NOTE 8—LOANS 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:


	September 30,			December 31,
(dollars in thousands)	2013			2012
Commercial (1)	$	1,381,216		$	1,336,820
Commercial real estate:
Construction		83,205			99,081
Other		1,082,561			1,156,802
Residential real estate		1,344,350			1,324,703
Consumer credit:
Heloc		249,013			258,114
Auto		585,285			526,085
Other		96,045			122,656
Covered loans		250,801			372,333

Total loans		5,072,476			5,196,594
Allowance for loan losses		(42,306	)		(49,047	)
Allowance for loan losses—covered loans		(5,012	)		(5,716	)

Net loans	$	5,025,158		$	5,141,831

(1)	Includes direct finance leases of $30.1 million at September 30, 2013 and $57.7 million at December 31, 2012.

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.

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 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.

Included with commercial real estate are construction loans, which 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

With respect to residential loans that are secured by 1-4 family residences and are generally owner occupied, Old National typically establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded. 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.

Consumer

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.

Covered Loans

On July 29, 2011, Old National acquired the banking operations of Integra Bank N.A. (“Integra”) in an FDIC assisted transaction. As part of the purchase and assumption agreement, the Company and the FDIC entered into loss sharing agreements (each, a “loss sharing agreement” and collectively, the “loss sharing agreements”), whereby the FDIC will cover a substantial portion of any future losses on loans (and related unfunded commitments), other real estate owned (“OREO”) and up to 90 days of certain accrued interest on loans. The acquired loans and OREO subject to the loss sharing agreements are referred to collectively as “covered assets.” Under the terms of the loss sharing agreements, the FDIC will reimburse Old National for 80% of losses up to $275.0 million, losses in excess of $275.0 million up to $467.2 million at 0% reimbursement, and 80% of losses in excess of $467.2 million. As of September 30, 2013, we do not expect losses to exceed $275.0 million. Old National will reimburse the FDIC for its share of recoveries with respect to losses for which the FDIC has reimbursed the Bank under the loss sharing agreements. The loss sharing provisions of the agreements for commercial and single family residential mortgage loans are in effect for five and ten years, respectively, from the July 29, 2011 acquisition date and the loss recovery provisions for such loans are in effect for eight years and ten years, respectively, from the acquisition date.

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.

No allowance was brought forward on any of the acquired loans as any credit deterioration evident in the loans was included in the determination of the fair value of the loans at the acquisition date. Purchased credit impaired (“PCI”) loans are not considered impaired until after the point at which there has been a degradation of cash flows below our expected cash flows at acquisition. Impairment on PCI loans would be recognized in the current period as provision expense.

Old National’s activity in the allowance for loan losses for the three months ended September 30, 2013 and 2012 is as follows:


				Commercial
(dollars in thousands)	Commercial			Real Estate			Consumer			Residential			Unallocated		Total
2013
Allowance for loan losses:
Beginning balance	$	15,084		$	26,595		$	4,844		$	2,795			—	$	49,318
Charge-offs		(750	)		(432	)		(1,822	)		(501	)		—		(3,505	)
Recoveries		472			1,571			1,132			54			—		3,229
Provision		(286	)		(2,864	)		657			769			—		(1,724	)

Ending balance	$	14,520		$	24,870		$	4,811		$	3,117			—	$	47,318


				Commercial
(dollars in thousands)	Commercial			Real Estate			Consumer			Residential			Unallocated		Total
2012
Allowance for loan losses:
Beginning balance	$	17,850		$	28,621		$	4,682		$	3,607			—	$	54,760
Charge-offs		(2,485	)		(771	)		(1,385	)		(545	)		—		(5,186	)
Recoveries		1,647			2,300			565			276			—		4,788
Provision		954			(945	)		663			(272	)		—		400

Ending balance	$	17,966		$	29,205		$	4,525		$	3,066			—	$	54,762

Old National’s activity in the allowance for loan losses for the nine months ended September 30, 2013 and 2012 is as follows:


				Commercial
(dollars in thousands)	Commercial			Real Estate			Consumer			Residential			Unallocated		Total
2013
Allowance for loan losses:
Beginning balance	$	14,642		$	31,289		$	5,155		$	3,677			—	$	54,763
Charge-offs		(2,719	)		(3,233	)		(5,336	)		(1,212	)		—		(12,500	)
Recoveries		2,501			3,309			3,540			277			—		9,627
Provision		96			(6,495	)		1,452			375			—		(4,572	)

Ending balance	$	14,520		$	24,870		$	4,811		$	3,117			—	$	47,318


				Commercial
(dollars in thousands)	Commercial			Real Estate			Consumer			Residential			Unallocated		Total
2012
Allowance for loan losses:
Beginning balance	$	19,964		$	26,993		$	6,954		$	4,149			—	$	58,060
Charge-offs		(5,725	)		(4,864	)		(5,935	)		(1,465	)		—		(17,989	)
Recoveries		3,940			4,421			3,090			391			—		11,842
Provision		(213	)		2,655			416			(9	)		—		2,849

Ending balance	$	17,966		$	29,205		$	4,525		$	3,066			—	$	54,762

The following tables provide Old National’s recorded investment in financing receivables by portfolio segment at September 30, 2013 and December 31, 2012 and other information regarding the allowance:


(dollars in thousands)	Commercial		CRE		Consumer		Residential		Unallocated		Total
September 30, 2013
Allowance for loan losses:
Ending balance: individually evaluated for impairment	$	3,959	$	2,572		—		—		—	$	6,531

Ending balance: collectively evaluated for impairment	$	10,359	$	15,073	$	4,158	$	3,050		—	$	32,640

Ending balance: noncovered loans acquired with deteriorated credit quality	$	202	$	2,811	$	86	$	36		—	$	3,135

Ending balance: covered loans acquired with deteriorated credit quality		—	$	4,414	$	567	$	31		—	$	5,012

Total allowance for credit losses	$	14,520	$	24,870	$	4,811	$	3,117		—	$	47,318

Loans and leases outstanding:
Ending balance: individually evaluated for impairment	$	24,945	$	41,568		—		—		—	$	66,513

Ending balance: collectively evaluated for impairment	$	1,376,178	$	1,108,595	$	978,419	$	1,344,331		—	$	4,807,523

Ending balance: loans acquired with deteriorated credit quality	$	579	$	30,613	$	14,262	$	156		—	$	45,610

Ending balance: covered loans acquired with deteriorated credit quality	$	14,818	$	88,526	$	19,477	$	30,009		—	$	152,830

Total loans and leases outstanding	$	1,416,520	$	1,269,302	$	1,012,158	$	1,374,496		—	$	5,072,476


(dollars in thousands)	Commercial		CRE		Consumer		Residential		Unallocated		Total
December 31, 2012
Allowance for loan losses:
Ending balance: individually evaluated for impairment	$	4,702	$	2,790		—		—		—	$	7,492

Ending balance: collectively evaluated for impairment	$	9,900	$	19,541	$	4,202	$	3,637		—	$	37,280

Ending balance: noncovered loans acquired with deteriorated credit quality	$	40	$	4,060	$	135	$	40		—	$	4,275

Ending balance: covered loans acquired with deteriorated credit quality		—	$	4,898	$	818		—		—	$	5,716

Total allowance for credit losses	$	14,642	$	31,289	$	5,155	$	3,677		—	$	54,763

Loans and leases outstanding:
Ending balance: individually evaluated for impairment	$	29,980	$	47,257		—		—		—	$	77,237

Ending balance: collectively evaluated for impairment	$	1,330,913	$	1,175,830	$	946,654	$	1,334,813		—	$	4,788,210

Ending balance: loans acquired with deteriorated credit quality	$	7,859	$	52,981	$	22,432	$	123		—	$	83,395

Ending balance: covered loans acquired with deteriorated credit quality	$	23,707	$	162,641	$	35,741	$	25,663		—	$	247,752

Total loans and leases outstanding	$	1,392,459	$	1,438,709	$	1,004,827	$	1,360,599		—	$	5,196,594

Credit Quality

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 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.

As of September 30, 2013 and December 31, 2012, the risk category of loans, excluding covered loans, by class of loans is as follows:


(dollars in thousands)
Corporate Credit Exposure	Commercial				Commercial Real Estate- Construction				Commercial Real Estate- Other
by Internally Assigned Grade	September 30, 2013		December 31, 2012		September 30, 2013		December 31, 2012		September 30, 2013		December 31, 2012
Grade:
Pass	$	1,238,695	$	1,237,274	$	64,874	$	62,604	$	952,765	$	965,967
Criticized		92,893		38,476		9,383		11,969		27,185		62,819
Classified—substandard		22,591		23,388		2,579		10,204		43,636		38,252
Classified—doubtful		27,037		37,682		6,369		14,304		58,975		89,764

Total	$	1,381,216	$	1,336,820	$	83,205	$	99,081	$	1,082,561	$	1,156,802

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 September 30, 2013 and December 31, 2012, excluding covered loans:


September 30, 2013	Consumer						Residential
(dollars in thousands)	Heloc		Auto		Other
Performing	$	247,546	$	583,629	$	94,227	$	1,334,043
Nonperforming		1,467		1,656		1,818		10,307

	$	249,013	$	585,285	$	96,045	$	1,344,350


December 31, 2012	Consumer						Residential
(dollars in thousands)	Heloc		Auto		Other
Performing	$	256,394	$	524,105	$	120,547	$	1,312,717
Nonperforming		1,720		1,980		2,109		11,986

	$	258,114	$	526,085	$	122,656	$	1,324,703

Impaired Loans

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 unless they are modified as a troubled debt restructuring. 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 all but purchased credit impaired loans, is to recognize interest income on impaired loans unless the loan is placed on nonaccrual status. For the nine months ended September 30, 2013 and 2012, the average balance of impaired loans was $71.9 million and $76.7 million, respectively. No additional funds are committed to be advanced in connection with these impaired loans.

The following table shows Old National’s impaired loans, excluding covered loans, that are individually evaluated as of September 30, 2013 and December 31, 2012. Of the loans purchased during 2012 and 2011 without FDIC loss share coverage, only those that have experienced subsequent impairment since the date acquired are included in the table below.


			Unpaid
	Recorded		Principal		Related
(dollars in thousands)	Investment		Balance		Allowance
September 30, 2013
With no related allowance recorded:
Commercial	$	15,439	$	15,795	$	—
Commercial Real Estate—Construction		563		671		—
Commercial Real Estate—Other		14,255		18,089		—
With an allowance recorded:
Commercial		9,506		13,442		3,959
Commercial Real Estate—Construction		3,133		3,133		69
Commercial Real Estate—Other		23,617		25,019		2,503

Total Commercial and CRE	$	66,513	$	76,149	$	6,531

December 31, 2012
With no related allowance recorded:
Commercial	$	6,563	$	9,280	$	—
Commercial Real Estate—Construction		1,179		1,287		—
Commercial Real Estate—Other		16,944		23,162		—
With an allowance recorded:
Commercial		23,417		28,574		4,702
Commercial Real Estate—Construction		3,227		3,227		69
Commercial Real Estate—Other		25,907		28,732		2,721

Total Commercial and CRE	$	77,237	$	94,262	$	7,492

The average balance of impaired loans, excluding covered loans, and interest income recognized on impaired loans during the three months ended September 30, 2013 and 2012 are included in the tables below.


	Average		Interest
	Recorded		Income
(dollars in thousands)	Investment		Recognized (1)
September 30, 2013
With no related allowance recorded:
Commercial	$	14,043	$	33
Commercial Real Estate—Construction		583		—
Commercial Real Estate—Other		13,868		44
With an allowance recorded:
Commercial		12,989		19
Commercial Real Estate—Construction		2,989		—
Commercial Real Estate—Other		26,556		4

Total Commercial and CRE	$	71,028	$	100

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


	Average		Interest
	Recorded		Income
(dollars in thousands)	Investment		Recognized (1)
September 30, 2012
With no related allowance recorded:
Commercial	$	8,514	$	40
Commercial Real Estate—Construction		1,322		2
Commercial Real Estate—Other		13,417		27
With an allowance recorded:
Commercial		19,372		(10	)
Commercial Real Estate—Construction		438		(2	)
Commercial Real Estate—Other		23,246		(1	)

Total Commercial and CRE	$	66,309	$	56

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

The average balance of impaired loans, excluding covered loans, and interest income recognized on impaired loans during the nine months ended September 30, 2013 and 2012 are included in the tables below.


	Average		Interest
	Recorded		Income
(dollars in thousands)	Investment		Recognized (1)
September 30, 2013
With no related allowance recorded:
Commercial	$	11,002	$	91
Commercial Real Estate—Construction		871		—
Commercial Real Estate—Other		15,600		57
With an allowance recorded:
Commercial		16,462		50
Commercial Real Estate—Construction		3,180		—
Commercial Real Estate—Other		24,763		99

Total Commercial and CRE	$	71,878	$	297

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


	Average		Interest
	Recorded		Income
(dollars in thousands)	Investment		Recognized (1)
September 30, 2012
With no related allowance recorded:
Commercial	$	10,246	$	40
Commercial Real Estate—Construction		796		2
Commercial Real Estate—Other		16,349		70
With an allowance recorded:
Commercial		23,081		58
Commercial Real Estate—Construction		3,464		—
Commercial Real Estate—Other		22,741		54

Total Commercial and CRE	$	76,677	$	224

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

For all loan classes, 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.

Covered loans accounted for under FASB ASC Topic 310-30 accrue interest, even though they may be contractually past due, as any nonpayment of contractual principal or interest is considered in the periodic re-estimation of expected cash flows and is included in the resulting recognition of current period covered loan loss provision or prospective yield adjustments. Similar to uncovered loans, covered loans accounted for outside FASB ASC Topic 310-30 are classified as nonaccrual when, in the opinion of management, collection of principal or interest is doubtful. Information for covered loans accounted for both under and outside FASB ASC Topic 310-30 is included in the table below in the row labeled covered loans.

Old National’s past due financing receivables as of September 30, 2013 and December 31, 2012 are as follows:


(dollars in thousands)	30-59 Days Past Due		60-89 Days Past Due		Recorded Investment > 90 Days and Accruing		Nonaccrual		Total Past Due		Current
September 30, 2013
Commercial	$	2,079	$	823	$	41	$	27,037	$	29,980	$	1,351,236
Commercial Real Estate:
Construction		—		60		—		6,369		6,429		76,776
Other		2,642		653		—		58,975		62,270		1,020,291
Consumer:
Heloc		851		71		125		1,467		2,514		246,499
Auto		3,256		805		145		1,656		5,862		579,423
Other		1,596		372		101		1,818		3,887		92,158
Residential		7,991		2,626		369		10,307		21,293		1,323,057
Covered loans		1,882		613		74		40,688		43,257		207,544

Total loans	$	20,297	$	6,023	$	855	$	148,317	$	175,492	$	4,896,984

December 31, 2012
Commercial	$	2,691	$	515	$	322	$	36,766	$	40,294	$	1,296,526
Commercial Real Estate:
Construction		11		—		—		14,304		14,315		84,766
Other		3,439		665		236		81,525		85,865		1,070,937
Consumer:
Heloc		961		15		—		1,720		2,696		255,418
Auto		4,070		881		328		1,980		7,259		518,826
Other		1,732		403		110		2,109		4,354		118,302
Residential		14,686		1,874		66		11,986		28,612		1,296,091
Covered loans		2,891		941		15		103,946		107,793		264,540

Total loans	$	30,481	$	5,294	$	1,077	$	254,336	$	291,188	$	4,905,406

Loan Participations

Old National has loan participations, which qualify as participating interests, with other financial institutions. At September 30, 2013, these loans totaled $223.8 million, of which $142.9 million had been sold to other financial institutions and $80.9 million was retained by Old National. The loan participations convey proportionate ownership rights with equal priority to each participating interest holder, involve no recourse (other than ordinary representations and warranties) to, or subordination by, any participating interest holder, all cash flows are divided among the participating interest holders in proportion to each holder’s share of ownership and no holder has the right to pledge the entire financial asset unless all participating interest holders agree.

Troubled Debt Restructurings

Old National may choose to restructure the contractual terms of certain loans. 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.

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. During the nine months ended September 30, 2013, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan, an extension of the maturity date at a stated rate of interest lower than the current market rate of new debt with similar risk, or a permanent reduction of the recorded investment of the loan.

Loans modified in a troubled debt restructuring are typically 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 for six months.

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, whichever is earlier.

For commercial troubled debt restructurings, an allocated reserve is established within the allowance for loan losses for the difference between the carrying value of the loan and its computed fair value. To determine the fair value of the loan, one of the following methods is selected: (1) the present value of expected cash flows discounted at the loans original effective interest rate, (2) the loan’s observable market price, or (3) the fair value of the collateral value, if the loan is collateral dependent. The allocated reserve is established as the difference between the carrying value of the loan and the collectable value. If there are significant changes in the amount or timing of the loan’s expected future cash flows, impairment is recalculated and the valuation allowance is adjusted accordingly.

For consumer and residential troubled debt restructurings, an additional amount is added to the loan loss reserve that represents the difference in the present value of the cash flows between the original terms and the new terms of the modified loan, using the original effective interest rate of the loan as a discount rate.

At September 30, 2013, our troubled debt restructurings consisted of $21.4 million of commercial loans, $22.7 million of commercial real estate loans, $0.9 million of consumer loans and $1.5 million of residential loans, totaling $46.5 million. Approximately $31.0 million of the troubled debt restructuring at September 30, 2013 were included with nonaccrual loans. At December 31, 2012, our troubled debt restructurings consisted of $12.7 million of commercial loans, $18.4 million of commercial real estate loans, $0.5 million of consumer loans and $0.5 million of residential loans, totaling $32.1 million. Approximately $22.1 million of the troubled debt restructuring at December 31, 2012 were included with nonaccrual loans.

As of September 30, 2013 and December 31, 2012, Old National has allocated $5.4 million and $4.5 million of specific reserves to customers whose loan terms have been modified in troubled debt restructurings, respectively. Old National has not committed to lend any additional amounts as of September 30, 2013 and December 31, 2012, respectively, to customers with outstanding loans that are classified as troubled debt restructurings.

The following table presents loans by class modified as troubled debt restructurings that occurred during the nine months ended September 30, 2013:


			Pre-modification		Post-modification
	Number of		Outstanding Recorded		Outstanding Recorded
(dollars in thousands)	Loans		Investment		Investment
Troubled Debt Restructuring:
Commercial		28	$	14,272	$	13,238
Commercial Real Estate—construction		—		—		—
Commercial Real Estate—other		28		9,741		8,961
Consumer —other		44		1,964		1,863

Total		100	$	25,977	$	24,062

The troubled debt restructurings described above increased the allowance for loan losses by $2.5 million and resulted in no charge-offs during the nine months ended September 30, 2013.

The following table presents loans by class modified as troubled debt restructurings that occurred during the twelve months ended December 31, 2012:


(dollars in thousands)	Number of Loans		Pre-modification Outstanding Recorded Investment		Post-modification Outstanding Recorded Investment
Troubled Debt Restructuring:
Commercial		44	$	9,585	$	9,574
Commercial Real Estate—construction		3		1,392		1,382
Commercial Real Estate—other		35		16,404		16,272
Consumer —other		26		996		994

Total		108	$	28,377	$	28,222

The troubled debt restructurings described above increased the allowance for loan losses by $0.4 million and resulted in charge-offs of $1.0 million during the twelve months ended December 31, 2012.

The following table presents loans by class modified as troubled debt restructuring for which there was a payment default within last twelve months following the modification during the nine months ended September 30, 2013. The impact of the defaults was immaterial.


(dollars in thousands)	Number of Contracts		Recorded Investment
Troubled Debt Restructuring
That Subsequently Defaulted:
Commercial		1	$	76
Commercial Real Estate		2		315

Total		3	$	391

The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the twelve months ended December 31, 2012:


(dollars in thousands)	Number of Contracts		Recorded Investment
Troubled Debt Restructuring
That Subsequently Defaulted:
Commercial		8	$	500
Commercial Real Estate		7		611

Total		15	$	1,111

A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms.

The terms of certain other loans were modified during the nine months ended September 30, 2013 that did not meet the definition of a troubled debt restructuring. It is our process to review all classified and criticized loans that, during the period, have been renewed, have entered into a forbearance agreement, have gone from principal and interest to interest only, or have had the maturity date extended. In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on its debt in the foreseeable future without the modification. The evaluation is performed under the Company’s internal underwriting policy. We also evaluate whether a concession has been granted or if we were adequately compensated through a market interest rate, additional collateral or a bona fide guarantee. We also consider whether the modification was insignificant relative to the other terms of the agreement or if the delay in a payment was 90 days or less.

Purchased credit impaired (“PCI”) loans are not considered impaired until after the point at which there has been a degradation of cash flows below our expected cash flows at acquisition. If a PCI loan is subsequently modified, and meets the definition of a TDR, it will be removed from PCI accounting and accounted for as a TDR only if the PCI loan was being accounted for individually. If the purchased credit impaired loan is being accounted for as part of a pool, it will not be removed from the pool. As of September 30, 2013, it has not been necessary to remove any loans from PCI accounting.

In general, once a modified loan is considered a TDR, the loan will always be considered a TDR, and therefore impaired, until it is paid in full, otherwise settled, sold or charged off. However, our policy also permits for loans to be removed from troubled debt restructuring status in the years following the restructuring if the following two conditions are met: (1) The restructuring agreement specifies an interest rate equal to or greater than the rate that the Company was willing to accept at the time of the restructuring for a new loan with comparable risk, and (2) the loan is not impaired based on the terms specified by the restructuring agreement.

The following table presents activity in troubled debt restructurings for the nine months ended September 30, 2013 and 2012:


(dollars in thousands)	Commercial			Commercial Real Estate			Consumer			Residential			Total
2013
Troubled debt restructuring:
Balance, January 1, 2013	$	12,660		$	18,422		$	473		$	499		$	32,054
(Charge-offs)/recoveries		639			474			(61	)		—			1,052
Payments		(5,122	)		(5,119	)		(408	)		(39	)		(10,688	)
Additions		13,238			8,961			836			1,027			24,062

Balance September 30, 2013	$	21,415		$	22,738		$	840		$	1,487		$	46,480


(dollars in thousands)	Commercial			Commercial Real Estate			Consumer			Residential			Total
2012
Troubled debt restructuring:
Balance, January 1, 2012	$	7,086		$	5,851		$	53		$	—		$	12,990
(Charge-offs)/recoveries		(1,381	)		(796	)		—			—			(2,177	)
Payments		(1,314	)		(3,245	)		(13	)		(32	)		(4,604	)
Additions		5,556			16,426			266			368			22,616

Balance September 30, 2012	$	9,947		$	18,236		$	306		$	336		$	28,825

Purchased Impaired Loans (non-covered 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 (ASC 310-30), 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 expected 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, $4.0 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, thus these lines have not been included in the following table. For these noncovered loans that meet the criteria of ASC 310-30 treatment, the carrying amount is as follows:


(dollars in thousands)	September 30, 2013		December 31, 2012
Commercial	$	579	$	7,859
Commercial real estate		30,613		52,981
Consumer		14,262		22,432
Residential		156		123

Carrying amount	$	45,610	$	83,395

Carrying amount, net of allowance	$	42,475	$	79,120

Allowance for loan losses	$	3,135	$	4,275

The outstanding balance of noncovered loans accounted for under ASC 310-30, including contractual principal, interest, fees and penalties, was $129.5 million and $179.5 million as of September 30, 2013 and December 31, 2012, respectively.

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. Accretion of $11.9 million has been recorded as loan interest income through the nine months ended September 30, 2013. Accretion of $7.9 million was recorded as loan interest income through the nine months ended September 30, 2012. Improvement in cash flow expectations has resulted in a reclassification from nonaccretable difference to accretable yield.

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


(dollars in thousands)	Monroe			Integra Noncovered			IBT			Total
Balance at January 1, 2013	$	11,834		$	3,575		$	16,170		$	31,579
New loans purchased		—			—			—			—
Accretion of income		(3,544	)		(1,028	)		(7,337	)		(11,909	)
Reclassifications from (to) nonaccretable difference		208			80			12,050			12,338
Disposals/other adjustments		(268	)		(49	)		(50	)		(367	)

Balance at September 30, 2013	$	8,230		$	2,578		$	20,833		$	31,641

Included in Old National’s allowance for loan losses is $3.1 million related to the purchased loans disclosed above for the first nine months of 2013. Included in Old National’s allowance for loan losses was $4.3 million related to the purchased loans in 2012. An immaterial amount of allowances for loan losses were reversed during 2013 and 2012 related to these loans.

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


(dollars in thousands)	Monroe Bancorp			Integra Bank (1)			IBT
Contractually required payments	$	94,714		$	921,856		$	118,535
Nonaccretable difference		(45,157	)		(226,426	)		(53,165	)

Cash flows expected to be collected at acquisition		49,557			695,430			65,370
Accretable yield		(6,971	)		(98,487	)		(11,945	)

Fair value of acquired loans at acquisition	$	42,586		$	596,943		$	53,425

(1)	Includes covered and noncovered.

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.