NOTE 8 – FINANCE RECEIVABLES AND ALLOWANCE FOR CREDIT LOSSES

Old National's finance receivables consist primarily of loans made to consumers and commercial clients in various industries including manufacturing, agribusiness, transportation, mining, wholesaling and retailing. Most of Old National's lending activity occurs within the Company's principal geographic markets of Indiana, Illinois and Kentucky. Old National has no concentration of commercial loans in any single industry exceeding 10% of its portfolio.


The composition of loans by lending classification was as follows:

		June 30,			December 31,
(dollars in thousands)		2011			2010
Commercial (1)	$	1,269,607		$	1,211,399
Commercial real estate:
Construction		98,670			101,016
Other		1,071,731			841,379
Residential real estate		795,442			664,705
Consumer credit:
Heloc		255,073			248,293
Auto		486,416			497,102
Other		140,402			179,557
Subtotal		4,117,341			3,743,451
Allowance for loan losses		(70,189	)		(72,309	)
Net loans	$	4,047,152		$	3,671,142

(1) Includes direct finance leases of $92.9 million at June 30, 2011 and $106.1 million at December 31, 2010.

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

Commercial

Commercial loans are primarily based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. 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

These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing Old National's commercial real estate portfolio are diverse in terms of type and geographic location. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. As a general rule, Old National avoids financing single purpose projects unless other underwriting factors are present to help mitigate risk. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans.

Construction

Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based on estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from Old National until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

Residential and Consumer

With respect to residential loans that are secured by 1-4 family residences and are generally owner occupied, Old National establishes a maximum loan-to-value ratio and generally requires private mortgage insurance if that ratio is exceeded. Home equity loans are typically secured by a subordinate interest in 1-4 family residences, and consumer loans are secured by consumer assets such as automobiles or recreational vehicles. Some consumer loans are unsecured such as small installment loans and certain lines of credit. 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 residential property values. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

Portfolio loans, or loans Old National intends to hold for investment purposes, are carried at the principal balance outstanding, net of earned interest, purchase premiums or discounts, deferred loan fees and costs, and an allowance for loan losses. Interest income is accrued on the principal balances of loans outstanding.

Allowance for loan losses

The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses incurred in the loan portfolio. Management's evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, pools of homogeneous loans, historical loss experience, and assessments of the impact of current economic conditions on the portfolio.

The allowance is increased through a provision charged to operating expense. Loans deemed to be uncollectible are charged to the allowance. Recoveries of loans previously charged-off are added to the allowance.

Old National's activity in the allowance for loan losses for the three months ended June 30, 2011 and 2010 is as follows:


		Commercial
(dollars in thousands)	Commercial	Real Estate	Consumer	Residential	Unallocated	Total
2011

Allowance for loan losses:
Beginning balance	$27,190	$32,550	$10,280	$2,729	0	$72,749
Charge-offs	(3,838)	(2,274)	(2,465)	(325)	0	(8,902)
Recoveries	1,302	316	1,468	49	0	3,135
Provision	1,375	1,898	(725)	659	0	3,207
Ending balance	$26,029	$32,490	$ 8,558	$3,112	0	$70,189

		Commercial
(dollars in thousands)	Commercial	Real Estate	Consumer	Residential	Unallocated	Total
2010

Allowance for loan losses:
Beginning balance	$27,764	$28,716	$13,967	$1,651	0	$72,098
Charge-offs	(4,498)	(3,105)	(3,456)	(748)	0	(11,807)
Recoveries	1,208	853	1,473	38	0	3,572
Provision	4,085	803	893	2,219	0	8,000
Ending balance	$28,559	$27,267	$12,877	$3,160	0	$71,863

Old National's activity in the allowance for loan losses for the six months ended June 30, 2011 and 2010 is as follows:


					Commercial
(dollars in thousands)		Commercial			Real Estate			Consumer			Residential		Unallocated		Total
2011

Allowance for loan losses:
Beginning balance	$	26,204		$	32,654		$	11,142		$	2,309		0	$	72,309
Charge-offs		(5,169	)		(2,981	)		(5,853	)		(1,173	)	0		(15,176	)
Recoveries		2,135			984			3,326			92		0		6,537
Provision		2,859			1,833			(57	)		1,884		0		6,519
Ending balance	$	26,029		$	32,490		$	8,558		$	3,112		0	$	70,189

					Commercial
(dollars in thousands)		Commercial			Real Estate			Consumer			Residential		Unallocated		Total
2010

Allowance for loan losses:
Beginning balance	$	26,869		$	27,138		$	13,853		$	1,688		0	$	69,548
Charge-offs		(7,991	)		(4,841	)		(8,211	)		(1,676	)	0		(22,719	)
Recoveries		3,458			1,145			3,093			57		0		7,753
Provision		6,223			3,825			4,142			3,091		0		17,281
Ending balance	$	28,559		$	27,267		$	12,877		$	3,160		0	$	71,863

The following table provides Old National's recorded investment in financing receivables by portfolio segment at June 30, 2011 and December 31, 2010 and other information regarding the allowance:


				Commercial
(dollars in thousands)		Commercial Real Estate				Consumer		Residential	Unallocated		Total
June 30, 2011
Allowance for loan losses:
Ending balance: individually
evaluated for impairment	$	10,162	$	7,736		0		0	0	$	17,898
Ending balance: collectively
evaluated for impairment	$	14,314	$	22,517	$	8,558	$	3,112	0	$	48,501
Ending balance: loans acquired
with deteriorated credit quality	$	1,553	$	2,237		0		0	0	$	3,790
Loans and leases outstanding:
Ending balance	$	1,269,607	$	1,170,401	$	881,891	$	795,442	0	$	4,117,341
Ending balance: individually
evaluated for impairment	$	34,099	$	39,905		0		0	0	$	74,004
Ending balance: collectively
evaluated for impairment	$	1,233,250	$	1,103,054	$	881,709	$	794,946	0	$	4,012,959
Ending balance: loans acquired
with deteriorated credit quality (1)	$	2,258	$	27,442	$	182	$	496	0	$	30,378

(1) Includes $2.4 million of revolving credits not accounted for under ASC 310-30.


				Commercial
(dollars in thousands)		Commercial		Real Estate		Consumer		Residential	Unallocated		Total
December 31, 2010
Allowance for loan losses:
Ending balance: individually
evaluated for impairment	$	6,063	$	8,514		0		0	0	$	14,577
Ending balance: collectively
evaluated for impairment	$	20,141	$	24,140	$	11,142	$	2,309	0	$	57,732
Loans and leases outstanding:
Ending balance	$	1,211,399	$	942,395	$	924,952	$	664,705	0	$	3,743,451
Ending balance: individually
evaluated for impairment	$	23,944	$	29,377		0		0	0	$	53,321
Ending balance: collectively
evaluated for impairment	$	1,187,455	$	913,018	$	924,952	$	664,705	0	$	3,690,130

Old National's management monitors the credit quality of its financing receivables in an on-going manner. Internally, management assigns a credit quality grade to each non-homogeneous commercial and commercial real estate loan in the portfolio. The primary determinants of the credit quality grade are based upon the reliability of the primary source of repayment and the past, present, and projected financial condition of the borrower. The credit quality rating also reflects current economic and industry conditions. Major factors used in determining the grade can vary based on the nature of the loan, but commonly include factors such as debt service coverage, internal cash flow, liquidity, leverage, operating performance, debt burden, FICO scores, occupancy, interest rate sensitivity, and expense burden. Old National uses the following definitions for risk ratings:

Criticized. Special mention loans that have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution's credit position at some future date.

Classified – Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

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

Pass rated loans are those loans that are other than criticized, classified – substandard or classified – doubtful.

The risk category of loans, including loans acquired from Monroe Bancorp, by class of loans is as follows:


(dollars in thousands)
Corporate Credit						Commercial Real Estate-				Commercial Real Estate-
Exposure		Commercial				Construction				Other
by Internally		June 30,		December 31,		June 30,		December 31,		June 30,		December 31,
Assigned Grade		2011		2010		2011		2010		2011		2010
Grade:
Pass	$	1,140,817	$	1,105,382	$	73,436	$	77,241	$	906,793	$	729,243
Criticized		43,263		38,629		13,458		16,223		48,847		29,161
Classified - substandard		49,337		41,899		8,905		7,552		51,702		52,559
Classified - doubtful		36,190		25,489		2,871		0		64,389		30,416
Total	$	1,269,607	$	1,211,399	$	98,670	$	101,016	$	1,071,731	$	841,379

Old National considers the performance of the loan portfolio and its impact on the allowance for loan losses. For residential and consumer loan classes, Old National also evaluates credit quality based on the aging status of the loan and by payment activity. The following table presents the recorded investment in residential and consumer loans based on payment activity as of June 30, 2011 and December 31, 2010:


June 30, 2011				Consumer				Residential
(dollars in
thousands)		Heloc		Auto		Other
Performing	$	254,035	$	484,155	$	138,521	$	785,635
Nonperforming		1,038		2,261		1,881		9,807
	$	255,073	$	486,416	$	140,402	$	795,442

December 31, 2010				Consumer				Residential
(dollars in
thousands)		Heloc		Auto		Other
Performing	$	246,390	$	494,771	$	177,470	$	655,986
Nonperforming		1,903		2,331		2,087		8,719
	$	248,293	$	497,102	$	179,557	$	664,705

Large commercial credits are subject to individual evaluation for impairment. Retail credits and other small balance credits that are part of a homogeneous group are not tested for individual impairment. A loan is considered impaired when it is probable that contractual interest and principal payments will not be collected either for the amounts or by the dates as scheduled in the loan agreement. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported net, at the present value of estimated cash flows using the loan's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Old National's policy for recognizing income on impaired loans is to accrue interest unless a loan is placed on nonaccrual status. For the six months ended June 30, 2011 and 2010, the average balance of impaired loans was $62.0 million and $49.5 million, respectively, for which no interest income was recorded. No additional funds are committed to be advanced in connection with these impaired loans.

The following table shows Old National's impaired loans that are individually evaluated as of June 30, 2011 and December 31, 2010. Of the purchased loans, only those that have experienced subsequent impairment since the date acquired are included in the table below. Purchased loans of $11.8 million migrated to classified-doubtful during the second quarter of 2011.


				Unpaid
		Recorded		Principal		Related
(dollars in thousands)		Investment		Balance		Allowance
June 30, 2011
With no related allowance recorded:
Commercial	$	8,751	$	9,986	$	0
Commercial Real Estate - Construction		0		0		0
Commercial Real Estate - Other		9,784		13,447		0
With an allowance recorded:
Commercial		25,348		28,578		10,162
Commercial Real Estate - Construction		0		0		0
Commercial Real Estate - Other		30,121		31,897		7,736
Total Commercial		74,004		83,908		17,898
December 31, 2010
With no related allowance recorded:
Commercial	$	6,116	$	8,001	$	0
Commercial Real Estate - Construction		0		0		0
Commercial Real Estate - Other		10,554		16,781		0
With an allowance recorded:
Commercial		17,828		20,341		6,063
Commercial Real Estate - Construction		0		0		0
Commercial Real Estate - Other		18,823		19,849		8,514
Total Commercial		53,321		64,972		14,577

The average balance of impaired loans and interest income recognized on impaired loans during the six months ended June 30, 2011 are included in the tables below.


		Average		Interest
		Recorded		Income
(dollars in thousands)		Investment		Recognized (1)
June 30, 2011
With no related allowance recorded:
Commercial	$	5,529	$	90
Commercial Real Estate - Construction		0		0
Commercial Real Estate - Other		8,821		105
With an allowance recorded:
Commercial		21,756		86
Commercial Real Estate - Construction		0		0
Commercial Real Estate - Other		25,872		134
Total Commercial		61,978		415

(1) The Company does not record interest on nonaccrual loans until principal is recovered.

A loan is generally placed on nonaccrual status when principal or interest becomes 90 days past due unless it is well secured and in the process of collection, or earlier when concern exists as to the ultimate collectibility of principal or interest. Interest accrued during the current year on such loans is reversed against earnings. Interest accrued in the prior year, if any, is charged to the allowance for loan losses. Cash interest received on these loans is applied to the principal balance until the principal is recovered or until the loan returns to accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current, remain current for six months and future payments are reasonably assured.

Old National's past due financing receivables as of June 30, 2011 and December 31, 2010 are as follows:


						Recorded
						Investment >
		30-59 Days		60-89 Days		90 Days and				Total
(dollars in thousands)		Past Due		Past Due		Accruing		Nonaccrual		Past Due		Current
June 30, 2011
Commercial	$	3,314	$	1,055	$	3	$	36,190	$	40,562	$	1,229,045
Commercial Real Estate:
Construction		0		0		0		2,871		2,871		95,799
Other		1,668		513		57		64,389		66,627		1,005,104
Consumer:
Heloc		289		101		40		1,038		1,468		253,605
Auto		4,934		871		159		2,261		8,225		478,191
Other		1,263		646		179		1,881		3,969		136,433
Residential		7,154		1,079		0		9,807		18,040		777,402
Total	$	18,622	$	4,265	$	438	$	118,437	$	141,762	$	3,975,579

December 31, 2010
Commercial	$	2,543	$	583	$	79	$	25,488	$	28,693	$	1,182,706
Commercial Real Estate:
Construction		0		0		0		0		0		101,016
Other		992		98		0		30,416		31,506		809,873
Consumer:
Heloc		849		477		189		1,903		3,418		244,875
Auto		5,791		1,316		120		2,331		9,558		487,544
Other		1,129		972		184		2,088		4,373		175,184
Residential		9,126		1,589		0		8,719		19,434		645,271
Total	$	20,430	$	5,035	$	572	$	70,945	$	96,982	$	3,646,469

In the course of resolving nonperforming loans, Old National may choose to restructure the contractual terms of certain loans. The Company may attempt to work out an alternative payment schedule with the borrower in order to avoid foreclosure actions. Any loans that are modified are reviewed by Old National to identify if a troubled debt restructuring ("TDR") has occurred, which is when for economic or legal reasons related to a borrower's financial difficulties, the Bank 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 Old National by increasing the ultimate probability of collection.

Loans modified in a troubled debt restructuring are placed on nonaccrual status until the Company determines the future collection of principal and interest is reasonably assured, which generally requires that the borrower demonstrate a period of performance according to the restructured terms of six months. At June 30, 2011, loans modified in a troubled debt restructuring, which are included in nonaccrual loans, totaled $7.5 million, consisting of $3.5 million of commercial loans and $4.0 million of commercial real estate loans, and had specific allocations of allowance for loan losses of $3.0 million. At December 31, 2010, loans modified in a troubled debt restructuring, which are included in nonaccrual loans, totaled $4.8 million, consisting of $3.8 million of commercial loans and $1.0 million of commercial real estate loans, and had specific allocations of allowance for loan losses of $1.6 million.

If the Company is unable to resolve a nonperforming loan issue the credit will be charged off when it is apparent there will be a loss. For large commercial type loans, each relationship is individually analyzed for evidence of apparent loss based on quantitative benchmarks or subjectively based upon certain events or particular circumstances. It is Old National's policy to charge off small commercial loans scored through our small business credit center with contractual balances under $250,000 that have been placed on nonaccrual status or became ninety days or more delinquent, without regard to the collateral position. For residential and consumer loans, a charge off is recorded at the time foreclosure is initiated or when the loan becomes 120 to 180 days past due.

Purchased Impaired Loans

Purchased loans acquired in a business combination are recorded at estimated fair value on their purchase date with no carryover of the related allowance for loan and lease losses. In determining the estimated fair value of purchased loans, management considers a number of factors including the remaining life of the acquired loans, estimated prepayments, estimated loss ratios, estimated value of the underlying collateral, net present value of cash flows expected to be received, among others. Purchased loans are accounted for in accordance with guidance for certain loans acquired in a transfer, when the loans have evidence of credit deterioration since origination and it is probable at the date of acquisition that the acquirer will not collect all contractually required principal and interest payments. The difference between contractually required payments and the cash flows expected to be collected at acquisition is referred to as the non-accretable difference. Subsequent decreases to the expected cash flows will generally result in a provision for loan and lease losses. Subsequent increases in cash flows will result in a reversal of the provision for loan losses to the extent of prior charges and then an adjustment to accretable yield, which would have a positive impact on interest income.

Old National has purchased loans for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected. Of these acquired credit impaired loans, $2.4 million in carrying balances did not meet the criteria to be accounted for under the guidance of ASC 310-30 as they were revolving lines of credit, this these lines have not been included in the following table. For the loans that meet the criteria of ASC 310-30 treatment, the carrying amount is as follows:


		June 30,
(dollars in thousands)		2011
Commercial	$	1,733
Commercial real estate		25,532
Consumer		181
Residential		496
Outstanding balance	$	27,942
Carrying amount, net of allowance of $827	$	27,115

The accretable difference on purchased loans acquired in a business combination is the difference between the expected cash flows and the net present value of expected cash flows with such difference accreted into earnings using the effective yield method over the term of the loans. The accretable difference that is expected to be accreted into future earnings of the Company totaled $7.0 million at the date of acquisition. Accretion of $5.2 million has been recorded as loan interest income through June 30, 2011.

Accretable yield, or income expected to be collected, is as follows:


(dollars in thousands)
Balance at January 1, 2011	$	0
New loans purchased		7,001
Accretion of income		(5,198	)
Reclassifications from (to) nonaccretable difference		12,235
Disposals/other adjustments		(80	)
Balance at June 30, 2011	$	13,958

For those purchased loans disclosed above, Old National established a $.8 million allowance for loan losses during the first six months of 2011. The amounts in the allowance for loan losses attributable to the purchased loans disclosed above were zero and $.8 million at the beginning and end of the period, respectively. No allowances for loan losses were reversed during the first six months of 2011 regarding these loans.

Purchased loans for which it was probable at acquisition that all contractually required payments would not be collected are as follows:


		June 30,
(dollars in thousands)		2011
Contractually required payments receivable of loans
purchased during the year:
Commercial	$	8,839
Commercial real estate		52,484
Consumer		305
Residential		1,124
	$	62,752
Cash flows expected to be collected at acquisition (January 1, 2011)	$	49,557
Fair value of acquired loans at acquisition (January 1, 2011)	$	42,587

Income is not recognized on certain purchased loans if Old National cannot reasonably estimate cash flows to be collected. Old National had no purchased loans for which it could not reasonably estimate cash flows to be collected.