Note 7.

Allowance for Loan Losses and Credit Quality of Loans

Allowance for Loan Losses

The allowance for loan losses is maintained at a level estimated by management to provide adequately for risk of probable losses inherent in the current loan portfolio. The adequacy of the allowance for loan losses is continuously monitored. It is assessed for adequacy using a methodology designed to ensure the level of the allowance reasonably reflects the loan portfolio's risk profile. It is evaluated to ensure that it is sufficient to absorb all reasonably estimable credit losses inherent in the current loan portfolio.

To develop and document a systematic methodology for determining the allowance for loan losses, the Company has divided the loan portfolio into three portfolio segments, each with different risk characteristics and methodologies for assessing risk. Each portfolio segment is broken down into class segments where appropriate. Class segments contain unique measurement attributes, risk characteristics and methods for monitoring and assessing risk that are necessary to develop the allowance for loan losses. Unique characteristics such as borrower type, loan type, collateral type, and risk characteristics define each class segment. The following table illustrates the portfolio and class segments for the Company's loan portfolio:

Portfolio	Class
Commercial Loans	Commercial
	Commercial Real Estate
	Agricultural
	Agricultural Real Estate
	Business banking

Consumer Loans	Indirect
	Home Equity
	Direct

Residential Real Estate Mortgages

Commercial – The Company offers a variety of loan options to meet the specific needs of our commercial customers including term loans, time notes and lines of credit. Such loans are made available to businesses for working capital such as inventory and receivables, business expansion and equipment purchases. Generally, a collateral lien is placed on equipment or other assets owned by the borrower. These loans carry a higher risk than commercial real estate loans due to the nature of the underlying collateral, which can be business assets such as equipment and accounts receivable and is generally less liquid than real estate. To reduce the risk, management also attempts to secure real estate as collateral and obtain personal guarantees of the borrowers.

Commercial Real Estate – The Company offers commercial real estate loans to finance real estate purchases, refinancings, expansions and improvements to commercial properties. Commercial real estate loans are made to finance the purchases of real property which generally consists of real estate with completed structures. These commercial real estate loans are secured by first liens on the real estate, which may include apartments, commercial structures, housing businesses, healthcare facilities, and other non owner-occupied facilities. These loans are typically less risky than commercial loans, since they are secured by real estate and buildings. The Company's underwriting analysis includes credit verification, independent appraisals, a review of the borrower's financial condition, and a detailed analysis of the borrower's underlying cash flows. These loans are typically originated in amounts of no more than 80% of the appraised value of the property.

Agricultural – The Company offers a variety of agricultural loans to meet the needs of our agricultural customers including term loans, time notes, and lines of credit. These loans are made to purchase livestock, purchase and modernize equipment, and finance seasonal crop expenses. Generally, a collateral lien is placed on the livestock, equipment, produce inventories, and/or receivables owned by the borrower. These loans may carry a higher risk than commercial and agricultural real estate loans due to the industry price volatility, and in some cases, the perishable nature of the underlying collateral. To reduce these risks, management may attempt to secure these loans with additional real estate collateral, obtain personal guarantees of the borrowers, or obtain government loan guarantees to provide further support.

Agricultural Real Estate – The Company offers real estate loans to our agricultural customers to finance farm related real estate purchases, refinancings, expansions, and improvements to agricultural properties such as barns, production facilities, and land. The agricultural real estate loans are secured by first liens on the farm real estate. Because they are secured by land and buildings, these loans may be less risky than agricultural loans. The Company's underwriting analysis includes credit verification, independent appraisals, a review of the borrower's financial condition, and a detailed analysis of the borrower's underlying cash flows. These loans are typically originated in amounts of no more than 75% of the appraised value of the property. Government loan guarantees may be obtained to provide further support.

Business Banking - The Company offers a variety of loan options to meet the specific needs of our business banking customers including term loans, business banking mortgages and lines of credit. Such loans are generally less than $350 thousand and are made available to businesses for working capital such as inventory and receivables, business expansion, equipment purchases, and agricultural needs. Generally, a collateral lien is placed on equipment or other assets owned by the borrower such as inventory and/or receivables. These loans carry a higher risk than commercial loans due to the smaller size of the borrower and lower levels of capital. To reduce the risk, the Company obtains personal guarantees of the owners for a majority of the loans.

Indirect – The Company maintains relationships with many dealers primarily in the communities that we serve. Through these relationships, the company finances the purchases of automobiles and recreational vehicles (such as campers, boats, etc.) indirectly through dealer relationships. Approximately 70% of the indirect relationships represent automobile financing. Most of these loans carry a fixed rate of interest with principal repayment terms typically ranging from three to six years, based upon the nature of the collateral and the size of the loan. The majority of indirect consumer loans are underwritten on a secured basis using the underlying collateral being financed.

Home Equity – The Company offers fixed home equity loans as well as home equity lines of credit to consumers to finance home improvements, debt consolidation, education and other uses. Consumers are able to borrower up to 85% of the equity in their homes. The Company originates home equity lines of credit and second mortgage loans (loans secured by a second [junior] lien position on one-to-four-family residential real estate). These loans carry a higher risk than first mortgage residential loans as they are in a second position with respect to collateral. Risk is reduced through underwriting criteria, which include credit verification, appraisals, a review of the borrower's financial condition, and personal cash flows. A security interest, with title insurance when necessary, is taken in the underlying real estate.

Direct – The Company offers a variety of consumer installment loans to finance vehicle purchases, mobile home purchases and personal expenditures. Most of these loans carry a fixed rate of interest with principal repayment terms typically ranging from one to ten years, based upon the nature of the collateral and the size of the loan. The majority of consumer loans are underwritten on a secured basis using the underlying collateral being financed or a customer's deposit account. In addition to installment loans, the Company also offers personal lines of credit and overdraft protection. A minimal amount of loans are unsecured, which carry a higher risk of loss.

Residential Real Estate – Residential real estate loans consist primarily of loans secured by first or second deeds of trust on primary residences. We originate adjustable-rate and fixed-rate, one-to-four-family residential real estate loans for the construction, purchase or refinancing of a mortgage. These loans are collateralized by owner-occupied properties located in the Company's market area. When market conditions are favorable, for longer term, fixed-rate residential mortgages without escrow, the Company retains the servicing, but sells the right to receive principal and interest to Freddie Mac. This practice allows the Company to manage interest rate risk, liquidity risk, and credit risk. Loans on one-to-four-family residential real estate are generally originated in amounts of no more than 85% of the purchase price or appraised value (whichever is lower), or have private mortgage insurance. Mortgage title insurance and hazard insurance are normally required. Construction loans have a unique risk, because they are secured by an incomplete dwelling. This risk is reduced through periodic site inspections, including one at each loan draw period.

Allowance for Loan Loss Calculation

Management considers the accounting policy related to the allowance for loan losses to be a critical accounting policy given the inherent uncertainty in evaluating the levels of the allowance required to cover credit losses in the portfolio and the material effect that such judgments can have on the consolidated results of operations.

For purposes of evaluating the adequacy of the allowance, the Company considers a number of significant factors that affect the collectibility of the portfolio. For individually analyzed loans, these include estimates of loss exposure, which reflect the facts and circumstances that affect the likelihood of repayment of such loans as of the evaluation date. For homogeneous pools of loans, estimates of the Company's exposure to credit loss reflect a current assessment of a number of factors, which could affect collectibility. These factors include: past loss experience; size, trend, composition, and nature of loans; changes in lending policies and procedures, including underwriting standards and collection, charge-offs and recoveries; trends experienced in nonperforming and delinquent loans; current economic conditions in the Company's market; portfolio concentrations that may affect loss experienced across one or more components of the portfolio; the effect of external factors such as competition, legal and regulatory requirements; and the experience, ability, and depth of lending management and staff. In addition, various regulatory agencies, as an integral component of their examination process, periodically review the Company's allowance for loan losses. Such agencies may require the Company to make loan grade changes as well as recognize additions to the allowance based on their examinations.

After a thorough consideration of the factors discussed above, any required additions or reductions to the allowance for loan losses are made periodically by charges or credits to the provision for loan losses. These charges or credits are necessary to maintain the allowance at a level which management believes is reasonably reflective of overall inherent risk of probable loss in the portfolio. While management uses available information to recognize losses on loans, additions and reductions of the allowance may fluctuate from one reporting period to another. These fluctuations are reflective of changes in risk associated with portfolio content and/or changes in management's assessment of any or all of the determining factors discussed above. The following table illustrates the changes in the allowance for loan losses by portfolio segment for the three and nine months ended September 30, 2012 and September 30, 2011:

Allowance for Loan Losses

(in thousands)

							Residential
	Commercial			Consumer			Real Estate
	Loans			Loans			Mortgages			Unallocated			Total
Balance as of June 30, 2012	$	37,495		$	27,235		$	5,943		$	61		$	70,734
Charge-offs		(1,904	)		(3,446	)		(480	)		-			(5,830	)
Recoveries		492			574			9			-			1,075
Provision		1,734			2,213			809			(1	)		4,755
Ending Balance as of September 30, 2012	$	37,817		$	26,576		$	6,281		$	60		$	70,734

Balance as of June 30, 2011	$	39,147		$	25,718		$	5,373		$	246		$	70,484
Charge-offs		(1,694	)		(3,526	)		(45	)		-			(5,265	)
Recoveries		367			571			2			-			940
Provision		1,073			3,533			588			(19	)		5,175
Ending Balance as of September 30, 2011	$	38,893		$	26,296		$	5,918		$	227		$	71,334

							Residential
	Commercial			Consumer			Real Estate
	Loans			Loans			Mortgages			Unallocated			Total
Balance as of December 31, 2011	$	38,831		$	26,049		$	6,249		$	205		$	71,334
Charge-offs		(4,685	)		(11,237	)		(1,130	)		-			(17,052	)
Recoveries		1,180			1,918			25			-			3,123
Provision		2,491			9,846			1,137			(145	)		13,329
Ending Balance as of September 30, 2012	$	37,817		$	26,576		$	6,281		$	60		$	70,734

Balance as of December 31, 2010	$	40,101		$	26,126		$	4,627		$	380		$	71,234
Charge-offs		(7,153	)		(10,420	)		(558	)		-			(18,131	)
Recoveries		1,262			1,803			5			-			3,070
Provision		4,683			8,787			1,844			(153	)		15,161
Ending Balance as of September 30, 2011	$	38,893		$	26,296		$	5,918		$	227		$	71,334

The following tables illustrate the allowance for loan losses and the recorded investment by portfolio segment as of September 30, 2012 and December 31, 2011:

Allowance for Loan Losses and Recorded Investment in Loans

(in thousands)

					Residential
	Commercial		Consumer		Real Estate
	Loans		Loans		Mortgages		Unallocated		Total
As of September 30, 2012

Allowance for loan losses	$	37,817	$	26,576	$	6,281	$	60	$	70,734

Allowance for loans individually evaluated for impairment		2,720		-		-				2,720

Allowance for loans collectively evaluated for impairment	$	35,097	$	26,576	$	6,281	$	60	$	68,014

Ending balance of loans	$	1,992,891	$	1,607,780	$	650,448			$	4,251,119

Ending balance of loans individually evaluated for impairment		13,017		-		-				13,017

Ending balance of loans collectively evaluated for impairment	$	1,979,874	$	1,607,780	$	650,448			$	4,238,102

As of December 31, 2011

Allowance for loan losses	$	38,831	$	26,049	$	6,249	$	205	$	71,334

Allowance for loans individually evaluated for impairment		175		-		-				175

Allowance for loans collectively evaluated for impairment	$	38,656	$	26,049	$	6,249	$	205	$	71,159

Ending balance of loans	$	1,702,577	$	1,516,115	$	581,511			$	3,800,203

Ending balance of loans individually evaluated for impairment		6,219		-		-				6,219

Ending balance of loans collectively evaluated for impairment	$	1,696,358	$	1,516,115	$	581,511			$	3,793,984

Credit Quality of Loans

Loans are placed on nonaccrual status when timely collection of principal and interest in accordance with contractual terms is doubtful. Loans are transferred to nonaccrual status generally when principal or interest payments become ninety days delinquent, unless the loan is well secured and in the process of collection, or sooner when management concludes or circumstances indicate that borrowers may be unable to meet contractual principal or interest payments. When a loan is transferred to a nonaccrual status, all interest previously accrued in the current period but not collected is reversed against interest income in that period. Interest accrued in a prior period and not collected is charged-off against the allowance for loan losses. The Company's nonaccrual policies are the same for all classes of financing receivable.

If ultimate repayment of a nonaccrual loan is expected, any payments received are applied in accordance with contractual terms. If ultimate repayment of principal is not expected, any payment received on a nonaccrual loan is applied to principal until ultimate repayment becomes expected. Nonaccrual loans are returned to accrual status when they become current as to principal and interest and demonstrate a period of performance under the contractual terms and, in the opinion of management, are fully collectible as to principal and interest. When in the opinion of management the collection of principal appears unlikely, the loan balance is charged-off in total or in part. For loans in all portfolios, the principal amount is charged off in full or in part as soon as management determines, based on available facts, that the collection of principal in full is improbable. For commercial loans, management considers specific facts and circumstances relative to individual credits in making such a determination. For consumer and residential loan classes, management uses specific guidance and thresholds from the Federal Financial Institutions Examination Council's Uniform Retail Credit Classification and Account Management Policy.

The following table illustrates the Company's nonaccrual loans by loan class:

Loans on Nonaccrual Status
As of September 30, 2012

(In thousands)	September 30, 2012		December 31, 2011
Commercial Loans
Commercial	$	6,915	$	1,699
Commercial Real Estate		6,432		4,868
Agricultural		2,587		3,307
Agricultural Real Estate		1,195		2,067
Business Banking		5,921		7,446
		23,050		19,387
Consumer Loans
Indirect		1,703		1,550
Home Equity		8,126		7,931
Direct		257		378
		10,086		9,859

Residential Real Estate Mortgages		9,525		9,044

Total Nonaccrual	$	42,661	$	38,290

The increase in nonaccrual commercial and commercial real estate loans from December 31, 2011 to September 30, 2012 was due primarily to one commercial relationship which moved to nonaccrual status during the first quarter. This relationship has been reviewed quarterly and as a result was specifically reserved for by the Company during the first and second quarters of 2012.

The following tables set forth information with regard to past due and nonperforming loans by loan class as of September 30, 2012 and December 31, 2011:

Age Analysis of Past Due Financing Receivables

As of September 30, 2012

(in thousands)

					Greater Than
	31-60 Days		61-90 Days		90 Days		Total						Recorded
	Past Due		Past Due		Past Due		Past Due						Total
	Accruing		Accruing		Accruing		Accruing		Non-Accrual		Current		Loans
Commercial Loans
Commercial	$	707	$	149	$	-	$	856	$	6,915	$	594,775	$	602,546
Commercial Real Estate		1,455		138		-		1,593		6,432		1,012,695		1,020,720
Agricultural		-		-		-		-		2,587		64,187		66,774
Agricultural Real Estate		-		-		-		-		1,195		35,348		36,543
Business Banking		1,114		555		80		1,749		5,921		258,638		266,308
		3,276		842		80		4,198		23,050		1,965,643		1,992,891

Consumer Loans
Indirect		9,406		1,729		978		12,113		1,703		948,803		962,619
Home Equity		5,478		888		573		6,939		8,126		561,143		576,208
Direct		705		130		47		882		257		67,814		68,953
		15,589		2,747		1,598		19,934		10,086		1,577,760		1,607,780

Residential Real Estate Mortgages		2,240		170		1,285		3,695		9,525		637,228		650,448
	$	21,105	$	3,759	$	2,963	$	27,827	$	42,661	$	4,180,631	$	4,251,119

Age Analysis of Past Due Financing Receivables

As of December 31, 2011

(in thousands)

					Greater Than
	31-60 Days		61-90 Days		90 Days		Total						Recorded
	Past Due		Past Due		Past Due		Past Due						Total
	Accruing		Accruing		Accruing		Accruing		Non-Accrual		Current		Loans
Commercial Loans
Commercial	$	663	$	50	$	-	$	713	$	1,699	$	508,662	$	511,074
Commercial Real Estate		1,942		-		-		1,942		4,868		828,089		834,899
Agricultural		77		13		-		90		3,307		63,140		66,537
Agricultural Real Estate		-		-		50		50		2,067		31,809		33,926
Business Banking		1,871		1,024		-		2,895		7,446		245,800		256,141
		4,553		1,087		50		5,690		19,387		1,677,500		1,702,577

Consumer Loans
Indirect		12,141		2,584		1,283		16,008		1,550		855,545		873,103
Home Equity		5,823		1,277		954		8,054		7,931		553,660		569,645
Direct		831		191		140		1,162		378		71,827		73,367
		18,795		4,052		2,377		25,224		9,859		1,481,032		1,516,115

Residential Real Estate Mortgages		2,003		139		763		2,905		9,044		569,562		581,511
	$	25,351	$	5,278	$	3,190	$	33,819	$	38,290	$	3,728,094	$	3,800,203

There were no material commitments to extend further credit to borrowers with nonperforming loans. Within nonaccrual loans, there are approximately $2.3 million and $4.0 million of troubled debt restructured loans at September 30, 2012 and December 31, 2011, respectively. This decrease was due primarily to the migration of certain commercial loans to accruing status during the first nine months of 2012.

Impaired loans, which primarily consist of nonaccruing commercial, commercial real estate, agricultural, agricultural real estate and business banking loans were $25.9 million at September 30, 2012 and $22.4 million at December 31, 2011.

The methodology used to establish the allowance for loan losses on impaired loans incorporates specific allocations on loans analyzed individually. Classified loans with outstanding balances of $500 thousand or more are evaluated for impairment through the Company's quarterly status review process. In determining that we will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreements, we consider factors such as payment history and changes in the financial condition of individual borrowers, local economic conditions, historical loss experience and the conditions of the various markets in which the collateral may be liquidated. For loans that are impaired as defined by accounting standards, impairment is measured by one of three methods: 1) the fair value of collateral less cost to sell, 2) present value of expected future cash flows or 3) the loan's observable market price. All impaired loans are reviewed on a quarterly basis for changes in the measurement of impairment. Any change to the previously recognized impairment loss is recognized as a change to the allowance account and recorded in the consolidated statement of income as a component of the provision for credit losses. At September 30, 2012, $6.1 million of the total impaired loans had a specific reserve allocation of $2.7 million compared to $.5 million of impaired loans at December 31, 2011 which had a specific reserve allocation of $0.2 million.

The following table provides additional information on impaired loans and specific reserve allocations as of September 30, 2012 and December 31, 2011:

	September 30, 2012						December 31, 2011
	Recorded		Unpaid				Recorded		Unpaid
	Investment		Principal				Investment		Principal
	Balance		Balance		Related		Balance		Balance		Related
(in thousands)	(Book)		(Legal)		Allowance		(Book)		(Legal)		Allowance
With no related allowance recorded:
Commercial Loans
Commercial	$	851	$	1,257			$	1,243	$	2,723
Commercial Real Estate		6,432		8,396				4,868		7,165
Agricultural		2,587		3,567				3,307		4,166
Agricultural Real Estate		1,195		1,382				2,067		2,288
Business Banking		5,921		8,078				7,446		9,976
Total Commercial Loans		16,986		22,680				18,931		26,318

Consumer Loans
Home Equity		1,777		1,879				2,000		2,103

Residential Real Estate Mortgages		1,105		1,275				1,040		1,125
	$	19,868	$	25,834			$	21,971	$	29,546

With an allowance recorded:
Commercial Loans
Commercial	$	6,064	$	6,113	$	2,720	$	456	$	808	$	175
Commercial Real Estate		-		-		-		-		-		-
Agricultural		-		-		-		-		-		-
Agricultural Real Estate		-		-		-		-		-		-
		6,064		6,113		2,720		456		808		175

Total:	$	25,932	$	31,947	$	2,720	$	22,427	$	30,354	$	175

The increase in commercial loans with a related allowance recorded from December 31, 2011 to September 30, 2012 is primarily due to the impairment of two commercial relationships during the nine months ended September 30, 2012.

The following table summarizes the average recorded investments on impaired loans and the interest income recognized for the three months ended September 30, 2012 and September 30, 2011:

	For the three months ended
	September 30, 2012						September 30, 2011
	Average		Interest Income				Average		Interest Income
	Recorded		Recognized				Recorded		Recognized
(in thousands)	Investment		Accrual		Cash		Investment		Accrual		Cash
With no related allowance recorded:
Commercial Loans
Commercial	$	854	$	9	$	9	$	1,794	$	3	$	3
Commercial Real Estate		6,732		16		16		6,106		14		14
Agricultural		2,627		51		51		3,516		59		59
Agricultural Real Estate		1,348		3		3		1,874		34		34
Business Banking		6,169		70		70		7,655		101		101
Consumer Loans
Home Equity		1,783		18		18		2,312		26		26
Residential Real Estate Mortgages		1,111		17		17		1,059		26		26
	$	20,624	$	184	$	184	$	24,316	$	263	$	263

With an allowance recorded:
Commercial Loans
Commercial	$	6,091	$	34	$	34	$	520	$	19	$	19
Commercial Real Estate		-		-		-		-		-		-
Agricultural		-		-		-		23		1		1
Agricultural Real Estate		-		-		-		-		-		-
	$	6,091	$	34	$	34	$	543	$	20	$	20

Total:	$	26,715	$	218	$	218	$	24,859	$	283	$	283

The following table summarizes the average recorded investments on impaired loans and the interest income recognized for the nine months ended September 30, 2012 and September 30, 2011:

	For the nine months ended
	September 30, 2012						September 30, 2011
	Average		Interest Income				Average		Interest Income
	Recorded		Recognized				Recorded		Recognized
(in thousands)	Investment		Accrual		Cash		Investment		Accrual		Cash
With no related allowance recorded:
Commercial Loans
Commercial	$	1,319	$	23	$	23	$	2,625	$	76	$	76
Commercial Real Estate		6,564		48		48		4,728		59		59
Agricultural		2,873		159		159		2,903		104		104
Agricultural Real Estate		1,734		13		13		1,622		72		72
Business Banking		6,824		166		166		5,662		203		203
Consumer Loans
Home Equity		1,840		66		66		1,851		84		84
Residential Real Estate Mortgages		1,066		73		73		887		53		53
	$	22,220	$	548	$	548	$	20,278	$	651	$	651

With an allowance recorded:
Commercial Loans
Commercial	$	4,178	$	43	$	43	$	991	$	68	$	68
Commercial Real Estate		-		-		-		382		-		-
Agricultural		-		-		-		1,055		68		68
Agricultural Real Estate		-		-		-		475		18		18
	$	4,178	$	43	$	43	$	2,903	$	154	$	154

Total:	$	26,397	$	591	$	591	$	23,181	$	805	$	805

There has been significant disruption and volatility in the financial and capital markets since the second half of 2008. Turmoil in the mortgage industry adversely impacted both domestic and global economies and led to a significant credit and liquidity crisis in many domestic markets. These conditions were attributable to a variety of factors, in particular the fallout associated with subprime mortgage loans (a type of lending we have never actively pursued). The disruption was exacerbated by the decline of the real estate and housing market. However, in the markets in which the Company does business, the disruption has been somewhat delayed and less significant than in the national market. For example, our real estate market has not suffered the extreme declines seen nationally and our unemployment rate, while notably higher than in prior periods, is still below the national average.

While we continue to adhere to prudent underwriting standards, as a lender we may be adversely impacted by general economic weaknesses and, in particular, a sharp downturn in the housing market nationally. Decreases in real estate values could adversely affect the value of property used as collateral for our loans. Adverse changes in the economy may have a negative effect on the ability of our borrowers to make timely loan payments, which would have an adverse impact on our earnings. An adverse impact on loan delinquencies would decrease our net interest income and adversely impact our loan loss experience, causing increases in our provision and allowance for loan losses.

The Company has developed an internal loan grading system to evaluate and quantify the Bank's loan portfolio with respect to quality and risk. The system focuses on, among other things, financial strength of borrowers, experience and depth of borrower's management, primary and secondary sources of repayment, payment history, nature of the business, and outlook on particular industries. The internal grading system enables the Company to monitor the quality of the entire loan portfolio on a consistent basis and provide management with an early warning system, enabling recognition and response to problem loans and potential problem loans.

Commercial Grading System

For commercial and agricultural loans, the Company uses a grading system that relies on quantifiable and measurable characteristics when available. This would include comparison of financial strength to available industry averages, comparison of transaction factors (loan terms and conditions) to loan policy, and comparison of credit history to stated repayment terms and industry averages. Some grading factors are necessarily more subjective such as economic and industry factors, regulatory environment, and management. Classified commercial loans consist of loans graded substandard and below. All classified loans with outstanding balances of $500 thousand or more are evaluated individually for impairment through the quarterly review process. The grading system for commercial and agricultural loans is as follows:

Doubtful

A doubtful loan has a high probability of total or substantial loss, but because of specific pending events that may strengthen the asset, its classification as a loss is deferred. Doubtful borrowers are usually in default, lack adequate liquidity or capital, and lack the resources necessary to remain an operating entity. Pending events can include mergers, acquisitions, liquidations, capital injections, the perfection of liens on additional collateral, the valuation of collateral, and refinancing. Generally, pending events should be resolved within a relatively short period and the ratings will be adjusted based on the new information. Nonaccrual treatment is required for doubtful assets because of the high probability of loss.

Substandard

Substandard loans have a high probability of payment default, or they have other well-defined weaknesses. They require more intensive supervision by bank management. Substandard loans are generally characterized by current or expected unprofitable operations, inadequate debt service coverage, inadequate liquidity, or marginal capitalization. Repayment may depend on collateral or other credit risk mitigants. For some Substandard loans, the likelihood of full collection of interest and principal may be in doubt and should be placed on nonaccrual. Although Substandard assets in the aggregate will have a distinct potential for loss, an individual asset's loss potential does not have to be distinct for the asset to be rated Substandard.

Special Mention

Special Mention loans have potential weaknesses that may, if not checked or corrected, weaken the asset or inadequately protect the Company's position at some future date. These loans pose elevated risk, but their weakness does not yet justify a Substandard classification. Borrowers may be experiencing adverse operating trends (declining revenues or margins) or may be struggling with an ill-proportioned balance sheet (e.g., increasing inventory without an increase in sales, high leverage, tight liquidity). Adverse economic or market conditions, such as interest rate increases or the entry of a new competitor, may also support a Special Mention rating. Although a Special Mention loan has a higher probability of default than a pass asset, its default is not imminent.

Pass

Loans graded as Pass encompass all loans not graded as Doubtful, Substandard, or Special Mention. Pass loans are in compliance with loan covenants, and payments are generally made as agreed. Pass loans range from superior quality to fair quality.

Business banking Grading System

Business banking loans are graded as either Classified or Non-classified:

Classified

Classified loans are inadequately protected by the current worth and paying capacity of the obligor or, if applicable, the collateral pledged. These loans have a well-defined weakness, or weaknesses, that jeopardize the liquidation of the debt, or in some cases make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Classified loans have a high probability of payment default, or a high probability of total or substantial loss. These loans require more intensive supervision by management and are generally characterized by current or expected unprofitable operations, inadequate debt service coverage, inadequate liquidity, or marginal capitalization. Repayment may depend on collateral or other credit risk mitigants. When the likelihood of full collection of interest and principal may be in doubt; classified loans are considered to have a nonaccrual status. In some cases, Classified loans are considered uncollectible and of such little value that their continuance as assets is not warranted.

Non-classified

Loans graded as Non-classified encompass all loans not graded as Classified. Non-classified loans are in compliance with loan covenants, and payments are generally made as agreed.

Consumer and Residential Mortgage Grading System

Consumer and Residential Mortgage loans are graded as either Performing or Nonperforming. Nonperforming loans are loans that are 1) over 90 days past due and interest is still accruing, 2) on nonaccrual status or 3) restructured. All loans not meeting any of these three criteria are considered Performing.

The following tables illustrate the Company's credit quality by loan class as of September 30, 2012 and December 31, 2011:

Credit Quality Indicators

As of September 30, 2012


Commercial Credit Exposure By Internally Assigned Grade:	Commercial		Commercial Real Estate		Agricultural		Agricultural Real Estate		Total
Pass	$	565,546	$	948,966	$	59,545	$	32,213	$	1,606,270
Special Mention		11,371		23,967		13		3		35,354
Substandard		22,656		47,787		7,168		4,327		81,938
Doubtful		2,973		-		48		-		3,021
Total	$	602,546	$	1,020,720	$	66,774	$	36,543	$	1,726,583

Business Banking Credit Exposure
By Internally Assigned Grade:	Business Banking								Total
Non-classified	$	251,284							$	251,284
Classified		15,024								15,024
Total	$	266,308							$	266,308

Consumer Credit Exposure By Payment Activity:	Indirect		Home Equity		Direct		Total
Performing	$	959,938	$	567,509	$	68,649	$	1,596,096
Nonperforming		2,681		8,699		304		11,684
Total	$	962,619	$	576,208	$	68,953	$	1,607,780

Residential Mortgage Credit Exposure	Residential
By Payment Activity:	Mortgage		Total
Performing	$	639,638	$	639,638
Nonperforming		10,810		10,810
Total	$	650,448	$	650,448

Credit Quality Indicators

As of December 31, 2011

Commercial Credit Exposure			Commercial				Agricultural
By Internally Assigned Grade:	Commercial		Real Estate		Agricultural		Real Estate		Total
Pass	$	470,332	$	758,673	$	58,481	$	28,927	$	1,316,413
Special Mention		10,346		24,478		42		10		34,876
Substandard		29,940		51,748		7,945		4,989		94,622
Doubtful		456		-		69		-		525
Total	$	511,074	$	834,899	$	66,537	$	33,926	$	1,446,436

Business Banking Credit Exposure	Business
By Internally Assigned Grade:	Banking		Total
Non-classified	$	237,887	$	237,887
Classified		18,254		18,254
Total	$	256,141	$	256,141

Consumer Credit Exposure
By Payment Activity:	Indirect		Home Equity		Direct		Total
Performing	$	870,270	$	560,760	$	72,849	$	1,503,879
Nonperforming		2,833		8,885		518		12,236
Total	$	873,103	$	569,645	$	73,367	$	1,516,115

Residential Mortgage Credit Exposure	Residential
By Payment Activity:	Mortgage		Total
Performing	$	571,704	$	571,704
Nonperforming		9,807		9,807
Total	$	581,511	$	581,511

Modifications

The Company's loan portfolio includes certain loans that have been modified in a TDR, where economic concessions have been granted to borrowers who have experienced or are expected to experience financial difficulties. These concessions typically result from the Company's loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Certain TDRs are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower's sustained repayment performance for a reasonable period, generally six months.

When the Company modifies a loan, management evaluates any possible impairment based on the present value of the expected future cash flows, discounted at the contractual interest rate of the original loan agreement, except when the sole (remaining) source of repayment for the loan is the operation or liquidation of the collateral. In these cases, management uses the current fair value of the collateral, less selling costs, instead of discounted cash flows. If management determines that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized by segment or class of loan as applicable, through an allowance estimate or a charge-off to the allowance. Segment and class status is determined by the loan's classification at origination.

There were no new modifications made during the three month period ending September 30, 2012. During the three month period ending September 30, 2012 there were no defaults on loans modified within the previous 12 months.

Modifications made during the three month period ending September 30, 2011 consisted of three commercial loans totaling $0.8 million. For all such modifications, the pre and post outstanding recorded investment amount remained unchanged. During the three month period ending September 30, 2011 there were no defaults on previously modified loans.

Modifications made during the nine month period ending September 30, 2012 consisted of one commercial loan totaling $1.0 million and one residential real estate mortgage totaling $0.2 million. For all such modifications, the pre and post outstanding recorded investment amount remained unchanged. During the nine month period ending September 30, 2012 there were no defaults on loans modified within the previous 12 months.

Modifications during the nine month period ending September 30, 2011 consisted of twenty-five home equity modifications totaling $2.3 million and four residential real estate mortgages totaling $0.8 million, in addition to the three aforementioned commercial loan modifications. For all such modifications, the pre and post outstanding recorded investment amount remained unchanged. During the nine months ended September 30, 2011, there were six home equity loans classified as TDRs totaling $0.6 million and two residential real estate loans classified as TDRs totaling $0.4 million that defaulted on their renegotiated terms.