have an adverse effect on our operating results and financial condition. There can be no assurance that our monitoring procedures and policies will reduce certain lending risks or that our allowance for loan losses will be adequate to cover actual losses.

If we foreclose on collateral property, we may be subject to the increased costs associated with ownership of real property, resulting in reduced revenues and earnings.

        We may have to foreclose on collateral property to protect our investment and may thereafter own and operate such property, in which case we will be exposed to the risks inherent in the ownership of real estate. The amount that we, as a mortgagee, may realize

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after a default is dependent upon factors outside of our control, including, but not limited to: (i) general or local economic conditions; (ii) neighborhood values; (iii) interest rates; (iv) real estate tax rates; (v) operating expenses of the mortgaged properties; (vi) environmental remediation liabilities; (vii) ability to obtain and maintain adequate occupancy of the properties; (viii) zoning laws; (ix) governmental rules, regulations and fiscal policies; and (x) acts of God. Certain expenditures associated with the ownership of real estate, principally real estate taxes, insurance, and maintenance costs, may adversely affect the income from the real estate. Therefore, the cost of operating real property may exceed the income earned from such property, and we may have to advance funds in order to protect our investment, or we may be required to dispose of the real property at a loss. The foregoing expenditures and costs could adversely affect our ability to generate revenues, resulting in reduced levels of profitability.

Significant interest rate volatility could reduce our profitability.

        Our results of operations are affected principally by net interest income, which is the difference between interest earned on loans and investments and interest expense paid on deposits and other borrowings. We cannot predict or control changes in interest rates. National, regional and local economic conditions and the policies of regulatory authorities, including monetary policies of the Board of Governors of the Federal Reserve System, affect market interest rates. While we have instituted policies and procedures designed to manage the risks from changes in market interest rates, at any given time our assets and liabilities will likely be affected differently by a given change in interest rates, principally because we do not match the maturities of our loans and investments precisely with our deposits and other funding sources. Changes in interest rates may also affect the level of voluntary prepayments on our loans and the level of financing or refinancing by customers. As of December 31, 2012, we had a negative interest rate gap of approximately 20% of interest earning assets in the one-year time frame. Although this is within our internal policy limits, our earnings will be adversely affected in periods of rising interest rates because, during such periods, the interest expense paid on deposits and borrowings will generally increase more rapidly than the interest income earned on loans and investments. If such an interest rate increase occurred gradually, we would use our established procedures to attempt to mitigate the effects over time. However, if such an interest rate increase occurred rapidly, or interest rates exhibited volatile increases and decreases, we might be unable to mitigate the effects, and our net interest income could suffer significant adverse effects. While management intends to continue to take measures to mitigate interest rate risk, we cannot assure you that such measures will be entirely effective in minimizing our exposure to the risk of rapid changes in interest rates.

The repeal of Regulation Q may increase competition for deposits and increase our interest expense.

        On July 18, 2011, the Board of Governors of the Federal Reserve System published a final rule repealing Regulation Q, which prohibits the payment of interest on demand deposits by institutions that are member banks of the Federal Reserve System. The rule implements Section 627 of the Dodd-Frank Wall Street Reform and Consumer Protection Act signed by President Obama on July 21, 2010, which repealed Section 19(i) of the Federal Reserve Act in its entirety effective July 21, 2011. As a result, banks and thrifts may now offer interest-bearing demand deposit accounts to commercial customers, which were previously forbidden under Regulation Q. The repeal of Regulation Q may cause increased competition from other financial institutions for these deposits. If the Bank decides to pay interest on demand accounts, it would expect interest expense to increase.

We may be required to pay significantly higher Federal Deposit Insurance Corporation (FDIC) premiums in the future.

        Insured institution failures during the past several years, as well as deterioration in banking and economic conditions, have significantly increased FDIC loss provisions, resulting in a decline in the designated reserve ratio to historical lows. The FDIC expects the higher rate of insured institution failures to continue for the next few years compared to the past; thus, the reserve ratio may continue to decline. In addition the Dodd-Frank Act permanently implemented FDIC insurance coverage for all deposit accounts up to $250,000 and revised the insurance premium assessment base from all domestic deposits to the average of total assets less tangible equity. The minimum reserve ratio of the deposit insurance fund has been increased from 1.15% to 1.35%, with the increase to be covered by assessments on insured institutions with assets over $10 billion until the new reserve ratio is reached.

        We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures, we may be required to pay even higher FDIC premiums than the recently increased levels. Additionally, the FDIC may make material changes to the calculation of the prepaid assessment from the current proposal. Any future changes in the calculation or assessment of FDIC insurance premiums may have a material adverse effect on our results of operations, financial condition and our ability to continue to pay dividends on our common shares at the current rate or at all.

Future growth or operating results may require the Company to raise additional capital but that capital may not be available or it may be dilutive.

        The Company is required by federal and state regulatory authorities to maintain adequate levels of capital to support its operations. To the extent the Company's future operating results erode capital or the Company elects to expand through loan growth or acquisition it may be required to raise capital. The Company's ability to raise capital will depend on conditions in the capital markets, which are outside of its control, and on the Company's financial performance. Accordingly, the Company cannot be assured

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of its ability to raise capital if needed or on favorable terms. If the Company cannot raise additional capital when needed, it will be subject to increased regulatory supervision and the imposition of restrictions on its growth and business. These could negatively impact the Company's ability to operate or further expand its operations through acquisitions or the establishment of additional branches and may result in increases in operating expenses and reductions in revenues that could have a material adverse effect on its financial condition and results of operations.

We rely heavily on our management and other key personnel, and the loss of any of them may adversely affect our operations.

        We are and will continue to be dependent upon the services of our management team. The loss of any of our senior managers could have an adverse effect on our growth and performance because of their skills, knowledge of the markets in which we operate and years of industry experience and the difficulty of promptly finding qualified replacement personnel. The loss of key personnel in a particular market could have an adverse effect on our performance in that market because it may be difficult to find qualified replacement personnel who are already located in or would be willing to relocate to a non-metropolitan market. Additionally, recent proposed regulations issued by banking regulators regarding executive compensation may impact our ability to compensate executives and, as a result, to attract and retain qualified personnel.

The geographic concentration of our markets makes our business highly susceptible to local economic conditions.

        Unlike larger banking organizations that are more geographically diversified, our operations are currently concentrated in 31 counties in Indiana, three counties in Illinois, two counties in Ohio, and three counties in Kentucky. As a result of this geographic concentration in four fairly contiguous markets, our financial results depend largely upon economic conditions in these market areas. A deterioration in economic conditions in one or all of these markets could result in one or more of the following:

    an increase in loan delinquencies;

    an increase in problem assets and foreclosures;

    a decrease in the demand for our products and services; or

    a decrease in the value of collateral for loans, especially real estate, in turn reducing customers' borrowing power, the value of assets associated with problem loans and collateral coverage.

If we do not adjust to rapid changes in the financial services industry, our financial performance may suffer.

        We face substantial competition for deposit, credit and trust relationships, as well as other sources of funding in the communities we serve. Competing providers include other banks, thrifts and trust companies, insurance companies, mortgage banking operations, credit unions, finance companies, money market funds and other financial and nonfinancial companies which may offer products functionally equivalent to those offered by our banks. Competing providers may have greater financial resources than we do and offer services within and outside the market areas we serve. In addition to this challenge of attracting and retaining customers for traditional banking services, our competitors now include securities dealers, brokers, mortgage bankers, investment advisors and finance and insurance companies who seek to offer one-stop financial services to their customers that may include services that banks have not been able or allowed to offer to their customers in the past. The increasingly competitive environment is primarily a result of changes in regulation, changes in technology and product delivery systems and the accelerating pace of consolidation among financial service providers. If we are unable to adjust both to increased competition for traditional banking services and changing customer needs and preferences, it could adversely affect our financial performance and your investment in our common stock.

Acquisitions entail risks which could negatively affect our operations.

        Acquisitions involve numerous risks, including:

    exposure to asset quality problems of the acquired institution;

    maintaining adequate regulatory capital;

    diversion of management's attention from other business concerns;

    risks and expenses of entering new geographic markets;

    potential significant loss of depositors or loan customers from the acquired institution; or

    exposure to undisclosed or unknown liabilities of an acquired institution.

        Any of these acquisition risks could result in unexpected losses or expenses and thereby reduce the expected benefits of the acquisition.

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Unanticipated costs related to our acquisitions could reduce MainSource's future earnings per share.

        MainSource believes it has reasonably estimated the likely costs of integrating the operations of the banks it acquires into MainSource and the incremental costs of operating such banks as a part of the MainSource family. However, it is possible that unexpected transaction costs such as taxes, fees or professional expenses or unexpected future operating expenses, such as increased personnel costs or increased taxes, as well as other types of unanticipated adverse developments, could have a material adverse effect on the results of operations and financial condition of MainSource. If unexpected costs are incurred, acquisitions could have a dilutive effect on MainSource's earnings per share. Current accounting guidance requires expensing of acquisition costs. In prior years, these costs could be capitalized. In other words, if MainSource incurs such unexpected costs and expenses as a result of its acquisitions, MainSource believes that the earnings per share of MainSource common stock could be less than they would have been if those acquisitions had not been completed.

MainSource may be unable to successfully integrate the operations of the banks it has acquired and may acquire in the future and retain employees of such banks.

        MainSource's acquisition strategy involves the integration of the banks MainSource has acquired and may acquire in the future as MainSource subsidiary banks. The difficulties of integrating the operations of such banks with MainSource and its other subsidiary banks include:

    coordinating geographically separated organizations;

    integrating personnel with diverse business backgrounds;

    combining different corporate cultures; or

    retaining key employees.

        The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of one or more of MainSource, its subsidiary banks and the banks MainSource has acquired and may acquire in the future and the loss of key personnel. The integration of such banks as MainSource subsidiary banks requires the experience and expertise of certain key employees of such banks who are expected to be retained by MainSource. We cannot be sure, however, that MainSource will be successful in retaining these employees for the time period necessary to successfully integrate such banks' operations as subsidiary banks of MainSource. The diversion of management's attention and any delays or difficulties encountered in connection with the mergers, along with the integration of the banks as MainSource subsidiary banks, could have an adverse effect on the business and results of operation of MainSource.

The Company may be subject to future goodwill impairment charges

        During 2009, the Company recorded $80,310 in goodwill impairment charges in the second and fourth quarters. No goodwill impairment charges were recorded in 2010, 2011, or 2012. While the Company does not currently anticipate that there will be additional impairment charges required in the future, it can make no guarantees that none will be taken. If more impairment is recorded, it will have a negative impact on future earnings.

Risks Relating to the Banking Industry

Changes in governmental regulation and legislation could limit our future performance and growth.

        We are subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of our operations, as well as any acquisitions we may propose to make. Any change in applicable federal or state laws or regulations could have a substantial impact on us, our subsidiary banks and our operations. While we cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, these changes could reduce the value of your investment.

Changes in regulation or oversight may have a material adverse impact on our operations.

        We are subject to extensive regulation, supervision and examination by the Indiana Department of Financial Institutions, the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission and other regulatory bodies. Such regulation and supervision governs the activities in which we may engage. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, investigations and limitations related to our securities, the classification of our assets and determination of the level of our allowance for loan losses. In light of the current conditions in the U.S. financial markets and economy, Congress and regulators have increased their focus on the regulation of the financial services industry. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material adverse impact on our business, financial condition or results of operations.

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Risks Related to the Company's Stock

We may not be able to pay dividends in the future in accordance with past practice.

        The Company has traditionally paid a quarterly dividend to common stockholders. The Company is a separate legal entity from the Bank and receives substantially all of its revenue and cash flow from dividends paid by the Bank to the Company. Indiana state law and agreements between the Bank and its federal and state regulators may limit the amount of dividends that the Bank may pay to the Company. In the event that the Bank is unable to pay dividends to the Company for an extended period of time, the Company may not be able to service its debt obligations or pay dividends on its common stock. Additionally, any payment of dividends in the future will depend, in large part, on the Bank's earnings, capital requirements, financial condition and other factors considered relevant by the Company's Board of Directors. Starting in the second quarter of 2009 and continuing to the second quarter of 2012, the Company reduced the amount of cash dividends paid. This reduction was made to preserve capital levels at the Company. Beginning in the third quarter of 2012, the Company raised the dividend to $.03/share, and in the first quarter of 2013 it raised the dividend to $.06/share.

The price of the Company's common stock may be volatile, which may result in losses for investors.

        General market price declines or market volatility in the future could adversely affect the price of the Company's common stock. In addition, the following factors may cause the market price for shares of the Company's common stock to fluctuate:

    announcements of developments related to the Company's business;

    fluctuations in the Company's results of operations;

    sales or purchases of substantial amounts of the Company's securities in the marketplace;

    general conditions in the Company's banking niche or the worldwide economy;

    a shortfall or excess in revenues or earnings compared to securities analysts' expectations;

    changes in analysts' recommendations or projections; and

    the Company's announcement of new acquisitions or other projects.

The Company's charter documents and federal regulations may inhibit a takeover, prevent a transaction that may favor or otherwise limit the Company's growth opportunities, which could cause the market price of the Company's common stock to decline.

        Certain provisions of the Company's charter documents and federal regulations could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of the Company. In addition, the Company must obtain approval from regulatory authorities before acquiring control of any other company.

ITEM 1B.    UNRESOLVED STAFF COMMENTS.

        None.

ITEM 2.    PROPERTIES

        As of December 31, 2012, the Company leased an office building located in Greensburg, Indiana, from one of its subsidiaries for use as its corporate headquarters. The Company's subsidiaries own, or lease, all of the facilities from which they conduct business. All leases are comparable to other leases in the respective market areas and do not contain provisions materially detrimental to the Company or its subsidiaries. As of December 31, 2012 the Company had 78 banking locations. At December 31, 2012, the Company had approximately $54,101 invested in premises and equipment.

ITEM 3.    LEGAL PROCEEDINGS

        The Company and its subsidiaries may be parties (both plaintiff and defendant) to ordinary litigation incidental to the conduct of business. Management is presently not aware of any material pending or contemplated legal proceedings.

ITEM 4.    MINE SAFETY DISCLOSURES

        Not applicable.

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PART II

ITEM 5.    MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER'S PURCHASES OF EQUITY SECURITIES

Market Information

        The Company's Common Stock is traded on the NASDAQ Stock Market under the symbol MSFG. The Common Stock was held by approximately 4,500 shareholders at March 12, 2013. The quarterly high and low closing prices for the Company's common stock as reported by NASDAQ and quarterly cash dividends declared and paid are set forth in the tables below. All per share data is retroactively restated for all stock dividends and splits.

        The range of known per share prices by calendar quarter, based on actual transactions, excluding commissions, is shown below.

 
  Market Prices  
2012
  Q1
  Q2
  Q3
  Q4
 
   

High

  $ 12.12   $ 12.05   $ 13.00   $ 12.97  

Low

  $ 8.84   $ 10.80   $ 11.27   $ 11.50  

2011

 

Q1


 

Q2


 

Q3


 

Q4


 
   

High

  $ 10.60   $ 10.05   $ 9.24   $ 9.89  

Low

  $ 8.74   $ 6.98   $ 7.46   $ 7.66  
 
 
Cash Dividends
 
2012
  Q1
  Q2
  Q3
  Q4
 
   

  $ 0.01   $ 0.01   $ 0.03   $ 0.03  

2011

 

Q1


 

Q2


 

Q3


 

Q4


 
   

  $ 0.01   $ 0.01   $ 0.01   $ 0.01  

        In the first quarter of 2013 the Board of Directors voted to raise the quarterly dividend to $.06/share. It is expected that the Company will continue to consider the Company's results of operations, capital levels and other external factors beyond management's control in making the decision to maintain or further raise the dividend.

Issuer Purchases of Equity Securities

        The Company purchased the following equity securities of the Company during the quarter ended December 31, 2012:

Period
  Total Number
of Shares (or
Units) Purchased
(1)

  Average Price Paid Per
Share (or Unit) (1)

  Total Number of Shares
(or Units) Purchased as
Part of Publicly
Announced Plans or
Programs

  Maximum Number (or
Approximate Dollar Value)
of Shares (or Units) That
May Yet Be Purchased
Under the Plans or Programs

 
   

October 2012

                0  

November 2012

                0  

December 2012

    19,050   $ 993.54         0  
       

Total:

    19,050   $ 993.54         0  
(1)
On December 5, 2012, the Company purchased 19,050 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, of the Company in a privately negotiated transaction at a price of $993.54/share.

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Stock Performance Graph

        The following performance graph compares the performance of our common shares to the performance of the NASDAQ Market Index (U.S.) and the NASDAQ Bank Stocks Index for the 60 months ended December 31, 2012. The graph assumes an investment of $100 in each of the Company's common shares, the NASDAQ Market Index (U.S.) and the NASDAQ Bank Stocks Index on December 31, 2007.

GRAPHIC

 
  12/31/07
  12/31/08
  12/31/09
  12/31/10
  12/31/11
  12/31/12
 
   

MainSource Financial Group

    100.00     99.75     31.27     64.83     55.02     78.60  

NASDAQ MARKET INDEX (U.S.)

    100.00     59.46     85.55     100.03     98.22     113.85  

NASDAQ Bank Stocks Index

    100.00     76.08     62.00     69.36     60.76     70.34  

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ITEM 6.    SELECTED FINANCIAL DATA

Selected Financial Data
(Dollar amounts in thousands except per share data)

 
  2012
  2011
  2010
  2009
  2008
 
   

Results of Operations

                               

Net interest income

  $ 94,082   $ 99,848   $ 101,252   $ 98,008   $ 87,525  

Provision for loan losses

    9,850     17,800     35,250     46,310     20,918  

Noninterest income

    43,891     45,308     41,291     40,050     29,697  

Noninterest expense, excluding goodwill impairment

    94,838     99,805     92,252     87,222     72,773  

Goodwill impairment

                80,310      

Income (loss) before income tax

    33,285     27,551     15,041     (75,784 )   23,531  

Income tax (benefit)

    6,027     3,738     239     (11,645 )   4,379  

Net income (loss)

    27,258     23,813     14,802     (64,139 )   19,152  

Preferred dividends and accretion

    2,110     3,054     3,054     2,919      

Net income (loss) available to common shareholders

    26,505     20,759     11,748     (67,058 )   19,152  

Dividends paid on common stock

    1,623     807     805     5,135     11,133  

Per Common Share*

                               

Earnings (loss) per share (basic)

  $ 1.31   $ 1.03   $ 0.58   $ (3.33 ) $ 1.00  

Earnings (loss) per share (diluted)

    1.30     1.03     0.58     (3.33 )   1.00  

Dividends paid

    0.08     0.04     0.04     0.26     0.58  

Book value — end of period

    15.21     13.87     12.24     11.84     14.90  

Tangible book value — end of period

    11.72     10.45     8.71     8.16     7.43  

Market price — end of period

    12.67     8.83     10.41     4.78     15.50  

At Year End

                               

Total assets

  $ 2,769,288   $ 2,754,180   $ 2,769,312   $ 2,906,530   $ 2,899,835  

Securities

    902,341     876,090     806,071     714,607     513,310  

Loans, excluding held for sale

    1,553,383     1,534,379     1,680,971     1,885,447     1,995,601  

Allowance for loan losses

    32,227     39,889     42,605     46,648     34,583  

Total deposits

    2,185,054     2,159,900     2,211,564     2,270,650     2,009,324  

Federal Home Loan Bank advances

    141,052     151,427     152,065     222,265     433,167  

Subordinated debentures

    50,418     50,267     50,117     49,966     49,816  

Shareholders' equity

    323,751     336,553     302,570     294,462     299,949  

Financial Ratios

                               

Return on average assets

    0.99 %   0.85 %   0.51 %   (2.19 )%   0.73 %

Return on average common shareholders' equity

    8.15     7.44     4.86     (22.61 )   6.90  

Allowance for loan losses to total loans (year end, excluding held for sale)

    2.07     2.60     2.53     2.47     1.73  

Allowance for loan losses to total non-performing loans (year end)

    63.04     61.18     46.55     50.60     58.31  

Shareholders' equity to total assets (year end)

    11.69     12.22     10.93     10.13     10.34  

Average equity to average total assets

    12.12     11.46     10.59     11.59     10.57  

Dividend payout ratio

    6.12     3.89     6.85     NM     58.13  

*
Adjusted for stock split and dividends

NM
Not meaningful

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ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management's Discussion and Analysis
(Dollar amounts in thousands except per share data)

Forward-Looking Statements

        Except for historical information contained herein, the discussion in this Annual Report includes certain forward-looking statements based upon management expectations. Actual results and experience could differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. The Company disclaims any intent or obligation to update such forward looking statements. Factors which could cause future results to differ from these expectations include the following: general economic conditions; legislative and regulatory initiatives; monetary and fiscal policies of the federal government; deposit flows; the cost of funds; general market rates of interest; interest rates on competing investments; demand for loan products; demand for financial services; changes in accounting policies or guidelines; changes in the quality or composition of the Company's loan and investment portfolios; the Company's ability to integrate acquisitions, and other factors, including the risk factors set forth in Item 1A of this Annual Report on Form 10-K and in other reports we file from time to time with the Securities and Exchange Commission. The Company intends the forward looking statements set forth herein to be covered by the safe harbor provisions for forward looking statements contained in the Private Securities Litigation Reform Act of 1995.

Overview

        MainSource Financial Group, Inc. ("MainSource" or the "Company") is a financial holding company whose principal activity is the ownership and management of its wholly owned subsidiary bank: MainSource Bank headquartered in Greensburg, Indiana (the "Bank"). The Bank operates under an Indiana state charter and is subject to regulation by the Indiana Department of Financial Institutions and the Federal Deposit Insurance Corporation. Non-banking subsidiaries include MainSource Insurance, LLC, Insurance Services Marketing, LLC and MainSource Title, LLC. These three subsidiaries are subject to regulation by the Indiana Department of Insurance. The Company sold the property and casualty and health insurance book of businesses related to MainSource Insurance, LLC in the fourth quarter of 2010, but retained its business relating to annuities and credit life insurance.

Business Strategy

        The Company operates under the broad tenets of a long-term strategic plan ("Plan") designed to improve the Company's financial performance, expand its competitive position and enhance long-term shareholder value. The Plan is premised on the belief of the Company's Board of Directors that it can best promote long-term shareholder interests by pursuing strategies which will continue to preserve its community-focused philosophy. The dynamics of the Plan assure continually evolving goals, with the enhancement of shareholder value being the constant, overriding objective. The extent of the Company's success will depend upon how well it anticipates and responds to competitive changes within its markets, the interest rate environment and other external forces.

Results of Operations

        Net income attributable to common shareholders was $26,505 in 2012, $20,759 in 2011, and $11,748 in 2010. Earnings per common share on a fully diluted basis were $1.30 in 2012, $1.03 in 2011, and $0.58 in 2010. The primary drivers that led to the increase in net income in 2012 were lower loan loss provision expense of $7,950, reduced consultant expenses of $5,397, higher mortgage banking income of $4,376, an increase in service charge income of $1,668, a reduction in FDIC premiums of $1,479, and smaller losses on OREO property of $1,385. Credit losses continued to decline and new impaired loans decreased in 2012. The third party consulting fees paid in 2011 were an increase in consultant expenses. A reduction in interest rates in 2012 led to increased mortgage refinancing activity. Continued emphasis on new account growth generated additional service charge income. FDIC premiums lowered as a result of a lower rate for the Company's premiums. Finally, OREO losses declined as a result of a reduced amount of OREO property. Offsetting these items was a reduction in securities gains of $9,990, lower net interest income of $5,766, and a pre payment penalty of $1,313 on a FHLB advance. As a result of favorable pricing, the Company recorded gains during 2011 on the sale of securities at a higher level than 2012. The reduction in the Company's yield on earnings assets was not completely offset by the reduction in the Company's cost of funds. The Company paid off a FHLB advance early and incurred a prepayment penalty. However, this should provide the Company with future decreased annual interest expense of $500.

        The primary drivers that led to the increase in net income in 2011 from 2010 were lower loan loss provision expense of $17,450, higher realized gains on securities of $8,378, increased trust and investment product fees of $887, a reduction in FDIC premiums of $966, and increased interchange income of $738. Credit losses continued to decline and new impaired loans decreased in 2011. As a result of favorable pricing, the Company recorded gains during 2011 on the sale of securities at a higher level than 2010. The full year effect of increasing the number of financial advisors in 2010 resulted in higher trust and investment product fees. The Company realized a savings in FDIC premiums due to the change in 2011 of basing the premium on total assets instead of deposits. Continued emphasis on new account growth generated additional interchange income. Offsetting these items was an increase in consulting expenses of $6,547, a decrease in mortgage banking income of $2,091, a reduction in insurance commissions of $1,711, an increase in OREO losses

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of $1,647 and a decrease in other income of $1,176 (approximately 85% of this reduction is due to the gain recognized on the sale of the property and casualty business lines of the Company's insurance division in 2010). In 2011, the Company completed an efficiency project with the aid of a third party consulting firm. As a result of the project, approximately 150 full-time equivalent positions were targeted for elimination. While mortgage rates remained low during 2011, mortgage financing levels declined and represented more normal activity. As mentioned above, the Company sold the property and casualty business lines in 2010 which caused the reduction in commissions. The OREO losses are the result of the Company continuing its efforts to reduce its non-performing assets.

Net Interest Income

        Net interest income and net interest margin are influenced by the volume and yield or cost of earning assets and interest-bearing liabilities. Tax equivalent net interest income of $101,054 in 2012 decreased from $107,033 in 2011. Net interest margin, on a fully-taxable equivalent basis, was 4.07% for 2012 compared to 4.23% for the same period a year ago. The Company was unable to match reductions in its yield on earning assets with a corresponding reduction in its cost of funds. Over the three year period interest income has continued to decline as decreases in earning assets and yields have had a negative impact on interest income. A significant portion of the Company's CDs matured in 2011 and the Company was able to reprice those deposits to current, lower market rates. The Company was also able to continue to lower the interest paid on deposit accounts. The Federal Reserve Bank continues to target the fed funds rate at 0%-.25%.

        The following table summarizes net interest income (on a tax-equivalent basis) for each of the past three years.

Average Balance Sheet and Net Interest Analysis (Taxable Equivalent Basis)*

 
  2012
  2011
  2010
 
 
     
Assets
  Average
Balance

  Interest
  Average
Rate

  Average
Balance

  Interest
  Average
Rate

  Average
Balance

  Interest
  Average
Rate

 
 
     

Short-term investments

  $ 48,712     134     0.28 % $ 69,960     167     0.24 % $ 33,037   $ 12     0.04 %

Federal funds sold and money market accounts

    10,811     30     0.28     16,644     48     0.29     44,025     190     0.43  

Securities

                                                       

Taxable

    567,437     12,510     2.20     523,760     16,040     3.06     512,749     18,828     3.67  

Non-taxable*

    302,040     18,707     6.19     304,366     19,100     6.28     246,312     15,940     6.47  
       

Total securities

    869,477     31,217     3.59     828,126     35,140     4.24     759,061     34,768     4.58  

Loans**

                                                       

Commercial*

    889,313     50,523     5.68     959,550     55,905     5.83     1,061,537     62,433     5.88  

Residential real estate

    393,844     19,969     5.07     380,255     21,970     5.78     400,994     24,536     6.12  

Consumer

    270,459     13,867     5.13     276,660     15,566     5.63     317,654     18,921     5.96  
       

Total loans

    1,553,616     84,359     5.43     1,616,465     93,441     5.78     1,780,185     105,890     5.95  
       

Total earning assets

    2,482,616     115,740     4.66     2,531,195     128,796     5.09     2,616,308     140,860     5.38  
       

Cash and due from banks

    43,107                 40,444                 41,427              

Unrealized gains (losses) on securities

    41,035                 26,222                 28,074              

Allowance for loan losses

    (37,626 )               (42,583 )               (43,711 )            

Premises and equipment, net

    50,710                 49,920                 49,696              

Intangible assets

    68,704                 70,006                 72,765              

Accrued interest receivable and other assets

    112,177                 115,695                 113,814              
                                                   

Total assets

  $ 2,760,723               $ 2,790,899               $ 2,878,373              
                                                   

Liabilities

                                                       

Interest-bearing deposits DDA, savings, and money market accounts

  $ 1,321,901     2,138     0.16   $ 1,294,274     4,275     0.33   $ 1,201,145   $ 6,184     0.51  

Certificates of deposit

    494,142     5,499     1.11     631,270     9,836     1.56     798,471     16,978     2.13  
       

Total interest-bearing deposits

    1,816,043     7,637     0.42     1,925,544     14,111     0.73     1,999,616     23,162     1.16  

Short-term borrowings

    30,514     104     0.34     30,946     161     0.52     40,320     258     0.64  

Subordinated debentures

    49,000     1,825     3.72     49,000     1,737     3.54     49,000     1,755     3.58  

Notes payable and FHLB borrowings

    148,466     5,120     3.45     150,814     5,754     3.82     197,769     8,144     4.12  
       

Total interest-bearing liabilities

    2,044,023     14,686     0.72     2,156,304     21,763     1.01     2,286,705     33,319     1.46  

Demand deposits

    348,858                 288,908                 259,607              

Other liabilities

    33,354                 25,734                 27,209              
                                                   

Total liabilities

    2,426,235                 2,470,946                 2,573,521              

Shareholders' equity

    334,488                 319,953                 304,852              
                                                   

Total liabilities and shareholders' equity

  $ 2,760,723     14,686     0.59 *** $ 2,790,899     21,763     0.86 *** $ 2,878,373     33,319     1.27 ***
                           

Net interest income

        $ 101,054     4.07 ****       $ 107,033     4.23 ****       $ 107,541     4.11 ****
                                 

Conversion of tax exempt income to a fully taxable equivalent basis using a marginal rate of 35%

        $ 6,972               $ 7,185               $ 6,289        
                                                   

*
Adjusted to reflect income related to securities and loans exempt from Federal income taxes.

**
Nonaccruing loans have been included in the average balances.

***
Total interest expense divided by total earning assets.

****
Net interest income divided by total earning assets.

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        The following table sets forth for the periods indicated a summary of the changes in interest income and interest expense resulting from changes in volume and changes in rates.

Volume/Rate Analysis of Changes in Net Interest Income
(Tax Equivalent Basis)

 
  2012 OVER 2011   2011 OVER 2010  
 
  Volume
  Rate
  Total
  Volume
  Rate
  Total
 
   

Interest income

                                     

Loans

  $ (3,547 ) $ (5,535 ) $ (9,082 ) $ (9,528 ) $ (2,921 ) $ (12,449 )

Securities

    1,688     (5,611 )   (3,923 )   3,035     (2,663 )   372  

Federal funds sold and money market funds

    (16 )   (2 )   (18 )   (93 )   (49 )   (142 )

Short-term investments

    (66 )   33     (33 )   26     129     155  
           

Total interest income

    (1,941 )   (11.115 )   (13,056 )   (6,560 )   (5,504 )   (12,064 )
           

Interest expense

                                     

Interest-bearing DDA, savings, and money market accounts

  $ 89   $ (2,226 ) $ (2,137 ) $ 449   $ (2,358 )   (1,909 )

Certificates of deposit

    (1,873 )   (2,464 )   (4,337 )   (3,138 )   (4,004 )   (7,142 )

Borrowings

    (89 )   (602 )   (691 )   (1,871 )   (616 )   (2,487 )

Subordinated debentures

        88     88         (18 )   (18 )
           

Total interest expense

    (1,873 )   (5,204 )   (7,077 )   (4,560 )   (6,996 )   (11,556 )
           

Change in net interest income

    (68 )   (5,911 )   (5,979 )   (2,000 )   1,492     (508 )
                       

Change in tax equivalent adjustment

                (213 )               896  
                                   

Change in net interest income before tax equivalent adjustment

              $ (5,766 )             $ (1,404 )
                                   

        Variances not attributed to rate or volume are allocated between rate and volume in proportion to the relationship of the absolute dollar amount of the change in each.

Provision for Loan Losses

        The Company expensed $9,850, $17,800, and $35,250 in provision for loan losses in 2012, 2011, and 2010 respectively. This level of provision allowed the Company to maintain an adequate allowance for loan losses. This topic is discussed in detail under the heading "Loans, Credit Risk and the Allowance and Provision for Loan Losses".

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Non-interest Income and Expense

 
   
   
   
  Percent Change  
 
  2012
  2011
  2010
  12/11
  11/10
 
   

Non-interest income

                               

Insurance commissions

  $   $   $ 1,711     0.0%     -100.0%  

Mortgage banking

    9,927     5,551     7,642     78.8%     -27.4%  

Trust and investment product fees

    3,650     3,250     2,363     12.3%     37.5%  

Service charges on deposit accounts

    19,815     18,147     17,462     9.2%     3.9%  

Net realized gains on securities sales

    1,367     11,357     2,979     -88.0%     281.2%  

Increase in cash surrender value of life insurance

    1,206     1,200     1,246     0.5%     -3.7%  

Interchange income

    6,540     6,225     5,487     5.1%     13.4%  

Gain/(loss) on sale of OREO

    (1,359 )   (2,744 )   (1,097 )   50.5%     -150.1%  

Other

    2,745     2,322     3,498     18.2%     -33.6%  
                   

Total non-interest income

  $ 43,891   $ 45,308   $ 41,291     -3.1%     9.7%  
                   

Non-interest expense

                               

Salaries and employee benefits

  $ 48,990   $ 49,950   $ 50,138     -1.9%     -0.4%  

Net occupancy

    6,769     6,686     6,654     1.2%     0.5%  

Equipment

    8,564     7,822     7,855     9.5%     -0.4%  

Intangibles amortization

    1,835     1,939     2,066     -5.4%     -6.1%  

Telecommunications

    1,729     1,991     1,882     -13.2%     5.8%  

Stationery, printing, and supplies

    1,337     1,510     1,478     -11.5%     2.2%  

FDIC assessment

    2,495     3,974     4,940     -37.2%     -19.6%  

Marketing

    4,397     4,057     3,412     8.4%     18.9%  

Collection expenses

    3,768     4,334     3,579     -13.1%     21.1%  

Consultant expense

    1,150     6,547         -82.4%     NA  

Prepayment penalty on FHLB advance

    1,313             NA     0.0%  

Interchange expense

    1,591     1,465     1,515     8.6%     -3.3%  

Other

    10,900     9,530     8,733     14.4%     9.1%  
                   

Total non-interest expense

  $ 94,838   $ 99,805   $ 92,252     -5.0%     8.2%  
                   

Non-interest Income

        Non-interest income was $43,891 for 2012 compared to $45,308 for the same period in 2011, a decrease of $1,417 or 3.1%. Increases in mortgage banking income, service charge on deposit accounts, lower losses on the sale of OREO, trust and investment product fees, and interchange income were the primary causes of the increase. These increases were offset by a reduction in securities gains. A reduction in interest rates in 2012 led to increased mortgage refinancing activity. Continued emphasis on new account growth generated additional service charge and interchange income. OREO losses declined as a result of a reduced amount of OREO property as well as more timely appraisals when the property is initially placed in OREO. As a result of favorable pricing, the Company recorded gains during 2011 on the sale of securities at a higher level than 2012.

        Non-interest income was $45,308 for 2011 compared to $41,291 for the same period in 2010, an increase of $4,017 or 9.7%. Increases in trust and investment product fees, service charges on deposit accounts, net realized gains on securities sales, and interchange income were the primary causes of the increase. These increases were offset by a reduction in insurance commissions, mortgage banking, losses on OREO property, and other income. The Company realized the full year effect of increasing the number of financial advisors in 2010. A continued emphasis on new account growth yielded additional service charge and interchange income. As a result of favorable pricing, the Company recorded gains during 2011 on the sale of securities at a higher level than 2010. The level of mortgage banking activity leveled off in 2011 from what the Company had experienced in 2010. The reduction of insurance commissions was caused by the sale of the property and casualty book of business during the fourth quarter of 2010. Also in connection with the sale of the property and casualty book of business, the Company recorded a $988 gain in 2010 on the sale. The Company continues to move the Other Real Estate (OREO) property as quickly as possible and incurred additional losses in 2011 as well as write-downs on some of the properties due to the significant changes in the properties' value. The Company obtained up to date appraisals on several properties which resulted in additional charge downs. Non-interest income as a percent of non-interest expense was 45.4% for 2011 compared to 44.8% for 2010.

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Non-interest Expense

        Total non-interest expense was $94,838 in 2012 compared to $99,805 in 2011, a decrease of $4,967 or 5.0%. The decrease was primarily attributable to a reduction in consultant expenses of $5,397. During 2011 the Company completed an efficiency project with the aid of a third party consulting firm. Almost all of the Company's departments and corresponding headcount were reviewed, as well as the entire organizational structure of the Company. As a result of the project, many of the non-interest expense categories showed reductions in 2012. These included salaries and employee benefits, telecommunications, and stationary and printing costs. Other categories also showing reductions were intangibles amortization, FDIC assessment, and collection expenses. FDIC premiums lowered as a result of a lower multiplier for the Company's premiums. Collection expenses decreased due to a reduction in new problem loans compared to 2011. Offsetting these decreases were increases in occupancy, equipment, marketing, other expenses, and a prepayment penalty on a FHLB advance. Occupancy, equipment, and marketing expenses increased primarily due to opening of three de novo branches in 2012. The largest contributor to other expense was expenses related to tax credit properties. Lastly, the Company paid off a FHLB advance early and incurred a prepayment penalty of $1,313. However, the pay off of this advance should lower interest expense costs by approximately $500 on an annual basis.

        Total non-interest expense was $99,805 in 2011 compared to $92,252 in 2010, an increase of $7,553 or 8.2%. The increase was primarily attributable to consultant expenses of $6,547 incurred in 2011 as a result of the previously described efficiency project. As a result of the project, approximately 150 full-time equivalent positions were targeted for elimination. The third party consulting firm also recommended various revenue enhancements which may require future payouts if certain targets are achieved. Marketing expense and collection expense increases of $645 and $755 were partially offset by a reduction in the Company's FDIC assessment of $966. The marketing expense increase was due to costs involved in generating new deposit accounts. Collection costs continue to be elevated as the Company is working through its problem credits. As a result of the FDIC changing the assessment base to total assets instead of deposits, the Company's FDIC assessment was lower in 2011.

Income Taxes

        The effective tax rate was 18.1% in 2012, 13.6% in 2011, and 1.6% in 2010. The increase in the Company's effective rate from 2011 to 2012 and from 2010 to 2011 was primarily due to an increase in taxable income in each year. The Company and its subsidiaries file consolidated income tax returns.

Balance Sheet

        At December 31, 2012, total assets were $2,769,288 compared to $2,754,180 at December 31, 2011, an increase of $15 million. Increases in loans ($27 million), investment securities ($26 million) and cash surrender value of life insurance ($11 million) were offset by decreases in cash and cash equivalents ($43 million) and other assets ($11 million).

Loans, Credit Risk and the Allowance and Provision for Loan Losses

        Loans remain the Company's largest concentration of assets and continue to represent the greatest potential risk. The loan underwriting standards observed by the Bank are viewed by management as a means of controlling problem loans and the resulting charge-offs. The Company also believes credit risks may be elevated if undue concentrations of loans in specific industry segments and to out-of-area borrowers are incurred. Accordingly, the Company's Board of Directors regularly monitors such concentrations to determine compliance with its loan concentration policy. The Company believes it has no undue concentrations of loans.

        Total loans (excluding those held for sale) increased by $19,004 from year-end 2011. The largest increase was in the Company's residential real estate portfolio as on balance sheet fixed-rate residential real estate loans refinanced during the year, and the Company elected to keep many of these loans instead of selling them to the secondary market. The remaining increase in loan balances was primarily due to an overall increase in loan demand. Decreases in certain other loan categories were primarily due to the following factors: a decrease in construction and development loans as the continued sluggish economy resulted in the Company ceasing the origination of these loans, charge-offs taken during 2012, and early payoffs on some credits. Residential real estate loans continue to represent the largest portion of the total loan portfolio and were 40% of total loans at December 31, 2012 compared to 48% of total loans at the end of 2011.

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        The following table details the Company's loan portfolio by type of loan.

Loan Portfolio

 
  2012
  2011
  2010
  2009
  2008
 
   

Types of loans

                               

Commercial and industrial

  $ 123,140   $ 107,538   $ 163,651   $ 195,509   $ 226,696  

Agricultural production financing

    45,879     32,325     36,596     41,889     40,334  

Farm real estate

    68,013     58,424     37,634     45,332     45,918  

Commercial real estate mortgage

    480,879     509,887     525,578     551,670     515,964  

Construction and development

    31,694     37,078     84,152     142,472     173,551  

Residential real estate mortgage

    753,230     730,374     759,409     813,602     877,145  

Consumer

    50,548     58,753     73,951     94,973     115,993  
       

Total loans

  $ 1,553,383   $ 1,534,379   $ 1,680,971   $ 1,885,447   $ 1,995,601  
       

        The following table indicates the amounts of loans (excluding residential and commercial mortgages and consumer loans) outstanding as of December 31, 2012 which, based on remaining scheduled repayments of principal, are due in the periods indicated.

Maturities and Sensitivity to Changes in Interest Rates of Commercial and Construction Loans

 
  Due:
  Within 1 Year
  1-5 Years
  Over 5 years
  Total
 

Loan Type

                           

Commercial and industrial

      $ 44,242   $ 37,693   $ 41,205   $ 123,140

Agricultural production financing

        28,184     14,711     2,984     45,879

Construction and development

        14,722     9,781     7,191     31,694
         

Totals

      $ 87,148   $ 62,185   $ 51,380   $ 200,713
         

Percent

        43%     31%     26%     100%
         

Rate Sensitivity

                           

Fixed Rate

      $ 5,147   $ 41,780   $ 22,095   $ 69,022

Variable Rate

        104,154     18,751     8,786     131,691
         

Totals

      $ 109,301   $ 60,531   $ 30,881   $ 200,713
         

        Loans are placed on "non-accrual" status when, in management's judgment, the collateral value and/or the borrower's financial condition does not justify accruing interest. As a general rule, commercial, commercial real estate, residential, and consumer loans are reclassified to non-accrual status at or before becoming 90 days past due. Interest previously recorded is reversed and charged against current income. Subsequent interest payments collected on non-accrual loans are thereafter applied as a reduction of the loan's principal balance. Non-performing loans were $51,118 as of December 31, 2012 compared to $65,196 as of December 31, 2011 and represented 3.29% of total loans at December 31, 2012 versus 4.25% one year ago. The significant reduction in 2012 is a result of the Company's continued emphasis on reducing the amount of non-performing loans.

        The following table details the Company's non-performing loans as of December 31 for the years indicated.

Non-performing Loans

 
  2012
  2011
  2010
  2009
  2008
 
   

Non-accruing loans

  $ 35,451   $ 41,528   $ 68,236   $ 77,074   $ 55,671  

Troubled debt restructurings

    15,102     20,402     22,250     11,843      

Accruing loans contractually past due 90 days or more

    565     3,266     990     3,279     3,639  
       

Total

  $ 51,118   $ 65,196   $ 91,476   $ 92,196   $ 59,310  
       

% of total loans

    3.29%     4.25%     5.44%     4.89%     2.97%  

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        A reconciliation of non-performing assets ("NPA") for 2012 and 2011 is as follows:

 
  2012
  2011
 
   

Beginning Balance — NPA — January 1

  $ 80,731   $ 102,955  

Non-accrual

             

Add: New non-accruals

    34,863     47,516  

Less: To accrual/payoff/restructured

    (18,142 )   (31,688 )

Less: To OREO

    (5,286 )   (23,093 )

Less: Charge offs

    (17,512 )   (19,443 )
       

Increase/(Decrease): Non-accrual loans

    (6,077 )   (26,708 )

Other Real Estate Owned (OREO)

             

Add: New OREO properties

    5,286     23,093  

Less: OREO sold

    (12,089 )   (16,125 )

Less: OREO losses (write-downs)

    (1,976 )   (2,965 )
       

Increase/(Decrease): OREO

    (8,779 )   4,003  

Increase/(Decrease): Repossessions

    (79 )   53  

Increase/(Decrease): 90 Days Delinquent

    (2,701 )   2,276  

Increase/(Decrease): TDR's

    (5,300 )   (1,848 )
       

Total NPA change

    (22,936 )   (22,224 )
       

Ending Balance — NPA — December 31

  $ 57,795   $ 80,731  
       

        At December 31, 2012, only one of the non-accrual loan balances was greater than $1,000. This loan is a real estate backed loan. The Company is working with this borrower in an attempt to minimize its losses. In the course of resolving problem loans, the Company may choose to restructure the contractual terms of certain loans. The Company attempts to work out an alternative payment schedule with the borrower in order to avoid foreclosure actions. Any loans that are modified are reviewed by the Company to identify if a troubled debt restructuring has occurred, which is when for economic or legal reasons related to a borrower's financial difficulties, the Company grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and could include reduction of the stated interest rate, other than normal market rate adjustments, extension of maturity dates, or reduction of principal balance or accrued interest. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit us by increasing the ultimate probability of collection. The Company reviews each relationship before it grants the concession to insure the creditor can comply with the new terms. To date, most of the concessions have been extensions of maturity dates. The provision for loan losses was $9,850 in 2012, $17,800 in 2011, and $35,250 in 2010. The Company's provision for loan losses continued to decline in 2012 due to the stabilization of problem credits. New non-accrual loans declined over 26% in 2012. Net charge-offs were $17,512 in 2012 compared to $20,516 in 2011 and $39,293 in 2010. As a percentage of average loans, net charge-offs equaled 1.13%, 1.27%, and 2.21% in 2012, 2011 and 2010, respectively.

        Potential problem loans are identified on the Company's watch list and consist of loans that require close monitoring by management and are not necessarily considered classified credits by regulators. Credits may be considered as a potential problem loan for reasons that are temporary or correctable, such as for a deficiency in loan documentation or absence of current financial statements of the borrower. Potential problem loans may also include credits where adverse circumstances are identified that may affect the borrower's ability to comply with the contractual terms of the loan. Other factors which might indicate the existence of a potential problem loan include the delinquency of a scheduled loan payment, deterioration in a borrower's financial condition identified in a review of periodic financial statements, a decrease in the value of the collateral securing the loan, or a change in the economic environment in which the borrower operates. Substandard commercial loans that were not classified as non-accrual were $28,785 at December 31, 2012 and $63,379 at December 31, 2011, a decrease of $34,594. The Company believes its substandard loans peaked in 2009 when the substandard balance was approximately $70,000. These loans which are $250 or greater are reviewed at least quarterly by senior management. This review includes monitoring how the borrower is performing vs their workout plan, obtaining and reviewing the borrower's financial information, and monitoring collateral values. Management believes these loans were well secured and had adequate allowance allocations at December 31, 2012.

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Summary of the Allowance for Loan Losses

 
  2012
  2011
  2010
  2009
  2008
 
   

Balance at January 1

  $ 39,889   $ 42,605   $ 46,648   $ 34,583   $ 14,331  

Chargeoffs

                               

Commercial

    1,946     2,211     8,190     8,686     1,866  

Commercial real estate mortgage

    13,553     16,954     29,177     21,140     948  

Residential real estate mortgage

    3,547     3,093     2,220     1,899     1,421  

Consumer

    3,286     2,636     2,859     4,477     3,032  
       

Total Chargeoffs

    22,332     24,894     42,446     36,202     7,267  
       

Recoveries

                               

Commercial

    543     1,172     518     350     214  

Commercial real estate mortgage

    2,432     1,371     873     226     17  

Residential real estate mortgage

    265     648     524     37     16  

Consumer

    1,580     1,187     1,238     1,344     790  
       

Total Recoveries

    4,820     4,378     3,153     1,957     1,037  
       

Net Chargeoffs

    17,512     20,516     39,293     34,245     6,230  

Addition resulting from acquisition

                    5,564  

Provision for loan losses

    9,850     17,800     35,250     46,310     20,918  
       

Balance at December 31

  $ 32,227   $ 39,889   $ 42,605   $ 46,648   $ 34,583  
       

Net Chargeoffs to average loans

    1.13%     1.27%     2.21%     1.73%     0.35%  

Provision for loan losses to average loans

    0.63%     1.10%     1.98%     2.35%     1.17%  

Allowance to total loans at year end

    2.07%     2.60%     2.53%     2.47%     1.73%  
       

        Although the allowance for loan loss is available for any loan that, in management's judgment, should be charged off, the following table details the allowance for loan losses by loan category and the percent of loans in each category compared to total loans at December 31.

Allocation of the Allowance for Loan Losses

 
  2012   2011   2010   2009   2008  
December 31
  Amount
  Percent
of loans
to total
loans

  Amount
  Percent
of loans
to total
loans

  Amount
  Percent
of loans
to total
loans

  Amount
  Percent
of loans
to total
loans

  Amount
  Percent
of loans
to total
loans

 
   

Real estate

                                                             

Residential

  $ 3,180     40 % $ 2,972     38 % $ 2,281     45 % $ 9,449     43 % $ 3,882     44 %

Farm real estate

    722     4     456     3     740     2     647     2     344     2  

Commercial

    20,465     41     24,187     45     20,034     31     14,754     29     11,448     26  

Construction and development

    2,970     2     5,833     2     11,879     5     10,205     8     6,500     9  
       

Total real estate

    27,337     87     33,448     88     34,934     83     35,055     82     22,174     81  
       

Commercial

                                                             

Agribusiness

    166     2     151     1     370     2     1,126     2     303     2  

Other commercial

    3,728     8     5,411     7     6,016     10     7,880     11     7,632     11  
       

Total Commercial

    3,894     10     5,562     8     6,386     12     9,006     13     7,935     13  
       

Consumer

    996     3     879     4     1,285     5     2,587     5     4,072     6  

Unallocated

                                        402        
       

Total

  $ 32,227     100 % $ 39,889     100 % $ 42,605     100 % $ 46,648     100 % $ 34,583     100 %
       

        Management maintains a list of loans warranting either the assignment of a specific reserve amount or other special administrative attention. This watch list, together with a listing of all classified loans, non-accrual loans and delinquent loans, is reviewed monthly by management and the Board of Directors. Additionally, the Company evaluates its consumer and residential real estate loan pools for probable losses incurred based on historical trends, adjusted by current delinquency and non-performing loan levels.

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        The Company has both internal and external loan review personnel who annually review approximately 50% of all loans. External loan review personnel examine the top 100 commercial credit relationships. This equates to approximately all relationships above $1,750.

        The ability to absorb loan losses promptly when problems are identified is invaluable to a banking organization. Most often, losses incurred as a result of prompt, aggressive collection actions are much lower than losses incurred after prolonged legal proceedings. Accordingly, the Company observes the practice of quickly initiating stringent collection efforts in the early stages of loan delinquency. During the latter part of 2008, the Company established a separate group to address its deteriorating credit quality. This group consists of seven full-time equivalent employees and reports directly to the Chief Credit Officer of the Company. At the present time, this group is charged with the task of efficiently resolving non-performing credits and disposing of foreclosed properties.

        The adequacy of the allowance for loan losses is reviewed at least quarterly. The determination of the provision amount in any period is based upon management's continuing review and evaluation of loan loss experience, changes in the composition of the loan portfolio, classified loans including non-accrual and impaired loans, current economic conditions, the amount of loans presently outstanding, and the amount and composition of loan growth. The Company's allowance for loan losses was $32,227, or 2.07% of total loans, at December 31, 2012 compared to $39,889, or 2.60% of total loans, at the end of 2011. This $7,662 decrease in the allowance was due in large part to write-offs in 2012 that had an allowance allocated in 2011 as well as continued monitoring of problem loans.

Securities, at Fair Value

 
  December 31,  
 
  2012
  2011
  2010
 
   

Available for Sale

                   

U.S. Government-sponsored entities

  $ 1,638   $   $  

State and municipal

    337,939     344,877     300,144  

Mortgage-backed

    554,278     522,271     498,828  

Equity and other

    8,486     8,942     7,099  
       

Total securities

  $ 902,341   $ 876,090   $ 806,071  
       

        Securities offer flexibility in the Company's management of interest rate risk, and are the primary means by which the Company provides liquidity and responds to changing maturity characteristics of assets and liabilities. The Company's investment policy prohibits trading activities and does not allow investment in high-risk derivative products or junk bonds.

        As of December 31, 2012, all of the securities are classified as available for sale ("AFS") and are carried at fair value with unrealized gains and losses, net of taxes, excluded from earnings and reported as a separate component of shareholders' equity. A net unrealized gain of $39,582 was recorded to adjust the AFS portfolio to current market value at December 31, 2012 compared to a net unrealized gain of $35,218 at December 31, 2011.

Securities
(Carrying Values at December 31)

 
  Within
1 Year

  2-5 Yrs
  6-10 Yrs
  Beyond
10 Years

  Total 2012
 
   

Available for sale

                               

US government agency

  $   $   $ 1,638       $ 1,638  

State and municipal

    6,857     52,613     100,781     177,688     337,939  

Mortgage-backed securities

    6     67     67,289     486,916     554,278  

Other securities

        2,557         990     3,547  
       

Total available for sale

  $ 6,863   $ 55,237   $ 169,708   $ 665,594   $ 897,402  
       

Weighted average yield*

    6.73%     5.09%     4.53%     3.20%     3.59%  

*
Adjusted to reflect income related to securities exempt from federal income taxes.

        Amounts in the table above are based on scheduled maturity dates. Variable interest rates are subject to change not less than annually based upon certain interest rate indexes. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Equity securities of $4,939 do not have contractual maturities and are excluded from the table above.

        As of December 31, 2012, there were no corporate bonds and other securities which represented more than 10% of shareholders' equity.

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Table of Contents

        For 2012 the tax equivalent yield of the investment securities portfolio was 3.59%, compared to 4.24% and 4.58% for 2011 and 2010, respectively. The average life of the Company's investment securities portfolio was 4.88 years at December 31, 2012. During 2012 the investment portfolio increased slightly in size as the Company's earnings were invested in the portfolio as loan demand remained soft. Cash flows from security sales and normal monthly principal pay downs were reinvested at materially lower yields leading to sizable decline in portfolio yield. The reinvestments were focused on a balanced approach between a likely long term low interest rate horizon and protection against cash flow extensions when rates do move higher. This investment strategy will allow the portfolio to meet cash needs for future loan growth.

        The Company and its investment advisor monitor the securities portfolio on at least a quarterly basis for other-than-temporary impairment ("OTTI"). The amount of the OTTI recognized in earnings depends on whether the Company intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment's amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total 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 total OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. In 2012, the Company recorded a $500 impairment loss on one of its equity securities. During 2010, the Company recorded $97 of impairment charges related to three of its equity securities. These securities were written down to their fair values, as based on the financial condition of the companies, recovery of the fair value above cost could not be readily projected.

Sources of Funds

        The Company relies primarily on customer deposits and securities sold under agreement to repurchase ("repurchase agreements") along with shareholders' equity to fund earning assets. Federal Home Loan Bank ("FHLB") advances are used to provide additional funding. The Company also attempts to obtain deposits through branch and whole bank acquisitions.

        Deposits generated within local markets provide the major source of funding for earning assets. Average total deposits were 87.2% and 87.7% of total average earning assets for 2012 and 2011, respectively. Total interest-bearing deposits averaged 83.9% and 87.0% of average total deposits during 2012 and 2011. Management is continuing its efforts to increase the percentage of transaction-related deposits to total deposits due to the positive effect on earnings.

        Repurchase agreements are high denomination investments utilized by public entities and commercial customers as an element of their cash management responsibilities. During 2012, repurchase agreements averaged $28,243, with an average cost of 0.34%.

        Another source of funding is the Federal Home Loan Bank (FHLB). The Company had FHLB advances of $141,052 outstanding at December 31, 2012. These advances have interest rates ranging from 0.5% to 5.9% (see Note 12 to the consolidated financial statements for the maturity schedule of these advances). The Company averaged $146,365 in FHLB advances during 2012 compared to $148,824 during 2011. This decrease in the average balance of FHLB borrowings was primarily due to the increased deposits generated by the Company which reduced the need for other funding sources. One final source of funding is federal funds purchased. The Company had $8,725 of federal funds purchased as of December 31, 2012 and $0 at December 31, 2011.

Average Deposits

 
  2012
  2011
  2010
 
 
     
 
  Amount
  Rate
  Amount
  Rate
  Amount
  Rate
 
   

Demand

  $ 348,858         $ 288,908         $ 259,607        

Interest Bearing Demand

    866,493     0.17 %   843,523     0.34 %   780,125     0.54 %

Savings/Money Markets

    455,408     0.14     450,751     0.30     421,020     0.48  

Certificates of Deposit

    494,142     1.11     631,270     1.56     798,471     2.13  
                                 

Totals

  $ 2,164,901     0.35 % $ 2,214,452     0.64 % $ 2,259,223     1.03 %
                                 

        As of December 31, 2012, certificates of deposit and other time deposits of $100 or more mature as follows:

 
  3 months or less
  4-6 months
  6-12 months
  over 12 months
  Total
 
   

Amount

  $ 32,527   $ 23,891   $ 25,649   $ 67,739   $ 149,806  

Percent

    22%     16%     17%     45%        

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Table of Contents

Capital Resources

        The Federal Reserve Board and other regulatory agencies have adopted risk-based capital guidelines that assign risk weightings to assets and off-balance sheet items. The Company's core capital ("Tier 1") consists of common shareholders' equity adjusted for unrealized gains or losses on available for sale (AFS) securities plus limited amounts of Trust Preferred Securities less goodwill and intangible assets. Total capital consists of core capital, certain debt instruments and a portion of the allowance for loan losses. At December 31, 2012, Tier 1 capital to average assets was 10.4%. Total capital to risk-weighted assets was 17.8%. Both ratios exceed all required ratios established for bank holding companies. Risk-adjusted capital levels of the Bank also exceed regulatory definitions of well-capitalized institutions.

        The Trust Preferred Securities (which are classified as subordinated debentures) currently qualify as Tier 1 capital or core capital with respect to the Company under the risk-based capital guidelines established by the Federal Reserve. Under such guidelines, capital received from the proceeds of the sale of these securities cannot constitute more than 25% of the total Tier 1 capital of the Company. Consequently, the amount of Trust Preferred Securities in excess of the 25% limitation constitutes Tier 2 capital, or supplementary capital, of the Company. As of December 31, 2012, all of the Company's Trust Preferred Securities qualify as Tier 1 capital.

        Common shareholders' equity is impacted by the Company's decision to categorize its securities portfolio as available for sale (AFS). Securities in this category are carried at fair value, and common shareholders' equity is adjusted to reflect unrealized gains and losses, net of taxes.

        The Company declared and paid common dividends of $.08 per share in 2012 compared to $.04 both in 2011 and 2010. Book value per common share increased to $15.21 at December 31, 2012 compared to $13.87 at the end of 2011. The net adjustment for AFS securities increased book value per share by $1.27 at December 31, 2012 and increased book value per share by $1.13 at December 31, 2011. Depending on market conditions, the adjustment for AFS securities can cause significant fluctuations in shareholders' equity.

        On January 16, 2009, the Company entered into an agreement with the United States Department of Treasury (the "Treasury Department") as part of the Treasury Department's Capital Purchase Program. Under this agreement, the Company issued to the Treasury Department 57,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A ("preferred stock") and a warrant to purchase up to 571,906 shares ("warrant shares") of the Company's common stock. Like stock options, the warrant issued through the Capital Purchase Program is potentially dilutive. The average stock price for the Company for 2012 and 2011 was $11.45 and $8.86 per share respectively, and the warrant issued in 2009 has an exercise price of $14.95 per share. This results in no additional potentially dilutive shares during 2012 and 2011.

        The preferred stock pays cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter. The Company may, at its option and at any time, redeem the preferred stock for the liquidation amount of $1,000 per share, plus any accrued and unpaid dividends. While the preferred stock is outstanding, the Company may only pay dividends on common stock if all accrued and unpaid dividends for the preferred stock have been paid. See Note 2 to the consolidated financial statements for additional details on the Company's participation in the Capital Purchase Program.

        On March 28, 2012, the U.S. Department of the Treasury priced its secondary public offering of 57,000 shares of the Company's Preferred Stock. The Company successfully bid for the purchase of 21,030 shares of the Preferred Stock. During the remainder of 2012, the Company purchased 20,870 additional shares of the preferred stock from third parties. See Note 2 in the Consolidated Financial Statements for more information related to the sale of the Preferred Stock.

Liquidity

        Liquidity management involves maintaining sufficient cash levels to fund operations and to meet the requirements of borrowers, depositors and creditors. Higher levels of liquidity bear higher corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets and higher interest expense involved in extending liability maturities. Liquid assets include cash and cash equivalents, loans and securities maturing within one year and money market instruments. In addition, the Company holds approximately $890,539 of AFS securities maturing after one year, which can be sold to meet liquidity needs.

        Maintaining a relatively stable funding base, which is achieved by diversifying funding sources, supports liquidity, extends the contractual maturity of liabilities, and limits reliance on volatile short-term purchased funds. Short-term funding needs may arise from declines in deposits or other funding sources, funding of loan commitments and requests for new loans. The Company's strategy is to fund assets to the maximum extent possible with core deposits, which provide a sizable source of relatively stable low-cost funds. The Company defines core deposits as all deposits except certificates of deposits greater than $100. Average core deposits funded approximately 80.6% of total earning assets during 2012 and approximately 79.5% in 2011.

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Table of Contents

        Management believes the Company has sufficient liquidity to meet all reasonable borrower, depositor and creditor needs in the present economic environment. The Company has not received any directives from regulatory authorities that would materially affect liquidity, capital resources or operations.

Contractual Obligations as of December 31, 2012

 
  Total
  Less than
1 Year

  1-3 Years
  3-5 Years
  More than
5 Years

 
   

Time Deposits

  $ 454,573   $ 274,659   $ 149,563   $ 22,027   $ 8,324  

FHLB Advances

    141,052     35,245     25,657     30,097     50,053  

Subordinated Debentures

    50,418                 50,418  

Operating Lease Commitments

    5,387     1,026     1,743     979     1,639  
       

Total

  $ 651,430   $ 310,930   $ 176,963   $ 53,103   $ 110,434  
       

Off-balance Sheet Arrangements

        The Bank incurs off-balance sheet risks in the normal course of business in order to meet the financing needs of its customers. These risks derive from commitments to extend credit and standby letters of credit. Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. See Note 16 to the Consolidated Financial Statements for additional details on the Company's off-balance sheet arrangements.

Interest Rate Risk Management

        Interest rate risk is the exposure of the Company's financial condition to adverse changes in market interest rates. In an effort to estimate the impact of sustained interest rate movements to the Company's earnings, the Company monitors interest rate risk through computer-assisted simulation modeling of its net interest income. The Company's simulation modeling monitors the potential impact to net interest income under various interest rate scenarios. The Company's objective is to actively manage its asset/liability position within a one-year interval and to limit the risk in any of the interest rate scenarios to a reasonable level of tax-equivalent net interest income within that interval. The Company monitors compliance within established guidelines of the Funds Management Policy. See Item 7A. Quantitative and Qualitative Disclosures About Market Risk section for further discussion regarding interest rate risk.

Critical Accounting Policies

        The accounting and reporting policies of the Company comply with accounting principles generally accepted in the United States and conform to general practices within the banking industry. These policies require estimates and assumptions. Changes in underlying factors, assumptions, or estimates in any of these areas could have a material impact on the Company's future financial condition and results of operations. In management's opinion, some of these areas have a more significant impact than others on the Company's financial reporting. These areas currently include accounting for the allowance for loan losses, goodwill, income taxes, and mortgage servicing rights.

        Allowance for Loan Losses — The level of the allowance for loan losses is based upon management's evaluation of the loan and lease portfolios, past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay (including the timing of future payments), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, and other pertinent factors. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The level of allowance maintained is believed by management to be adequate to cover losses inherent in the portfolio. The allowance is increased by provisions charged to expense and decreased by charge-offs, net of recoveries of amounts previously charged-off.

        Goodwill — Goodwill and intangible assets deemed to have indefinite lives are subject to annual impairment tests. The Company has selected June 30 as its date for annual impairment testing, but will test more frequently if circumstances warrant. No goodwill impairment was identified during testing performed in 2012 or 2011.

        Income taxes — The Company is subject to the income tax laws of the U.S., its states and the municipalities in which it operates. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant government taxing authorities. The Company reviews income tax expense and the carrying value of deferred tax assets; and as new information becomes available, the balances are adjusted as appropriate. In establishing a provision for income tax expense, the Company makes judgments and interpretations about the application of these inherently complex tax laws and also makes estimates about when in the future certain items will affect taxable income in the various tax jurisdictions.

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        Mortgage servicing rights — The Company originally records mortgage servicing rights at fair value and amortizes them over the period of the estimated future net servicing income of the underlying loans. The servicing rights are evaluated for impairment based upon the fair value of the rights as compared to the carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount.

New Accounting Matters

        See Note 1 to the Consolidated Financial Statements regarding the adoption of new accounting standards in 2012.

ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        The Company's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee and Boards of Directors of the Company and the Bank. Primary market risks, which impact the Company's operations, are liquidity risk and interest rate risk, as discussed above.

        As discussed previously, the Company monitors interest rate risk by the use of computer simulation modeling to estimate the potential impact on its net interest income under various interest rate scenarios. Another method by which the Company's interest rate risk position can be estimated is by computing estimated changes in its net portfolio value ("NPV"). This method estimates interest rate risk exposure from movements in interest rates by using interest rate sensitivity analysis to determine the change in the NPV of discounted cash flows from assets and liabilities. Computations are based on a number of assumptions, including the relative levels of market interest rates and prepayments in mortgage loans and certain types of investments. These computations do not contemplate any actions management may undertake in response to changes in interest rates, and should not be relied upon as indicative of actual results. In addition, certain shortcomings are inherent in the method of computing NPV. Should interest rates remain or decrease below current levels, the proportion of adjustable rate loans could decrease in future periods due to refinancing activity. In the event of an interest rate change, prepayment levels would likely be different from those assumed in the table. Lastly, the ability of many borrowers to repay their adjustable rate debt may decline during a rising interest rate environment.

        The following tables provide an assessment of the risk to NPV in the event of sudden and sustained 1% and 2% increases and decreases in prevailing interest rates. The table indicates that as of December 31, 2012 the Company's estimated NPV might be expected to increase in the event of a decrease in prevailing interest rates, and might be expected to generally decrease in the event of an increase in prevailing interest rates (dollars in thousands). As of December 31, 2011 the Company's estimated NPV would generally increase in the event of a decrease in prevailing rates and decrease in the event of an increase in rates.

December 31, 2012

 
   
  $ Amount
  $ Change
  NPV Ratio
  Change
 
   
      +2%     585,912     (67,797 )   21.22%     (88 )
      +1%     619,214     (34,495 )   21.69%     (41 )
      Base     653,709         22.10%      
      -1%     668,411     14,702     21.91%     (19 )
      -2%     771,237     117,528     24.35%     225  

December 31, 2011

 
  Change in Rates
  $ Amount
  $ Change
  NPV Ratio
  Change
 
      +2%     644,734     (71,698 )   23.28%     (88)
      +1%     679,598     (36,834 )   23.75%     (41)
      Base     716,432         24.16%    
      -1%     723,324     6,892     23.73%     (43)
      -2%     814,930     98,498     25.51%     135

        The above discussion, and the portions of MANAGEMENT'S DISCUSSION AND ANALYSIS in Item 7 of this Report that are referenced in the above discussion contains statements relating to future results of the Company that are considered "forward-looking-statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to, among other things, simulation of the impact on net interest income from changes in interest rates. Actual results may differ materially from those expressed or implied therein as a result of certain risks and uncertainties, including those risks and uncertainties expressed above, those that are described in MANAGEMENT'S DISCUSSION AND ANALYSIS in Item 7 of this Report, those that are described in Item 1 of this Report, "Business," under the caption "Forward-Looking-Statements," and those that are described in Item 1A of this Report, "Risk Factors", all of which discussions are incorporated herein by reference.

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ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


LOGO
   
    Crowe Horwath LLP
Independent Member Crowe Horwath International

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders
MainSource Financial Group, Inc.
Greensburg, Indiana

        We have audited the accompanying consolidated balance sheets of MainSource Financial Group, Inc. as of December 31, 2012 and 2011 and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2012. We also have audited MainSource Financial Group, Inc.'s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). MainSource Financial Group, Inc.'s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the company's internal control over financial reporting based on our audits.

        We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

        A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

        Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

        In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of MainSource Financial Group, Inc. as of December 31, 2012 and 2011, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, MainSource Financial Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control — Integrated Framework issued by the COSO.

    /s/ Crowe Horwath LLP

Indianapolis, Indiana
March 14, 2013

 

 

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MAINSOURCE FINANCIAL GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Dollar amounts in thousands except per share data)

 
  December 31,
2012

  December 31,
2011

 
   

Assets

             

Cash and due from banks

  $ 58,100   $ 66,864  

Money market funds and federal funds sold

    7,550     42,284  
       

Cash and cash equivalents

    65,650     109,148  

Securities available for sale

    902,341     876,090  

Loans held for sale

    17,025     16,620  

Loans, net of allowance for loan losses of $32,227 and $39,889

    1,521,156     1,494,490  

Restricted stock, at cost

    15,639     15,856  

Premises and equipment, net

    54,101     50,652  

Goodwill

    63,947     61,919  

Purchased intangible assets

    6,993     7,163  

Cash surrender value of life insurance

    59,410     48,204  

Interest receivable and other assets

    63,026     74,038  
       

Total assets

  $ 2,769,288   $ 2,754,180  
       

Liabilities

             

Deposits

             

Noninterest bearing

  $ 405,167   $ 334,345  

Interest bearing

    1,779,887     1,825,555  
       

Total deposits

    2,185,054     2,159,900  

Other borrowings

    34,519     25,789  

Federal Home Loan Bank (FHLB) advances

    141,052     151,427  

Subordinated debentures

    50,418     50,267  

Other liabilities

    34,494     30,244  
       

Total liabilities

    2,445,537     2,417,627  

Commitments and contingent liabilities (Notes 1 and 16)

             

Shareholders' equity

             

Preferred stock, no par value

             

Authorized shares — 400,000

             

Issued shares — 57,000;

             

Outstanding shares — 15,100 and 57,000

             

Aggregate liquidation preference $15,100 and $57,000

    14,918     56,387  

Common stock $.50 stated value:

             

Authorized shares — 100,000,000

             

Issued shares — 20,859,027 and 20,780,616

             

Outstanding shares — 20,304,525 and 20,206,214

    10,450     10,411  

Treasury stock — 554,502 and 574,402 shares, at cost

    (9,043 )   (9,367 )

Additional paid-in capital

    224,096     223,510  

Retained earnings

    57,602     32,720  

Accumulated other comprehensive income

    25,728     22,892  
       

Total shareholders' equity

    323,751     336,553  
       

Total liabilities and shareholders' equity

  $ 2,769,288   $ 2,754,180  
       

The accompanying notes are an integral part of these consolidated financial statements.

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MAINSOURCE FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, 2012, 2011, AND 2010
(Dollar amounts in thousands except per share data)

 
  2012
  2011
  2010
 
   

Interest income

                   

Loans, including fees

  $ 83,934   $ 92,941   $ 105,179  

Securities

                   

Taxable

    12,510     16,040     18,830  

Tax exempt

    12,160     12,415     10,360  

Other interest income

    164     215     202  
       

Total interest income

    108,768     121,611     134,571  
       

Interest expense

                   

Deposits

    7,637     14,111     23,162  

Federal Home Loan Bank advances

    5,120     5,754     8,144  

Subordinated debentures

    1,825     1,737     1,755  

Other borrowings

    104     161     258  
       

Total interest expense

    14,686     21,763     33,319  
       

Net interest income

    94,082     99,848     101,252  

Provision for loan losses

    9,850     17,800     35,250  
       

Net interest income after provision for loan losses

    84,232     82,048     66,002  

Non-interest income

                   

Service charges on deposit accounts

    19,815     18,147     17,462  

Interchange income

    6,540     6,225     5,487  

Mortgage banking

    9,927     5,551     7,642  

Trust and investment product fees

    3,650     3,250     2,363  

Increase in cash surrender value of life insurance

    1,206     1,200     1,246  

Net realized gains on securities

    1,867     11,357     2,979  

Gain/(loss) on sale and write-down of OREO

    (1,359 )   (2,744 )   (1,097 )

Other-than-temporary loss

                   

Total impairment loss

    (500 )        

Loss recognized in other comprehensive income

             
       

Net impairment loss recognized in earnings

    (500 )        

Insurance commissions

            1,711  

Other income

    2,745     2,322     3,498  
       

Total non-interest income

    43,891     45,308     41,291  

Non-interest expense

                   

Salaries and employee benefits

    48,990     49,950     50,138  

Net occupancy

    6,769     6,686     6,654  

Equipment

    8,564     7,822     7,855  

Intangibles amortization

    1,835     1,939     2,066  

Telecommunications

    1,729     1,991     1,882  

Stationery printing and supplies

    1,337     1,510     1,478  

FDIC assessment

    2,495     3,974     4,940  

Marketing

    4,397     4,057     3,412  

Collection expense

    3,768     4,334     3,579  

Prepayment penalty on FHLB advance

    1,313          

Consultant expense

    1,150     6,547      

Interchange expense

    1,591     1,465     1,515  

Other expenses

    10,900     9,530     8,733  
       

Total non-interest expense

    94,838     99,805     92,252  
       

Income before income tax

    33,285     27,551     15,041  

Income tax expense

    6,027     3,738     239  
       

Net income

  $ 27,258   $ 23,813   $ 14,802  

Preferred dividends and discount accretion

    (2,110 )   (3,054 )   (3,054 )

Redemption of preferred stock

    1,357          
       

Net income attributable to common shareholders

  $ 26,505   $ 20,759   $ 11,748  
       

Cash dividends declared per common share

  $ 0.08   $ 0.04   $ 0.04  

Net income per common share:

                   

Basic

  $ 1.31   $ 1.03   $ 0.58  

Diluted

  $ 1.30   $ 1.03   $ 0.58  

The accompanying notes are an integral part of these consolidated financial statements.

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MAINSOURCE FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
YEARS ENDED DECEMBER 31, 2012, 2011, AND 2010
(Dollar amounts in thousands except per share data)

 
  2012
  2011
  2010
 
   

Net income

  $ 27,258   $ 23,813   $ 14,802  

Other comprehensive income:

                   

Unrealized holding gains on securities available for sale

    5,731     32,025     (1,868 )

Reclassification adjustment for (gains) included in net income

    (1,867 )   (11,357 )   (2,979 )

Reclassification adjustment for other than temporary loss included in net income

    500          

Tax effect

    (1,528 )   (7,234 )   1,694  
       

Other comprehensive income

    2,836     13,434     (3,153 )
       

Comprehensive income

  $ 30,094   $ 37,247   $ 11,649  
       

The accompanying notes are an integral part of these consolidated financial statements.

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MAINSOURCE FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2012, 2011, AND 2010
(Dollar amounts in thousands except per share data)

 
   
  Common Stock    
   
   
   
   
 
 
   
   
   
   
  Accumulated
Other
Comprehensive
Income/(Loss)

   
 
 
  Preferred Stock
  Shares
Outstanding

  Amount
  Treasury
Stock

  Additional Paid-in Capital
  Retained
Earnings

  Total
 
   

Balance, January 1, 2010

  $ 55,979     20,136,188   $ 10,394   $ (9,367 ) $ 223,020   $ 1,825   $ 12,611   $ 294,462  

Net income

                                  14,802           14,802  

Other comprehensive income

                                        (3,153 )   (3,153 )

Stock option expense

                            114                 114  

Dividends — common stock ($.04 per share)

                                  (805 )         (805 )

Dividends — preferred stock

                                  (2,850 )         (2,850 )

Accretion of preferred stock discount

    204                             (204 )          
       

Balance, December 31, 2010

    56,183     20,136,188     10,394     (9,367 )   223,134     12,768     9,458     302,570  
       

Net income

                                  23,813           23,813  

Other comprehensive income

                                        13,434     13,434  

Stock option expense

                            72                 72  

Dividends — common stock ($.04 per share)

                                  (807 )         (807 )

Restricted stock award

          46,244     5           96                 101  

Director retainer award

          23,782     12           208                 220  

Dividends — preferred stock

                                  (2,850 )         (2,850 )

Accretion of preferred stock discount

    204                             (204 )          
       

Balance, December 31, 2011

    56,387     20,206,214     10,411     (9,367 )   223,510     32,720     22,892     336,553  
       

Net income

                                  27,258           27,258  

Other comprehensive income

                                        2,836     2,836  

Stock option exercise

          19,900     10     324     (214 )               120  

Stock option expense

                            169                 169  

Dividends — common stock ($.08 per share)

                                  (1,623 )         (1,623 )

Restricted stock award

          48,061     14           308                 322  

Director retainer award

          30,350     15           323                 338  

Dividends — preferred stock

                                  (1,967 )         (1,967 )

Repurchase of preferred shares

    (41,612 )                           1,357           (40,255 )

Accretion of preferred stock discount

    143                             (143 )          
       

Balance, December 31, 2012

  $ 14,918     20,304,525   $ 10,450   $ (9,043 ) $ 224,096   $ 57,602   $ 25,728   $ 323,751  
       

The accompanying notes are an integral part of these consolidated financial statements.

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MAINSOURCE FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2012, 2011, AND 2010
(Dollars in thousands)

 
  2012
  2011
  2010
 
   

Operating Activities

                   

Net income

  $ 27,258   $ 23,813   $ 14,802  

Adjustments to reconcile net income to net cash provided by operating activities:

                   

Provision for loan losses

    9,850     17,800     35,250  

Depreciation expense

    5,440     5,074     5,276  

Amortization of mortgage servicing rights

    1,964     1,388     1,424  

Valuation allowance on mortgage servicing rights

    676     (45 )   (132 )

Securities amortization, net

    4,717     2,693     1,794  

Amortization of purchased intangible assets

    1,835     1,939     2,066  

Earnings on cash surrender value of life insurance policies

    (1,206 )   (1,200 )   (1,246 )

Gain on life insurance benefit

        (141 )   (67 )

Gain on sale of insurance related business line

            (988 )

Securities gains, net of impairment

    (1,367 )   (11,357 )   (2,979 )

Gain on loans sold

    (7,068 )   (3,494 )   (5,152 )

Loans originated for sale

    (246,596 )   (195,344 )   (274,111 )

Proceeds from loan sales

    253,259     188,063     278,546  

Stock based compensation expense

    491     173     114  

Stock portion of director retainer fee expense

    338     220      

Loss on sale and write-down of OREO

    1,359     2,744     1,097  

Prepayment penalty on FHLB advance

    1,313          

Change in other assets and liabilities

    1,928     3,734     6,940  
       

Net cash provided by operating activities

    54,191     36,060     62,634  

Investing Activities

                   

Purchases of securities available for sale

    (220,543 )   (527,834 )   (363,844 )

Proceeds from calls, maturities, and payments on securities available for sale

    131,130     120,588     157,154  

Proceeds from sales of securities available for sale

    64,176     366,559     111,564  

Loan originations and payments, net

    (15,060 )   102,983     154,068  

Purchases of premises and equipment

    (7,387 )   (6,865 )   (4,660 )

Proceeds from sale of OREO

    12,706     16,346     8,928  

Sale of insurance related business line

            2,000  

Purchase of life insurance policies

    (10,000 )        

Proceeds from redemption of restricted stock

    217     3,646     7,857  

Proceeds from life insurance benefit

        893     124  

Cash received from branch acquisitions, net

    5,464          
       

Net cash provided (used) by investing activities

    (39,297 )   76,316     73,191  

Financing Activities

                   

Net change in deposits

    (11,709 )   (51,664 )   (59,086 )

Net change in other borrowings

    8,730     (7,392 )   (14,450 )

Proceeds from FHLB advances

    95,000     15,000      

Repayment of FHLB advances

    (106,688 )   (15,638 )   (70,200 )

Cash dividends on preferred stock

    (1,967 )   (2,850 )   (2,850 )

Cash dividends on common stock

    (1,623 )   (807 )   (805 )

Repurchase of preferred shares

    (40,255 )        

Proceeds from exercise of stock options

    120          
       

Net cash (used) by financing activities

    (58,392 )   (63,351 )   (147,391 )
       

Net change in cash and cash equivalents

    (43,498 )   49,025     (11,566 )

Cash and cash equivalents, beginning of year

    109,148     60,123     71,689  
       

Cash and cash equivalents, end of year

  $ 65,650   $ 109,148   $ 60,123  
       

Supplemental cash flow information

                   

Interest paid

  $ 15,382   $ 23,263   $ 34,714  

Income taxes paid/(refunded)

    3,893     2,672     (1,675 )

Supplemental non cash disclosure

                   

Loan balances transferred to foreclosed real estate

    5,286     23,093     11,115  

        See Note 26 regarding non-cash transactions included in acquisitions.

The accompanying notes are an integral part of these consolidated financial statements.

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Dollar amounts in thousands except per share data)

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

        Nature of Operations and Principles of Consolidation: The consolidated financial statements include MainSource Financial Group, Inc. and its wholly owned subsidiaries, together referred to as "the Company". Intercompany transactions and balances are eliminated in consolidation.

        The Company's wholly owned subsidiaries include MainSource Bank ("the Bank"), MainSource Title, LLC, MainSource Insurance, LLC, and Insurance Services Marketing, LLC. On October 1, 2010, the Company sold its property and casualty and health insurance book of businesses related to its insurance subsidiary, MainSource Insurance (MSI), to Encore Insurance Group, LLC. This sale did not materially affect the Company's financial condition or results of operation.

        The Company provides financial services through its offices in Indiana, Illinois, Ohio, and Kentucky. Its primary deposit products are checking, savings, and term certificate accounts, and its primary lending products are residential mortgage, commercial, and installment loans. Substantially all loans are secured by specific items of collateral including business assets, consumer assets and real estate. Other financial instruments which potentially represent concentrations of credit risk include deposit accounts in other financial institutions and federal funds sold. See the Loan Policy section for further discussion on loan information.

        Use of Estimates: To prepare financial statements in conformity with U. S. generally accepted account principles, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided and actual results could differ. The allowance for loan losses, carrying value of goodwill, loan servicing rights, other real estate owned, deferred tax assets and fair values of financial instruments are particularly subject to change.

        Cash Flows: Cash and cash equivalents include cash and due from banks, interest bearing deposits with other financial institutions with maturities under 90 days, money market funds and federal funds sold. Net cash flows are reported for loan and deposit transactions, federal funds purchased and repurchase agreements.

        Securities: Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of tax.

        Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method, which considers prepayments only on mortgage-backed securities. Gains and losses on sales are recorded on the trade date and are based on the amortized cost of the security sold. The Company evaluates securities for other-than-temporary impairment ("OTTI") at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) other-than-temporary impairment (OTTI) related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.

        Loans Held for Sale: Loans originated and intended for sale in the secondary market are carried at the lower of cost or market in the aggregate, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings.

        Mortgage loans held for sale are generally sold with servicing rights retained. The carrying value of mortgage loans sold is reduced by the amount allocated to the servicing right. Gains and losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold.

        Loans: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of purchase premiums or discounts, unearned interest, deferred loan fees and costs, and an allowance for loan losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.

        For all classes of financing receivables, interest income is not reported when full loan repayment is in doubt, typically when the loan is impaired or payments are past due over 90 days. Past due status is based on the contractual terms of the loan. Loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

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        For all classes of financing receivables, interest accrued but not received for loans placed on non-accrual is reversed against interest income. Payments received on such loans subsequent to being placed on non-accrual are applied to the principal balance of the loans. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Non-accrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans. Troubled Debt Restructurings, (TDRs), normally follow the same guidelines as regular loans in placing on non-accrual status.

        Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off.

        The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the most recent 3 years. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations

        For allowance purposes, the following portfolio segments have been identified: Commercial, Commercial Real Estate (CRE), Residential and Consumer. The classes within the Commercial portfolio are commercial and industrial and agricultural. The classes within the Commercial Real Estate portfolio are farm, hotel, construction and development, and other. The classes within the Residential portfolio are 1-4 family and home equity. Finally, the classes within the Consumer portfolio are direct and indirect.

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

Commercial

        The commercial portfolio contains commercial and industrial and agricultural loans. Commercial loans are made to commercial customers for use in normal business operations to finance working capital needs, equipment purchases, agricultural financing, or other projects and are repaid from operations of the business. The majority of these borrowers are customers doing business within the Company's geographic regions. Commercial loans are generally underwritten individually and secured with the assets of the company and/or the personal guarantee of the business owners. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate

        Commercial real estate loans consist of loans for income-producing real estate properties and real estate developers. The Company mitigates its risk on these loans by requiring collateral values that exceed the loan amount and underwriting the loan with projected cash flow in excess of the debt service requirement. These loans are made to finance properties such as apartment buildings, office and industrial buildings, hotels, farm real estate, and retail shopping centers; and are repaid through cash flows related to the operation, sale, or refinance of the property.

Residential

        The residential portfolio contains residential mortgage and home equity loans. Residential mortgage loans represent loans to consumers for the purchase or refinance of a residence. These loans are generally financed over a 15- to 30- year term, and in most cases, are extended to borrowers to finance their primary residence. Residential loans are secured by the residence being financed. For residential loans that are secured by 1-4 family residences and are generally owner occupied, the Company generally establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded. Home equity lending includes both home equity loans and lines-of-credit. This type of lending, which is secured by a first- or second- lien on the borrower's residence, allows customers to borrow against the equity in their home. Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas such as unemployment levels. Repayment can also be impacted by changes in property values on residential properties. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

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Consumer

        The consumer portfolio consists of direct and indirect installment loans. The largest percentage of the direct consumer loans are automobile loans and the automobile or other vehicle is normally used as collateral for the loan. The Company no longer writes any indirect loans. These loans are generally financed over a short (3-7 year) time horizon. Similar to the residential loans above, repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas such as unemployment levels. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

        All loans are charged off when the Company has determined that future collectability of the entire loan balance is doubtful. For commercial and commercial real estate loans, collateral dependent loans are written down to the discounted fair value of the collateral.

        A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Loans, for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Impairment is measured on a loan by loan basis for commercial and commercial real estate loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential real estate loans for impairment disclosures. A specific reserve is established as a component of the allowance when a loan has been determined to be impaired for all commercial and commercial real estate loans greater than $250.

        Federal Home Loan Bank (FHLB) Stock: The Bank is a member of the Federal Home Loan Bank ("FHLB") system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income.

        Premises and Equipment: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 30 to 39 years for buildings and 5 to 15 years for related components. Furniture, fixtures and equipment are depreciated using the straight-line method with useful lives ranging from 3 to 10 years.

        Foreclosed Assets: Assets acquired through or instead of loan foreclosure are initially recorded at fair value net of estimated selling costs when acquired, establishing a new cost basis. If fair value declines after acquisition, a valuation allowance is recorded through expense. Costs after acquisition are expensed.

        Company Owned Life Insurance: The Company has purchased life insurance policies on certain employees. Company owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.

        Servicing Assets: Servicing rights are recognized separately when they are acquired through sales of loans. When mortgage loans are sold, servicing rights are initially recorded at fair value with the income statement effect recorded in mortgage banking in non-interest income. Fair value is based on a valuation model that calculates the present value of estimated future net servicing income. All classes of servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans.

        Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount. If the Company later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. Changes in valuation allowances are reported with mortgage banking on the income statement. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.

        Servicing fee income, which is reported on the income statement as mortgage banking in non-interest income, is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal, or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee

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income. Servicing fees totaled $1,864, $2,104 and $1,890 for the years ended December 31, 2012, 2011 and 2010. Late fees and ancillary fees related to loan servicing are not material.

        Mortgage Banking Derivatives: Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are accounted for as free standing derivatives. Fair values of these mortgage derivatives are estimated based on changes in mortgage interest rates from the date the interest rate on the loan is locked. The Company enters into forward commitments for the future delivery of mortgage loans when interest rate locks are entered into, in order to hedge the change in interest rates resulting from its commitments to fund the loans. Any changes are recorded in mortgage banking on the income statement. The amount of income related to these derivatives was $1,740, $40, and $144 in 2012, 2011, and 2010 and is included in the "Gain from sale of mortgage loans and interest rate locks" in Note 14. See Note 14 for additional information on mortgage banking activities.

        Transfers of Financial Assets: Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Company does not maintain effective control over the transferred assets through an agreement or option to repurchase them before their maturity.

        Goodwill and Other Intangible Assets: Goodwill resulting from business combinations prior to January 1, 2009 represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill resulting from business combinations after January 1, 2009, is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually. The Company has selected June 30 of each year as the date to perform its impairment review. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on the Company's balance sheet.

        Other intangible assets consist largely of core deposit and acquired customer relationship intangibles arising from whole bank and branch acquisitions. They are initially measured at fair value and then are amortized on an accelerated method over their estimated useful lives, generally ten years.

        Loan Commitments and Related Financial Instruments: Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.

        Long-term Assets: Premises and equipment and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.

        Income Taxes: Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

        A tax position is recognized as a benefit only if it is "more likely than not" that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the "more likely than not" test, no tax benefit is recorded.

        The Company recognizes interest and/or penalties related to income tax matters in income tax expense.

        Stock-Based Compensation: Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.

        Retirement Plans: Employee 401(k) and profit sharing plan expense is the amount of matching contributions and discretionary contributions, respectively.

        Earnings (Loss) Per Common Share: Basic earnings (loss) per common share is net income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per common share include the dilutive effect of additional potential common shares issuable under stock options. Earnings and dividends per share are restated for all stock splits and dividends through the date of issuance of the financial statements.

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        Comprehensive Income (Loss): Comprehensive income (loss) consists of net income (loss) and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale which are also recognized as a separate component of equity.

        Loss Contingencies: Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are now any such matters that will have a material effect on the financial statements.

        Restrictions on Cash: Cash on hand or on deposit with the Federal Reserve Bank was required to meet regulatory reserve and clearing requirements.

        Equity: Stock dividends in excess of 20% are reported by transferring the par value of the stock issued from retained earnings to common stock. Stock dividends for 20% or less are reported by transferring the fair value, as of the ex-dividend date, of the stock issued from retained earnings to common stock and additional paid-in capital. Fractional share amounts are paid in cash with a reduction in retained earnings. Treasury stock is carried at cost and valued on an average cost basis.

        Dividend Restriction: Banking regulations require maintaining certain capital levels and may limit the dividends paid by the banks to the holding company or by the holding company to shareholders.

        Fair Value of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a Note 7. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.

        Operating Segments: While the Company's chief decision makers monitor the revenue streams of the various Company products and services, the identifiable segments are not material and operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company's financial service operations are considered by management to be aggregated in one reportable operating segment.

        Reclassifications: Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year net income or shareholders' equity.

    Adoption of New Accounting and Newly Issued but Not Yet Effective Standards:

        In July 2012, the FASB amended existing guidance relating to testing indefinite-lived intangible assets for impairment. The amendment permits an assessment of qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, it is concluded that it is not more likely than not that the indefinite-lived intangible asset is impaired, then no further action is required. However, after the same assessment, if it is concluded that it is more likely than not that the indefinite-lived intangible asset is impaired, then a quantitative impairment test should be performed whereby the fair value of the indefinite-lived intangible asset is compared to the carrying amount. The amendments in this guidance are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted. It is expected that the effect of adopting this standard will not have a material effect on the Company's operating results or financial condition.

        In June 2011, the FASB amended existing guidance and eliminated the option to present the components of other comprehensive income as part of the statement of changes in shareholders' equity. The amendment requires that comprehensive income be presented in either a single continuous statement or in two separate consecutive statements. The amendments in this guidance are effective as of the beginning of a fiscal reporting year, and interim periods within that year, that begins after December 15, 2011. The adoption of this amendment had no impact on the consolidated financial statements as the current presentation of comprehensive income is in compliance with this amendment.

        In September 2011, the FASB amended existing guidance relating to goodwill impairment testing. The amendment permits an assessment of qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing these events or circumstances, it is concluded that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. The amendments in this guidance are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The effect of adopting this standard did not have a material effect on the Company's operating results or financial condition.

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NOTE 2 — PREFERRED STOCK AND STOCK REPURCHASE

        On January 16, 2009, the Company entered into an agreement with the United States Department of Treasury (the "Treasury Department") as part of the Treasury Department's Capital Purchase Program. Under this agreement, the Company issued to the Treasury Department 57,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A ("preferred stock"), having a liquidation amount per share of $1,000, for a total price of $57 million and a warrant to purchase up to 571,906 shares ("warrant shares") of the Company's common stock, at an initial per share exercise price of $14.95, for an aggregate purchase price of $8.55 million.

        The preferred stock pays cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter. Dividends are payable quarterly in arrears on February 15, May 15, August 15 and November 15 of each year. The Company may, at its option and at any time, redeem the preferred stock for the liquidation amount of $1,000 per share, plus any accrued and unpaid dividends. While the preferred stock is outstanding, the Company may only pay dividends on common stock if all accrued and unpaid dividends for the preferred stock have been paid.

        In addition to the preferred shares, the Treasury Department received a warrant to purchase 571,906 shares of the Company's common stock at an initial per share exercise price of $14.95. The warrant provides for the adjustment of the exercise price and the number of shares of the Company's common stock issuable upon exercise pursuant to customary anti-dilution provisions, such as upon stock splits or distributions of securities or other assets to holders of Company common stock, and upon certain issuances of the Company common stock at or below a specified price relative to the initial exercise price. The warrant has a term of ten years and is currently exercisable. The Treasury Department has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the warrant. Like stock options, the warrant issued through the Capital Purchase Program is potentially dilutive. The average stock price for the Company for 2012 and 2011 was $11.45 and $8.86 per share and the warrant issued in 2009 has an exercise price of $14.95 per share. This resulted in no additional dilutive shares in calculating earnings per share for 2012, 2011, or 2010.

        On March 28, 2012, the U.S. Department of the Treasury priced its secondary public offering of 57,000 shares of the Company's Preferred Stock. The Company successfully bid for the purchase of 21,030 shares of the Preferred Stock for a total purchase price of $19,581, plus accrued and unpaid dividends on the Preferred Stock from and including February 15, 2012 to the settlement date, April 3, 2012. The book value of the preferred stock retired was $20,823. As a result of its successful bid in the offering, the Company retired 21,030 shares of its original sale of 57,000 shares of Preferred Stock on March 29, 2012. The difference between the book value and the bid price of $1,242 was credited to retained earnings. The remaining 35,970 shares were purchased by unrelated third parties. On May 31, 2012 the Company purchased from one of these parties an additional 1,820 shares or $1,820 of the preferred stock at a cost of $1,747. The difference between the book value and the bid price of $60 was credited to retained earnings. On December 5, 2012 the Company purchased an additional 19,050 shares or $19,050 of the preferred stock at a price of $18,927. The difference between the book value and the bid price of $55 was credited to retained earnings. None of the remaining shares of outstanding Preferred Stock are held by the U.S. Treasury. Included in 2012 operating results are $250 of expenses associated with Treasury's auction and the Company's purchase of the Preferred Stock.

NOTE 3 — RESTRICTION ON CASH AND DUE FROM BANKS

        The Bank is required to maintain reserve funds in cash or on deposit with the Federal Reserve Bank. The reserves required at December 31, 2012 and 2011 were $14,357 and $7,474. The Company had no compensating balance requirements at December 31, 2012 and 2011.

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NOTE 4 — SECURITIES

        The fair value of securities available for sale and related gross unrealized gains and losses recognized in accumulated other comprehensive income was as follows:

 
  Amortized Cost
  Gross Unrealized Gains
  Gross Unrealized Losses
  Fair Value
 
   

As of December 31, 2012

                         

Available for Sale

                         

U. S. government agency

  $ 1,600   $ 38   $   $ 1,638  

State and municipal

    310,552     27,484     (97 )   337,939  

Mortgage-backed securities-residential (Government Sponsored Entity)

    219,352     7,711     (8 )   227,055  

Collateralized mortgage obligations (Government Sponsored Entity)

    322,758     4,604     (139 )   327,223  

Equity securities

    4,939             4,939  

Other securities

    3,558         (11 )   3,547  
       

Total available for sale

  $ 862,759   $ 39,837   $ (255 ) $ 902,341  
       

As of December 31, 2011

                         

Available for Sale

                         

State and municipal

  $ 320,269   $ 24,723   $ (115 ) $ 344,877  

Mortgage-backed securities-residential (Government Sponsored Entity)

    264,619     7,074     (189 )   271,504  

Collateralized mortgage obligations (Government Sponsored Entity)

    246,985     3,807     (25 )   250,767  

Equity securities

    5,410             5,410  

Other securities

    3,589         (57 )   3,532  
       

Total available for sale

  $ 840,872   $ 35,604   $ (386 ) $ 876,090  
       

        Contractual maturities of securities at December 31, 2012 were as follows. Securities not due at a single maturity or with no maturity at year end are shown separately.

 
  Available for Sale  
 
  Amortized Cost
  Fair Value
 
   

Within one year

  $ 6,722   $ 6,857  

One through five years

    52,535     55,170  

Six through ten years

    95,047     102,419  

After ten years

    161,406     178,678  

Mortgage-backed securities-residential (Government Sponsored Entity)

    219,352     227,055  

Collateralized mortgage obligations (Government Sponsored Entity)

    322,758     327,223  

Equity securities

    4,939     4,939  
       

Total available for sale securities

  $ 862,759   $ 902,341  
       

        Gross proceeds from sales of securities available for sale during 2012, 2011 and 2010 were $64,176, $366,559, and $111,564. Gross gains of $1,944, $11,440 and $3,018 and gross losses of $77, $83, and $39 were realized on those sales in 2012, 2011 and 2010, respectively. The tax provision related to these net realized gains was $635, $3,861, and $1,049 respectively.

        Securities with a carrying value of $259,613 and $206,639 were pledged at December 31, 2012 and 2011 to secure certain deposits and repurchase agreements, secure future funding needs, and for other purposes as permitted or required by law.

        At year end 2012 and 2011, there were no holdings of securities of any one issuer, other than the U.S. Government and its sponsored entities, in an amount greater than 10% of shareholders' equity.

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        Below is a summary of securities with unrealized losses as of year-end 2012 and 2011 presented by length of time the securities have been in a continuous unrealized loss position.

2012
  Less than 12 months
  12 months or longer
  Total
 
 
     
Description of securities
  Fair Value
  Unrealized
Losses

  Fair Value
  Unrealized
Losses

  Fair Value
  Unrealized
Losses

 
   

State and municipal

  $ 6,646   $ (97 ) $   $   $ 6,646   $ (97 )

Mortgage-backed securities-residential (GSE's)

    12,766     (8 )           12,766     (8 )

Collateralized mortgage obligations (GSE's)

    32,330     (139 )           32,330     (139 )

Other securities

    990     (11 )           990     (11 )
       

Total temporarily impaired

  $ 52,732   $ (255 ) $   $   $ 52,732   $ (255 )
       

 

2011
  Less than 12 months
  12 months or longer
  Total
 
 
     
Description of securities
  Fair Value
  Unrealized
Losses

  Fair Value
  Unrealized
Losses

  Fair Value
  Unrealized
Losses

 
   

State and municipal

  $ 1,576   $ (72 ) $ 237   $ (43 ) $ 1,813   $ (115 )

Mortgage-backed securities-residential (GSE's)

    50,493     (189 )           50,493     (189 )

Collateralized mortgage obligations (GSE's)

    25,527     (25 )           25,527     (25 )

Other securities

    945     (57 )           945     (57 )
       

Total temporarily impaired

  $ 78,541   $ (343 ) $ 237   $ (43 ) $ 78,778   $ (386 )
       

Other-Than-Temporary-Impairment

        Management evaluates securities for other-than-temporary impairment ("OTTI") at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. The investment securities portfolio is evaluated for OTTI by segregating the portfolio into two general segments and applying the appropriate OTTI model. Investment securities are generally evaluated for OTTI under ASC 320. However, certain purchased beneficial interests, including non-agency mortgage-backed securities, asset-backed securities, and collateralized debt obligations, that had credit ratings at the time of purchase of below AA are evaluated using the model outlined in ASC 325-10 (formerly EITF Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests that Continue to be Held by a Transfer in Securitized Financial Assets). The Company holds no securities that fall within the scope of ASC 325-10.

        In determining OTTI under ASC 320, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. 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.

        When OTTI occurs under either model, the amount of the OTTI recognized in earnings depends on whether the Company intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current period credit loss. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment's amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total 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 total OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.

        As of December 31, 2012, the Company's security portfolio consisted of 1,006 securities, 33 of which were in an unrealized loss position. Unrealized losses on state and municipal securities of $97 have not been recognized into income because management has the ability to hold for a period of time sufficient to allow for any anticipated recovery in fair value and it is unlikely that management will be required to sell the securities before their anticipated recovery. The decline in value is primarily attributable to temporary illiquidity and the financial crisis affecting these markets and not the expected cash flows of the individual securities. The fair value of these debt securities is expected to recover as the securities approach their maturity date.

        At December 31, 2012, all of the mortgage-backed securities held by the Company were issued by U.S. government-sponsored entities and agencies, primarily Fannie Mae and Freddie Mac, institutions which the government has affirmed its commitment to

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support. Because the decline in fair value of approximately $8 is attributable to changes in interest rates and illiquidity, and not credit quality, and because the Company does not have the intent to sell these mortgage-backed securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at December 31, 2012.

        The Company's collateralized mortgage obligation securities portfolio includes agency collateralized mortgage obligations with a market value of $327,223 which had unrealized losses of approximately $139 at December 31, 2012. The Company monitors to insure it has adequate credit support and as of December 31, 2012, the Company believes there is no OTTI and does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery. All securities are investment grade.

        The unrealized losses on other securities are related to one single issue trust preferred security and has not been recognized into income because management has the ability to hold for a period of time sufficient to allow for any anticipated recovery in fair value and it is unlikely that management will be required to sell the security before its anticipated recovery. The Company performs a quarterly review of this security and based on this review, no evidence of adverse changes in expected cash flows is anticipated. The decline in value is primarily attributable to temporary illiquidity and the financial crisis affecting these markets and not the expected cash flows of the individual security. Currently, the issuer has made all contractual payments and given no indication that they will not be able to make them into the future. The fair value of these debt securities is expected to recover as the securities approach their maturity date. As of December 31, 2012, the Company owned $990 of these securities with an unrealized loss of $11.

        In 2012, there was a $500 impairment loss recognized on one equity security reducing its fair value to $250. This amount is shown as an impairment loss on the income statement. During 2010, the Company determined that three of its equity holdings were other than temporarily impaired and wrote down the securities by $97 to their fair value of $136. This amount was included in other income in 2010.

NOTE 5 — LOANS AND ALLOWANCE FOR LOAN LOSSES

        Loans were as follows:

 
  December 31,
2012

  December 31,
2011

 
   

Commercial

             

Commercial and industrial

  $ 126,965   $ 114,367  

Agricultural

    32,769     20,741  

Commercial Real Estate

             

Farm

    62,896     46,308  

Hotel

    131,495     146,358  

Construction and development

    25,208     30,746  

Other

    507,231     540,752  

Residential

             

1-4 family

    394,195     365,710  

Home equity

    224,329     212,202  

Consumer

             

Direct

    45,844     51,157  

Indirect

    2,451     6,038  
       

Total loans

    1,553,383     1,534,379  

Allowance for loan losses

    (32,227 )   (39,889 )
       

Net loans

  $ 1,521,156   $ 1,494,490  
       

        The following tables presents the activity in the allowance for loan losses by portfolio segment for the years ending December 31, 2012 and 2011:

2012
  Commercial
  Commercial
Real Estate

  Residential
  Consumer
  Total
 
   

Allowance for loan loss

                               

Balance, January 1

  $ 5,562   $ 30,476   $ 2,972   $ 879   $ 39,889  

Provision charged to expense

    (265 )   4,802     3,490     1,823     9,850  

Losses charged off

    (1,946 )   (13,553 )   (3,547 )   (3,286 )   (22,332 )

Recoveries

    543     2,432     265     1,580     4,820  
       

Balance, December 31

  $ 3,894   $ 24,157   $ 3,180   $ 996   $ 32,227  
       

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2011
  Commercial
  Commercial
Real Estate

  Residential
  Consumer
  Total
 
   

Allowance for loan loss

                               

Balance, January 1

  $ 6,386   $ 32,653   $ 2,281   $ 1,285   $ 42,605  

Provision charged to expense

    215     13,406     3,136     1,043     17,800  

Losses charged off

    (2,211 )   (16,954 )   (3,093 )   (2,636 )   (24,894 )

Recoveries

    1,172