Quarterly Report (10-q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



þ	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2013 .



o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to __________.

Commission file number: 000-24611

CFS Bancorp, Inc.

(Exact name of registrant as specified in its charter)



Indiana	35-2042093
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

707 Ridge Road, Munster, Indiana	46321
(Address of principal executive offices)	(Zip code)

(219) 836-2960
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES þ NO o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

YES þ NO o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):



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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO þ

The Registrant had 10,897,670 shares of Common Stock issued and outstanding as of April 30, 2013.

CFS BANCORP, INC.

Form 10-Q

TABLE OF CONTENTS



		Page
	PART I - FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)
	Condensed Consolidated Statements of Condition	3
	Condensed Consolidated Statements of Income	4
	Condensed Consolidated Statements of Comprehensive Income	5
	Condensed Consolidated Statements of Changes in Shareholders’ Equity	6
	Condensed Consolidated Statements of Cash Flows	7
	Notes to Condensed Consolidated Financial Statements	9

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	36

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	64

Item 4.	Controls and Procedures	66

	PART II - OTHER INFORMATION

Item 1.	Legal Proceedings	66

Item 1A.	Risk Factors	66

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	66

Item 3.	Defaults Upon Senior Securities	67

Item 4.	Mine Safety Disclosures	67

Item 5.	Other Information	67

Item 6.	Exhibits	67

Signature Page		68

Certifications of Principal Executive Officer and Principal Financial Officer
	Exhibit 31.1
	Exhibit 31.2
	Exhibit 32.0

CFS BANCORP, INC.

Condensed Consolidated Statements of Condition



	March 31, 2013			December 31, 2012
	(Unaudited)
	(Dollars in thousands)
ASSETS
Cash and amounts due from depository institutions	$	20,474		$	20,577
Interest-earning deposits with banks	133,766			114,122
Cash and cash equivalents	154,240			134,699
Investment securities available-for-sale, at fair value	220,196			203,290
Investment securities held-to-maturity, at cost	14,981			15,458
Loans receivable, net of deferred fees	664,308			692,267
Allowance for loan losses	(12,024		)	(12,185		)
Net loans	652,284			680,082
Loans held for sale	955			1,509
Federal Home Loan Bank stock, at cost	6,188			6,188
Bank-owned life insurance	36,233			36,604
Accrued interest receivable	2,669			2,528
Other real estate owned	23,698			23,347
Office properties and equipment	15,519			15,768
Net deferred tax assets	11,032			11,302
Other assets	8,373			7,334
Total assets	$	1,146,368		$	1,138,109

LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits	$	974,328		$	965,791
Borrowed funds	49,828			50,562
Advance payments by borrowers for taxes and insurance	4,542			4,734
Other liabilities	4,893			5,200
Total liabilities	1,033,591			1,026,287

Commitments and contingencies

Shareholders’ equity:
Preferred stock, $.01 par value; 15,000,000 shares authorized	—			—
Common stock, $.01 par value; 85,000,000 shares authorized; 23,423,306 shares issued; 10,898,168 and 10,874,687 shares outstanding	234			234
Additional paid-in capital	186,975			187,260
Retained earnings	78,310			76,914
Treasury stock, at cost; 12,525,138 and 12,548,619 shares	(154,411		)	(154,698		)
Accumulated other comprehensive income, net of tax	1,669			2,112
Total shareholders’ equity	112,777			111,822
Total liabilities and shareholders’ equity	$	1,146,368		$	1,138,109

See accompanying notes to the unaudited condensed consolidated financial statements.

CFS BANCORP, INC.

Condensed Consolidated Statements of Income



	Three Months Ended March 31,
	2013		2012
	(Unaudited)
	(Dollars in thousands, except share and per share data)
Interest income:
Loans receivable	$	7,700	$	8,386
Investment securities	1,593		2,130
Other interest-earning assets	124		93
Total interest income	9,417		10,609
Interest expense:
Deposits	931		1,390
Borrowed funds	285		296
Total interest expense	1,216		1,686
Net interest income	8,201		8,923
Provision for loan losses	510		1,050
Net interest income after provision for loan losses	7,691		7,873
Non-interest income:
Deposit related fees	1,520		1,469
Net gain (loss) on sale of:
Investment securities (includes $184 and $418 for the three months ended March 31, 2013 and 2012, respectively, related to accumulated other comprehensive earnings reclassifications)	184		418
Loans held for sale	463		159
Other real estate owned	10		(47		)
Income from bank-owned life insurance	330		540
Other income	347		285
Total non-interest income	2,854		2,824
Non-interest expense:
Compensation and employee benefits	4,370		4,713
Net occupancy expense	694		708
Data processing	513		438
FDIC insurance premiums and regulatory assessments	481		488
Furniture and equipment expense	403		457
Professional fees	328		253
Marketing	269		404
Other real estate owned related expense, net	250		618
Loan collection expense	133		118
Severance and early retirement expense	—		876
Other general and administrative expenses	1,014		1,134
Total non-interest expense	8,455		10,207
Income before income tax expense	2,090		490
Income tax expense	588		—
Net income	$	1,502	$	490

Per share data:
Basic earnings per share	.14		.05
Diluted earnings per share	.14		.05
Cash dividends declared per share	.01		.01
Weighted-average common and common share equivalents outstanding:
Basic	10,739,160		10,697,892
Diluted	10,810,800		10,746,398

See accompanying notes to the unaudited condensed consolidated financial statements.

CFS BANCORP, INC.

Condensed Consolidated Statements of Comprehensive Income



	Three Months Ended March 31,
	2013			2012
	(Unaudited)
	(Dollars in thousands)
Net income	$	1,502		$	490
Other comprehensive loss:
Unrealized holding losses arising during the period related to investment securities available-for-sale:
Unrealized net losses	(569		)	(318		)
Related income tax benefit	239			286
Net unrealized losses	(330		)	(32		)
Less: reclassification adjustment for net gains realized during the period on investment securities available-for-sale:
Realized net gains	184			418
Related income tax expense	(71		)	(151		)
Net realized gains	113			267
Other comprehensive loss	(443		)	(299		)
Comprehensive income	$	1,059		$	191

See accompanying notes to the unaudited condensed consolidated financial statements.

CFS BANCORP, INC.

Condensed Consolidated Statements of Changes in Shareholders’ Equity



	Common Stock		Additional Paid-In Capital			Retained Earnings			Treasury Stock				Accumulated Other Comprehensive Income (Loss)				Total
	(Unaudited) (Dollars in thousands)
Balance at January 1, 2012	$	234	$	187,030		$	72,683		$	(154,773	)		$	(1,926	)		$	103,248
Net income	—		—			490			—				—				490
Other comprehensive loss	—		—			—			—				(299		)		(299		)
Amortization of stock based compensation	—		3			—			—				—				3
Forfeiture of restricted stock awards	—		552			2			(552		)		—				2
Grants of restricted stock awards	—		(590		)	—			590				—				—
Dividends declared on common stock ($.01 per share)	—		—			(109		)	—				—				(109		)
Balance at March 31, 2012	$	234	$	186,995		$	73,066		$	(154,735	)		$	(2,225	)		$	103,335

Balance at January 1, 2013	$	234	$	187,260		$	76,914		$	(154,698	)		$	2,112			$	111,822
Net income	—		—			1,502			—				—				1,502
Other comprehensive loss	—		—			—			—			(443		)		(443		)
Amortization of stock based compensation	—		2			—			—				—				2
Forfeiture of restricted stock awards	—		538			3			(538		)		—				3
Grants of restricted stock awards	—		(825		)	—			825				—				—
Dividends declared on common stock ($.01 per share)	—		—			(109		)	—				—				(109		)
Balance at March 31, 2013	$	234	$	186,975		$	78,310		$	(154,411	)		$	1,669			$	112,777

See accompanying notes to the unaudited condensed consolidated financial statements.

CFS BANCORP, INC.

Condensed Consolidated Statements of Cash Flows



	Three Months Ended March 31,
	2013			2012
	(Unaudited)
	(Dollars in thousands)
OPERATING ACTIVITIES:
Net income	$	1,502		$	490
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses	510			1,050
Depreciation and amortization	323			396
Net discount accretion on investment securities available-for-sale	(307		)	(303		)
Net premium amortization on investment securities held-to-maturity	26			33
Net (gain) loss on sale of:
Investment securities	(184		)	(418		)
Loans held for sale	(463		)	(159		)
Other real estate owned	(10		)	47
Properties and equipment	(3		)	(8		)
Writedowns on other real estate owned	108			485
Deferred income tax expense	599			2
Amortization of cost of stock benefit plans	2			3
Proceeds from sale of loans held for sale	12,151			9,445
Origination of loans held for sale	(11,177		)	(9,285		)
Increase in cash surrender value of bank-owned life insurance	(330		)	(540		)
Net change in other assets and liabilities	(1,319		)	(3,451		)
Net cash flows provided by (used for) operating activities	1,428			(2,213		)
INVESTING ACTIVITIES:
Proceeds from sale of:
Investment securities, available-for-sale	1,094			13,458
Other real estate owned	1,773			674
Properties and equipment	3			26
Proceeds from maturities and paydowns of:
Investment securities, available-for-sale	9,890			11,053
Investment securities, held-to-maturity	451			427
Purchases of:
Investment securities, available-for-sale	(28,153		)	(29,394		)
Properties and equipment	(74		)	(300		)
Net change in loans receivable	24,981			1,901
Proceeds from bank-owned life insurance	701			542
Net cash flows provided by (used for) investing activities	10,666			(1,613		)
FINANCING ACTIVITIES:
Net increase (decrease) in:
Deposit accounts	8,482			27,000
Advance payments by borrowers for taxes and insurance	(192		)	275
Short-term borrowed funds	(676		)	(2,211		)
Repayments of Federal Home Loan Bank advances	(58		)	(54		)
Dividends paid on common stock	(109		)	(109		)
Net cash flows provided by financing activities	7,447			24,901
Increase in cash and cash equivalents	19,541			21,075
Cash and cash equivalents at beginning of period	134,699			92,072
Cash and cash equivalents at end of period	$	154,240		$	113,147

CFS BANCORP, INC.

Condensed Consolidated Statements of Cash Flows (continued)



	Three Months Ended March 31,
	2013		2012
	(Unaudited)
	(Dollars in thousands)
Supplemental disclosures:
Loans and land transferred to other real estate owned	$	2,222	$	1,544
Cash paid for interest on deposits	911		1,395
Cash paid for interest on borrowed funds	285		297
Cash paid for income taxes	—		—

See accompanying notes to the unaudited condensed consolidated financial statements.

CFS BANCORP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)


1.	Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information or footnotes necessary for a complete presentation of financial condition, results of operations, or cash flows in accordance with U.S. generally accepted accounting principles. In our opinion, all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation have been included. The results of operations for the three months ended March 31, 2013 are not necessarily indicative of the results expected for the year ending December 31, 2013 . The March 31, 2013 condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes for the year ended December 31, 2012 included in the Company’s Annual Report on Form 10-K. The Company’s condensed consolidated statement of condition as of December 31, 2012 has been derived from the Company’s audited consolidated statement of condition as of that date.

The preparation of the condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates, judgments, or assumptions that could have a material effect on the carrying value of certain assets and liabilities. These estimates, judgments, and assumptions affect the amounts reported in the condensed consolidated financial statements and the disclosures provided. The determination of the allowance for loan losses, valuations and impairments of investment securities, and the accounting for income tax expense are highly dependent on management’s estimates, judgments, and assumptions where changes in any of these could have a significant impact on the financial statements.

The condensed consolidated financial statements include the accounts of CFS Bancorp, Inc. (the Company ), its wholly-owned subsidiary, Citizens Financial Bank (the Bank ), and its wholly-owned subsidiary, WHCC, LLC. All material intercompany balances and transactions have been eliminated in consolidation.

Certain items in the condensed consolidated financial statements of prior periods have been reclassified to conform to the current period’s presentation.


2.	Earnings Per Share

Basic earnings per common share ( EPS ) is computed by dividing net income by the weighted-average number of common shares outstanding during the year. Restricted stock shares which have not vested and shares held in Rabbi Trust accounts are not considered to be outstanding for purposes of calculating basic EPS. Diluted EPS is computed by dividing net income by the average number of common shares outstanding during the year and includes the dilutive effect of stock options, unearned restricted stock awards, and treasury shares held in Rabbi Trust accounts pursuant to deferred compensation plans. The dilutive common stock equivalents are computed based on the treasury stock method using the average market price for the period.

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



	Three Months Ended March 31,
	2013		2012
	(Dollars in thousands, except share and per share data)
Net income	$	1,502	$	490
Weighted-average common shares:
Outstanding	10,739,160		10,697,892
Equivalents (1)	71,640		48,506
Total	10,810,800		10,746,398
Earnings per share:
Basic	$	.14	$	.05
Diluted	.14		.05
Number of anti-dilutive stock options excluded from the diluted earnings per share calculation	387,795		451,995
Weighted-average exercise price of anti-dilutive option shares	$	14.07	$	14.06


(1)	Assumes exercise of dilutive stock options, a portion of the unearned restricted stock awards, and treasury shares held in Rabbi Trust accounts.


3.	Investment Securities

The amortized cost of investment securities and their fair values are as follows for the periods indicated:



	March 31, 2013
	Par Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
Available-for-sale investment securities:
U.S. Treasury securities	$	32,000	$	32,408	$	414	$	(4	)	$	32,818
Government sponsored entity ( GSE ) securities	45,000		45,592		726		(1		)	46,317
Collateralized mortgage obligations	69,345		65,437		3,439		(20		)	68,856
Commercial mortgage-backed securities	45,417		46,237		1,042		(1		)	47,278
GSE residential mortgage-backed securities	2,213		2,385		—		(69		)	2,316
Asset backed securities	3,995		3,721		254		—			3,975
Pooled trust preferred securities	23,673		21,701		—		(3,065		)	18,636
Total available-for-sale investment securities	$	221,643	$	217,481	$	5,875	$	(3,160	)	$	220,196

Held-to-maturity investment securities:
Asset backed securities	$	5,995	$	6,101	$	187	$	—		$	6,288
Municipal securities	8,880		8,880		54		—			8,934
Total held-to-maturity investment securities	$	14,875	$	14,981	$	241	$	—		$	15,222



	December 31, 2012
	Par Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
Available-for-sale investment securities:
U.S. Treasury securities	$	17,000	$	16,964	$	405	$	(6	)	$	17,363
Government sponsored entity ( GSE ) securities	45,000		45,628		848		(8		)	46,468
Collateralized mortgage obligations	67,902		63,367		3,735		(36		)	67,066
Commercial mortgage-backed securities	44,267		45,178		1,251		—			46,429
GSE residential mortgage-backed securities	2,224		2,400		—		(32		)	2,368
Asset backed securities	4,182		3,876		177		—			4,053
Pooled trust preferred securities	24,508		22,409		—		(2,867		)	19,542
GSE preferred stock	200		—		1		—			1
Total available-for-sale investment securities	$	205,283	$	199,822	$	6,417	$	(2,949	)	$	203,290

Held-to-maturity investment securities:
Asset backed securities	$	6,446	$	6,578	$	219	$	—		$	6,797
Municipal securities	8,880		8,880		45		—			8,925
Total held-to-maturity investment securities	$	15,326	$	15,458	$	264	$	—		$	15,722

The Company’s investments in collateralized mortgage obligations consisted of $11.5 million and $4.0 million , respectively, of GSE issued investment securities and $57.4 million and $63.1 million , respectively, of non-agency (private issued) residential investment securities at March 31, 2013 and December 31, 2012 .

Investment securities with unrealized losses aggregated by investment category and length of time that individual investment securities have been in a continuous unrealized loss position are presented in the following tables for the dates indicated:



	March 31, 2013
	Less than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(Dollars in thousands)
U.S. Treasury securities	$	4,987	$	(4	)	$	—	$	—		$	4,987	$	(4	)
GSE securities	2,014		(1		)	—		—			2,014		(1		)
Collateralized mortgage obligations	7,842		(13		)	1,188		(7		)	9,030		(20		)
Commercial mortgage-backed securities	1,329		(1		)	—		—			1,329		(1		)
GSE residential mortgage-backed securities	2,316		(69		)	—		—			2,316		(69		)
Pooled trust preferred securities	—		—			18,636		(3,065		)	18,636		(3,065		)
	$	18,488	$	(88	)	$	19,824	$	(3,072	)	$	38,312	$	(3,160	)



	December 31, 2012
	Less than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(Dollars in thousands)
U.S. Treasury securities	$	4,984	$	(6	)	$	—	$	—		$	4,984	$	(6	)
GSE securities	2,468		(8		)	—		—			2,468		(8		)
Collateralized mortgage obligations	6,705		(36		)	—		—			6,705		(36		)
GSE residential mortgage-backed securities	2,368		(32		)	—		—			2,368		(32		)
Pooled trust preferred securities	—		—			19,542		(2,867		)	19,542		(2,867		)
	$	16,525	$	(82	)	$	19,542	$	(2,867	)	$	36,067	$	(2,949	)

Management evaluates all investment securities on a quarterly basis, and more frequently when economic conditions warrant additional evaluations, for determining if an other-than-temporary impairment ( OTTI ) exists pursuant to guidelines established in the Financial Accounting Standards Board Accounting Standards Codification ( ASC ) 320-10, Investments - Debt and Equity Securities. Current accounting guidance generally provides that if a marketable security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the investment securities must assess whether the impairment is other-than-temporary.

In management’s belief, the decline in value of the Company’s investment in collateralized mortgage obligations is minimal and primarily attributable to changes in market interest rates and macroeconomic conditions affecting liquidity and not necessarily the expected cash flows of the individual investment securities. The fair value of these investment securities is expected to recover as macroeconomic conditions improve, interest rates rise, and the investment securities approach their maturity date.

At March 31, 2013 , the Company’s pooled trust preferred investment securities consisted of “Super Senior” securities backed by senior securities issued mainly by bank and thrift holding companies. Due to the structure of the securities, as deferrals and defaults on the underlying collateral increase, cash flows are increasingly diverted from mezzanine and subordinate tranches to pay down principal for the “Super Senior” tranches. In management’s belief, the continued decline in value is primarily attributable to macroeconomic conditions affecting the liquidity of these securities and not necessarily the expected cash flows of the individual securities. The fair value of these securities is expected to recover as the securities approach their maturity date.

Unrealized losses on collateralized mortgage obligations and pooled trust preferred investment securities have not been recognized in income because management does not have the intent to sell these securities and has the ability to hold these securities for a period of time sufficient to allow for any anticipated recovery in fair value, which may be at maturity. We may, from time to time, dispose of an impaired security in response to asset/liability management decisions, regulatory considerations, market movements, business plan changes, or if the net proceeds could be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time. The Company concluded that the unrealized losses that existed at March 31, 2013 did not constitute other-than-temporary impairments.

The amortized cost and fair value of investment securities at March 31, 2013 , by contractual maturity, are shown in the following tables. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Investment securities not due at a single maturity date are shown separately.



	Available-for-Sale
	Amortized Cost		Fair Value
	(Dollars in thousands)
U.S. Treasury securities:
Due after one year through five years	$	32,408	$	32,818
GSE securities:
Due in one year or less	18,535		18,745
Due after one year through five years	20,589		21,089
Due after five years through ten years	6,468		6,483
Collateralized mortgage obligations:
Due after five years through ten years	4,871		5,096
Due after ten years	60,566		63,760
Commercial mortgage-backed securities:
Due after ten years	46,237		47,278
GSE residential mortgage-backed securities:
Due after ten years	2,385		2,316
Asset backed securities:
Due after ten years	3,721		3,975
Pooled trust preferred securities:
Due after ten years	21,701		18,636
	$	217,481	$	220,196



	Held-to-Maturity
	Amortized Cost		Fair Value
	(Dollars in thousands)
Asset backed securities:
Due after one year through five years	$	6,101	$	6,288
Municipal securities:
Due in one year or less	3,000		3,007
Due after one year through five years	5,880		5,927
	$	14,981	$	15,222

The Company realized gains on the sale of available-for-sale investment securities totaling $184,000 and $418,000 , respectively, for the three months ended March 31, 2013 and 2012 .

The carrying value of investment securities pledged as collateral to secure public deposits, repurchase sweep agreement ( Repo Sweep) accounts, and other purposes was $27.0 million and $29.1 million , respectively, at March 31, 2013 and December 31, 2012 .

At March 31, 2013 , other than the U.S. Government, its agencies, and GSEs, the Company had holdings of investment securities from two separate issuers in an amount greater than 10% of shareholders’ equity as identified in the following table:



	Book Value		Market Value		# of Underlying Pools
	(Dollars in thousands)
Issuer:
IMPAC CMB Trust	$	10,031	$	11,377	3
JP Morgan Chase Commercial Mortgage Securities Corp	17,919		18,414		4

There are three different pools of collateral backing three collateralized mortgage obligation securities issued by IMPAC CMB Trust. These pools consist primarily of floating-rate, first lien mortgages originated prior to 2005 on single-family properties in multiple states. There are four different collateral pools of geographically diversified commercial real estate loans backing four commercial mortgage-backed securities issued by JP Morgan Chase Commercial Mortgage Securities Corp. Three of the four collateral pools consist of commercial real estate loans originated prior to 2006 and one collateral pool consists of loans originated in 2010.

4. Loans Receivable

Loans receivable are summarized as follows:



	March 31, 2013			December 31, 2012
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	91,649		$	102,628
Commercial real estate:
Owner occupied	99,030			98,046
Non-owner occupied	159,414			164,392
Multifamily	71,630			75,228
Commercial construction and land development	15,335			20,228
Commercial participations	5,137			5,311
Total commercial loans	442,195			465,833
Retail loans:
One-to-four family residential	172,540			175,943
Home equity lines of credit	45,616			46,477
Retail construction	1,370			1,176
Consumer	3,025			3,305
Total retail loans	222,551			226,901
Total loans receivable	664,746			692,734
Net deferred loan fees	(438		)	(467		)
Total loans receivable, net of deferred loan fees	$	664,308		$	692,267

5. Allowance for Loan Losses

The Company maintains an allowance for loan losses at a level management believes is appropriate in relation to the estimated risk inherent in the loan portfolio. The allowance for loan losses represents the Company’s estimate of probable incurred losses in our loan portfolio at each statement of condition date and is based on the review of available and relevant information.

The first component of the allowance for loan losses contains allocations for probable incurred losses that we have identified relating to impaired loans pursuant to ASC 310-10, Receivables. The Company individually evaluates for impairment all loans classified substandard and over $375,000 to enable management to identify potential losses over a larger cross section of the loan portfolio. We also individually evaluate for impairment all loans for which we have initiated foreclosure proceedings. For all portfolio segments, loans are considered impaired when, based on current information and events, it is probable that the borrower will not be able to fulfill its obligation according to the contractual terms of the loan agreement. The impairment loss, if any, is generally measured based on the present value of expected cash flows discounted at the loan’s effective interest rate. As a practical expedient, impairment may be measured based on the loan’s observable market price, or the fair value of the collateral, if the loan is collateral-dependent. A loan is considered collateral-dependent when the repayment of the loan will be provided solely by the underlying collateral and there are no other available and reliable sources of repayment. If management determines a loan is collateral-dependent, management will charge-off any identified collateral shortfall against the allowance for loan losses.

If foreclosure is probable, the Company is required to measure the impairment based on the fair value of the collateral. The fair value of the collateral is generally obtained from the evaluation of the collateral, and one of the methods of evaluation is an independent third-party appraisal. When current appraisals are not available, management utilizes other evaluation methods to estimate the fair value of the collateral giving consideration to several factors including for real estate properties the price at which individual unit(s) could be sold in the current market, the period of time over which the unit(s) could be sold, the estimated cost to complete the unit(s), the risks associated with completing and selling the unit(s), the required return on the investment a potential acquirer may have, and the current market interest rates. The analysis of each loan involves a high degree of judgment in estimating the amount of the loss associated with the loan, including the estimation of the amount and timing of future cash flows and collateral values.

The second component of the Company’s allowance for loan losses contains allocations for probable incurred losses within various pools of loans with similar characteristics pursuant to ASC 450-20, Contingencies: Loss Contingencies. This component is based in part on certain loss factors applied to various stratified loan pools excluding loans evaluated individually for impairment. In determining the appropriate loss factors for all portfolio segments, management considers historical charge-offs and recoveries; levels of and trends in delinquencies, impaired loans, and other classified loans; concentrations of credit within the commercial loan portfolios; volume and type of lending; and current and anticipated economic conditions.

Loan losses for all portfolio segments are charged-off against the allowance for loan losses when the loan balance or a portion of the loan balance is no longer covered by the repayment capacity of the borrower based on an evaluation of available and projected cash resources and collateral value. Recoveries of amounts previously charged-off are credited to the allowance. The Company assesses the appropriateness of the allowance on a quarterly basis and adjusts the allowance by recording a provision for loan losses in an amount sufficient to maintain the allowance at a level deemed appropriate by management. The evaluation of the appropriateness of the allowance is inherently subjective as it requires estimates that are susceptible to significant revision as additional information becomes available or as future events occur. To the extent that actual outcomes differ from management’s estimates, an additional provision for loan losses could be required which could adversely affect earnings or the Company’s financial position in future periods.

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

Commercial and Industrial Loans ( C&I )

C&I loans are primarily based on the identified historic and/or the projected cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, do fluctuate based on changes in the company’s internal and external environment including management, human and capital resources, economic conditions, competition, regulation, and product innovation/obsolescence. The collateral securing these loans may also fluctuate in value and generally has advance rates between 50 - 80% of the collateral value. Most C&I loans are secured by business assets being financed such as equipment, accounts receivable, and/or inventory and generally incorporate a secured or unsecured personal guarantee. Occasionally, some loans may be made on an unsecured basis. In the case of loans secured by accounts receivable and/or inventory, the collateral securing the advances is generally monitored through a borrowing base certificate submitted by the borrower which may identify deterioration in collateral value. The ability of the borrower to collect amounts due from its customers may be affected by its customers’ economic and financial condition. The availability of funds for the repayment of these loans may be substantially dependent on each of the factors described above.

Commercial Real Estate – Owner Occupied, Non-Owner Occupied, and Multifamily

These types of commercial real estate loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally dependent upon the cash flows from the successful operation of the property securing the loan or the cash flows from the owner occupied business conducted on the property securing the loan. A borrower’s business and/or the property securing the loan may be adversely affected by business conditions generally, and fluctuations in the real estate markets or in the general economy, which if adverse, can negatively affect the borrowers’ ability to repay the loan. The value and cash flow of the property can be influenced by changes in market rental rates, changes in interest rates or investors’ required rates of return, the condition of the property, zoning, or environmental issues. The properties securing the commercial real estate portfolio are diverse in terms of type and are generally located in the Chicagoland/Northwest Indiana market. Owner occupied loans are generally a borrower purchased building where the borrower occupies at least 51% of the space with the primary source of repayment dependent on sources other than the underlying collateral. Non-owner occupied and single tenant properties may have higher risk than owner occupied loans since the primary source of repayment is dependent upon the ability to lease out the collateral as well as the financial stability of the businesses occupying the collateral. Multifamily loans can also be impacted by vacancy/collection losses and tenant turnover due to generally shorter term leases or even month-to-month leases. Management monitors and evaluates commercial real estate loan portfolio concentrations based upon cash flow, collateral, geography, and risk grade criteria. As a general rule, management avoids financing single purpose projects unless other underwriting factors mitigate the credit risk to an acceptable level. The Company’s loan policy generally requires lower loan-to-value ratios against these types of properties.

Commercial Construction and Land Development Loans

Construction loans are underwritten utilizing feasibility studies, independent appraisals, sensitivity analysis of absorption and lease rates, presale or prelease/Letters of Intent analysis, and financial analysis of the developers and property owners. Construction loans are generally based on the estimated cost to construct and cash flows associated with the completed project or stabilized value. These estimates are subjective in nature and if erroneous, may preclude the borrower from being able to repay the loan. Construction loans often involve the disbursement of substantial funds with repayment dependent on the success of the completed project. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions, the ability to sell the property, and the availability of long-term financing.

Commercial Participation Loans

Participation loans generally have larger principal balances, portions of which are sold to multiple participant banks in order to spread credit risk. The collateral securing these loans is often real estate and is often located outside of the Company’s geographic footprint. Loans outside of the Company’s geographical footprint pose additional risk due to the lack of knowledge of general economic conditions where the project is located along with various project specific risks regarding buyer demand and project specific risks regarding project competition risks. The participant banks are required to underwrite these credits utilizing their own internal analysis techniques and their own credit standards. However, the participant banks are reliant upon the information about the borrowers and the collateral provided by the lead bank. These loans carry higher levels of risk due to the participant banks being dependent on the lead bank for monitoring and managing the credit relationship, including the workout and/or foreclosure process should the borrower default.

Retail Loans

The Company’s retail loans include one-to-four family residential mortgage loans, home equity loans and lines of credit, retail construction, and other consumer loans. Management has established a maximum loan-to-value ratio ( LTV ) of 80% for one-to-four family residential mortgages and home equity loans and lines of credit that are secured by a first or second mortgage on owner and non-owner occupied residences. Loan applications exceeding 80% LTV require private mortgage insurance ( PMI ) from a mortgage insurance company deemed acceptable by management. Residential construction loans are underwritten to the same standards and generally require an end loan financing commitment either from the Company or another financial institution acceptable to the Company. Other consumer loans are generally small dollar auto and personal loans based on the credit score and income of the applicant. These loans are homogeneous in nature and are rated in pools based on similar characteristics.

The following tables present the activity in the allowance for loan losses for the three months ended March 31, 2013 and 2012 :



	Three Months Ended March 31, 2013
				Commercial Real Estate
	Commercial and Industrial			Owner Occupied		Non- Owner Occupied			Multifamily			Construction and Land Development			Commercial Participations		One-to- four Family Residential			HELOC			Retail Construction			Consumer			Total
	(Dollars in thousands)
Balance at beginning of period	$	1,169		$	2,470	$	3,761		$	926		$	1,436		$	601	$	1,101		$	552		$	16		$	153		$	12,185
Provision for loan losses	(16		)	146		238			54			(264		)	46		107			63			95			41			510
Loans charged-off:
Current period charge-offs	(80		)	—		(435		)	(70		)	—			—		(110		)	(62		)	(64		)	(57		)	(878		)
Previously established specific reserves	—			—		—			—			—			—		—			—			—			—			—
Total loans charged-off	(80		)	—		(435		)	(70		)	—			—		(110		)	(62		)	(64		)	(57		)	(878		)
Recoveries	8			28		139			1			—			—		20			1			—			10			207
Balance at end of period	$	1,081		$	2,644	$	3,703		$	911		$	1,172		$	647	$	1,118		$	554		$	47		$	147		$	12,024



	Three Months Ended March 31, 2012
				Commercial Real Estate
	Commercial and Industrial			Owner Occupied		Non- Owner Occupied			Multifamily			Construction and Land Development		Commercial Participations			One-to- four Family Residential			HELOC			Retail Construction		Consumer			Total
	(Dollars in thousands)
Balance at beginning of period	$	1,236		$	2,129	$	3,935		$	370		$	1,198	$	1,467		$	1,521		$	442		$	3	$	123		$	12,424
Provision for loan losses	(67		)	67		818			608			115		(516		)	44			(17		)	1		(3		)	1,050
Loans charged-off:
Current period charge-offs	(119		)	—		(361		)	(378		)	—		—			(114		)	(52		)	—		(17		)	(1,041		)
Previously established specific reserves	—			—		(718		)	—			—		—			—			—			—		—			(718		)
Total loans charged-off	(119		)	—		(1,079		)	(378		)	—		—			(114		)	(52		)	—		(17		)	(1,759		)
Recoveries	13			—		23			—			—		—			8			1			—		8			53
Balance at end of period	$	1,063		$	2,196	$	3,697		$	600		$	1,313	$	951		$	1,459		$	374		$	4	$	111		$	11,768

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



	At March 31, 2013
			Commercial Real Estate
	Commercial and Industrial		Owner Occupied		Non- Owner Occupied		Multifamily		Construction and Land Development		Commercial Participations		One-to- four Family Residential		HELOC		Retail Construction		Consumer		Total
	(Dollars in thousands)
Ending allowance balance:
Individually evaluated for impairment	$	—	$	54	$	217	$	—	$	215	$	—	$	—	$	—	$	—	$	—	$	486
Collectively evaluated for impairment	1,081		2,590		3,486		911		957		647		1,118		554		47		147		11,538
Total evaluated for impairment	$	1,081	$	2,644	$	3,703	$	911	$	1,172	$	647	$	1,118	$	554	$	47	$	147	$	12,024

Loans receivable:
Individually evaluated for impairment	$	7,549	$	7,846	$	23,733	$	1,910	$	2,357	$	339	$	3,178	$	534	$	85	$	7	$	47,538
Collectively evaluated for impairment	84,100		91,184		135,681		69,720		12,978		4,798		169,362		45,082		1,285		3,018		617,208
Total loans receivable	$	91,649	$	99,030	$	159,414	$	71,630	$	15,335	$	5,137	$	172,540	$	45,616	$	1,370	$	3,025	$	664,746



	At December 31, 2012
			Commercial Real Estate
	Commercial and Industrial		Owner Occupied		Non- Owner Occupied		Multifamily		Construction and Land Development		Commercial Participations		One-to- four Family Residential		HELOC		Retail Construction		Consumer		Total
	(Dollars in thousands)
Ending allowance balance:
Individually evaluated for impairment	$	—	$	—	$	217	$	—	$	180	$	—	$	—	$	—	$	—	$	—	$	397
Collectively evaluated for impairment	1,169		2,470		3,544		926		1,256		601		1,101		552		16		153		11,788
Total evaluated for impairment	$	1,169	$	2,470	$	3,761	$	926	$	1,436	$	601	$	1,101	$	552	$	16	$	153	$	12,185

Loans receivable:
Individually evaluated for impairment	$	2,039	$	9,082	$	21,503	$	3,351	$	2,366	$	339	$	1,808	$	620	$	—	$	—	$	41,108
Collectively evaluated for impairment	100,589		88,964		142,889		71,877		17,862		4,972		174,135		45,857		1,176		3,305		651,626
Total loans receivable	$	102,628	$	98,046	$	164,392	$	75,228	$	20,228	$	5,311	$	175,943	$	46,477	$	1,176	$	3,305	$	692,734

The Company, as a matter of good risk management practices, utilizes objective loan grading matrices to assign risk ratings to all commercial loans. The risk rating criteria is supported by core credit attributes that emphasize debt service coverage and guarantor support. The loan grading matrices are designed to remove subjective criteria and bias from the grading analysis. Retail loans are rated pass until they become 90 days or more delinquent, transferred to non-accrual status, and generally rated substandard.

The Company uses the following definitions for risk ratings:


•	Pass. Loans that meet the conservative underwriting guidelines that include core credit attributes noted above as measured by the loan grading matrices at levels that are in excess of the minimum amounts required to adequately service the loans.

•

Pass Watch. Loans which are performing per their contractual terms and are not necessarily demonstrating signs of credit or operational weakness. A credit will generally be graded as pass watch due to a nonrecurring event that has caused a decrease in a cash flow source, a potential future event that could impair the cash flow or repayment of the loan, or lack of current financial information needed to review the credit. Loans in this category are monitored by management for timely payments. This rating is considered transitional because management does not have current financial information to determine the appropriate risk grade or the quality of the loan appears to be changing. Loans may be graded as pass watch when a single event may have occurred that could be indicative of an emerging issue or indicate trending that would warrant a change in the risk rating.


•	Special Mention. Loans that have a potential weakness that will be closely monitored by management. A credit graded special mention does not expose the Company to elevated risk that would warrant an adverse classification.


•	Substandard. Loans that are inadequately protected by the current net worth and paying capacity of the borrower, guarantor, or the collateral pledged. Loans classified as substandard have a well-defined weakness or weaknesses, characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.


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

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



	Risk Rating at March 31, 2013
	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	78,535	$	3,346	$	2,599	$	7,169	$	—	$	91,649
Commercial real estate:
Owner occupied	82,411		7,776		768		8,075		—		99,030
Non-owner occupied	116,103		17,723		4,415		21,173		—		159,414
Multifamily	66,718		2,596		594		1,722		—		71,630
Commercial construction and land development	4,601		8,377		—		2,007		350		15,335
Commercial participations	4,688		—		110		339				5,137
Total commercial loans	353,056		39,818		8,486		40,485		350		442,195

Retail loans:
One-to-four family residential	166,983		—		—		5,557		—		172,540
Home equity lines of credit	44,941		—		—		675		—		45,616
Retail construction	1,285		—		—		85		—		1,370
Consumer	3,018		—		—		7		—		3,025
Total retail loans	216,227		—		—		6,324		—		222,551
Total loans receivable	$	569,283	$	39,818	$	8,486	$	46,809	$	350	$	664,746



	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Current	$	564,675	$	38,934	$	7,872	$	20,964	$	—	$	632,445
Delinquent:
30-59 days	3,616		781		—		—		—		4,397
60-89 days	75		103		614		1,147		—		1,939
90 days or more	917		—		—		—		—		917
Non-accrual	—		—		—		24,698		350		25,048
Total loans receivable	$	569,283	$	39,818	$	8,486	$	46,809	$	350	$	664,746



	Risk Rating at December 31, 2012
	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	79,622	$	12,896	$	8,411	$	1,699	$	—	$	102,628
Commercial real estate:
Owner occupied	78,247		11,121		745		7,933		—		98,046
Non-owner occupied	116,080		19,115		18,899		10,214		84		164,392
Multifamily	68,213		3,233		597		3,185		—		75,228
Commercial construction and land development	17,088		774		—		2,016		350		20,228
Commercial participations	4,860		112		—		339		—		5,311
Total commercial loans	364,110		47,251		28,652		25,386		434		465,833

Retail loans:
One-to-four family residential	170,138		—		—		5,805		—		175,943
Home equity lines of credit	45,638		—		—		839		—		46,477
Retail construction	1,027		—		—		149		—		1,176
Consumer	3,305		—		—		—		—		3,305
Total retail loans	220,108		—		—		6,793		—		226,901
Total loans receivable	$	584,218	$	47,251	$	28,652	$	32,179	$	434	$	692,734



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

For all loan categories, past due status is based on the contractual terms of the loan. Interest income is generally not accrued on loans which are delinquent 90 days or more, or for loans which management believes, after giving consideration to a number of factors, including economic and business conditions and collection efforts, collection of interest is doubtful. In all cases, loans are transferred to non-accrual status or charged-off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not received for loans transferred to non-accrual status is reversed against interest income. Interest subsequently received on non-accrual loans is accounted for using the cost-recovery basis for commercial loans and the cash-basis for retail loans until qualifying for return to accrual status.

Commercial loans are generally transferred to non-accrual status once they become 90 days past due. Management reviews all current financial information of the borrower and guarantor(s) and action plans to bring the loan current before determining if the loan should be transferred to non-accrual status. Management requires appropriate justification to maintain a commercial loan on accrual status once 90 days past due. Occasionally, commercial loans are transferred to non-accrual status before the loan becomes significantly past due if current information indicates that future repayment of principal and interest may be doubtful.

Commercial loans are returned to accrual status when management, based on a thorough analysis of the borrower, can expect the full repayment of principal and interest. The analysis will reflect the borrower’s capacity to service the debt and/or the guarantor’s ability and willingness to make the required debt service payments, either under the original note agreement and terms, or, in the case of an A/B note structure, under the terms of the new A note. Analysis may also include the proceeds from the disposition of the collateral as a potential repayment source based upon the net realizable value of the property.

In addition, a note may be considered for return to accrual status when payments (equal to or greater than those required in the final A note structure) have been made by the borrower for a minimum of six months and the borrower is in compliance with all other terms of the applicable agreement.

Retail loans are returned to accrual status primarily based on the payment status of the loan. A retail loan is automatically transferred to non-accrual status immediately upon becoming 90 days past due. The loan remains on non-accrual status, with interest income recognized on a cash basis when a payment is made, until the loan is paid current. Once current, the loan is automatically returned to accrual status. If management identifies other information to indicate that future repayment of the loan balance may still be questionable, the loan may be manually transferred to non-accrual status until management determines otherwise.

The Company’s loan portfolio delinquency status and its non-accrual loans are presented in the following tables at the dates indicated. The Company’s loans that are current and in non-accrual status include loans that have been restructured as troubled debt restructurings ( TDRs ) and have not yet met the required six months of payments under the restructured terms to be returned to accrual status.

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



	Delinquency at March 31, 2013
	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Non- accrual		Total Past Due and Non- accrual		Current		Total Loans Receivable		Current Non- accrual Loans
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	430	$	1,147	$	917	$	1,532	$	4,026	$	87,623	$	91,649	$	325
Commercial real estate:
Owner occupied	467		20		—		5,484		5,971		93,059		99,030		2,225
Non-owner occupied	623		103		—		7,698		8,424		150,990		159,414		666
Multifamily	—		594		—		1,314		1,908		69,722		71,630		—
Commercial construction and land development	567		—		—		2,357		2,924		12,411		15,335		250
Commercial participations	—		—		—		339		339		4,798		5,137		—
Total commercial loans	2,087		1,864		917		18,724		23,592		418,603		442,195		3,466

Retail loans:
One-to-four family residential	2,010		52		—		5,557		7,619		164,921		172,540		2,279
Home equity lines of credit	298		23		—		675		996		44,620		45,616		111
Retail construction	—		—		—		85		85		1,285		1,370		—
Consumer	2		—		—		7		9		3,016		3,025		—
Total retail loans	2,310		75		—		6,324		8,709		213,842		222,551		2,390
Total loans receivable	$	4,397	$	1,939	$	917	$	25,048	$	32,301	$	632,445	$	664,746	$	5,856



	Delinquency at December 31, 2012
	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Non- accrual		Total Past Due and Non- accrual		Current		Total Loans Receivable		Current Non- accrual Loans
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	152	$	917	$	—	$	449	$	1,518	$	101,110	$	102,628	$	228
Commercial real estate:
Owner occupied	426		21		—		5,417		5,864		92,182		98,046		2,976
Non-owner occupied	276		153		—		9,083		9,512		154,880		164,392		1,564
Multifamily	597		—		—		2,775		3,372		71,856		75,228		—
Commercial construction and land development	—		—		—		2,366		2,366		17,862		20,228		250
Commercial participations	—		—		—		339		339		4,972		5,311		—
Total commercial loans	1,451		1,091		—		20,429		22,971		442,862		465,833		5,018

Retail loans:
One-to-four family residential	1,836		908		—		5,671		8,415		167,528		175,943		1,596
Home equity lines of credit	417		—		—		683		1,100		45,377		46,477		48
Retail construction	—		—		—		150		150		1,026		1,176		—
Consumer	12		—		—		—		12		3,293		3,305		—
Total retail loans	2,265		908		—		6,504		9,677		217,224		226,901		1,644
Total loans receivable	$	3,716	$	1,999	$	—	$	26,933	$	32,648	$	660,086	$	692,734	$	6,662

The Company’s impaired loans are summarized in the tables below and include loans that are individually reviewed for impairment as well as impaired retail loans at March 31, 2013 that have not had foreclosure proceedings initiated and are below management’s scope for individual impairment review due to immateriality.



	At March 31, 2013
	Recorded Investment		Unpaid Principal Balance		Partial Charge-offs to Date		Related Allowance
	(Dollars in thousands)
Loans without a specific valuation allowance:
Commercial loans:
Commercial and industrial	$	7,549	$	7,663	$	80	$	—
Commercial real estate:
Owner occupied	6,709		8,867		2,034		—
Non-owner occupied	21,228		23,408		1,830		—
Multifamily	1,910		2,386		377		—
Commercial construction and land development	957		1,017		61		—
Commercial participations	339		5,583		5,103		—
Retail loans:
One-to-four family residential	6,783		6,930		147		—
Home equity lines of credit	675		794		120		—
Retail construction	85		150		65		—
Consumer	7		9		2		—
Total	$	46,242	$	56,807	$	9,819	$	—

Loans with a specific valuation allowance:
Commercial real estate:
Owner occupied	$	1,137	$	1,137	$	—	$	54
Non-owner occupied	2,505		2,584		—		217
Commercial construction and land development	1,400		1,450		—		215
Total	$	5,042	$	5,171	$	—	$	486

Total impaired loans:
Commercial	$	43,734	$	54,095	$	9,485	$	486
Retail	7,550		7,883		334		—
Total	$	51,284	$	61,978	$	9,819	$	486



	At December 31, 2012
	Recorded Investment		Unpaid Principal Balance		Partial Charge-offs to Date		Related Allowance
	(Dollars in thousands)
Loans without a specific valuation allowance:
Commercial loans:
Commercial and industrial	$	2,039	$	2,498	$	423	$	—
Commercial real estate:
Owner occupied	9,082		11,201		2,034		—
Non-owner occupied	18,979		21,290		1,740		—
Multifamily	3,351		3,979		550		—
Commercial construction and land development	956		1,017		60		—
Commercial participations	339		5,583		5,104		—
Retail loans:
One-to-four family residential	7,041		7,206		165		—
Home equity lines of credit	713		808		95		—
Retail construction	150		150		—		—
Total	$	42,650	$	53,732	$	10,171	$	—

Loans with a specific valuation allowance:
Commercial real estate:
Non-owner occupied	$	2,524	$	2,586	$	—	$	217
Commercial construction and land development	1,410		1,450		—		180
Total	$	3,934	$	4,036	$	—	$	397

Total impaired loans:
Commercial	$	38,680	$	49,604	$	9,911	$	397
Retail	7,904		8,164		260		—
Total	$	46,584	$	57,768	$	10,171	$	397

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



	Three Months Ended March 31,
	2013				2012
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(Dollars in thousands)
Loans without a specific valuation allowance:
Commercial loans:
Commercial and industrial	$	7,769	$	9	$	2,106	$	31
Commercial real estate:
Owner occupied	6,744		26		11,469		11
Non-owner occupied	21,665		56		25,643		82
Multifamily	1,921		9		2,395		13
Commercial construction and land development	956		—		2,781		—
Commercial participations	339		—		1,972		—
Retail loans:
One-to-four family residential	6,838		61		6,889		46
Home equity lines of credit	699		5		503		3
Retail construction	147		—		169		—
Consumer	9		—		—		—
Total	$	47,087	$	166	$	53,927	$	186

Loans with a specific valuation allowance:
Commercial real estate:
Owner occupied	$	1,141	$	17	$	—	$	—
Non-owner occupied	2,512		—		—		—
Commercial construction and land development	1,403		—		—		—
Total	$	5,056	$	17	$	—	$	—

Total impaired loans:
Commercial	$	44,450	$	117	$	46,366	$	137
Retail	7,693		66		7,561		49
Total	$	52,143	$	183	$	53,927	$	186

The Company may grant a concession or modification for economic or legal reasons related to a borrower’s financial condition that it would not otherwise consider resulting in a modified loan which is then identified as a TDR. The Company may modify loans through rate reductions, short-term extensions of maturity, interest only payments, or payment modifications to better match the timing of cash flows due under the modified terms with the cash flows from the borrowers’ operations. Loan modifications are intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. TDRs are considered impaired loans for purposes of calculating the Company’s allowance for loan losses.

The Company identifies loans for potential restructure primarily through direct communication with the borrower and evaluation of the borrower’s financial statements, revenue projections, tax returns, and credit reports. Even if the borrower is not presently in default, management will consider the likelihood that cash flow shortages, adverse economic conditions, and negative trends may result in a payment default in the near future.

For one-to-four family residential loans and home equity lines of credit, a restructure often occurs with past due loans and may be offered as an alternative to foreclosure. There are other situations where borrowers, who are not past due, experience a sudden job loss, become over-extended with credit obligations, or experience other problems, have indicated that they will be unable to make the required monthly payment and request payment relief.

When considering a loan restructure, management will determine if: (i) the financial distress is short or long term; (ii) loan concessions are necessary; and (iii) the restructure is a viable solution.

When a loan is restructured, the new terms often require a reduced monthly debt service payment. For commercial loans, management completes an analysis of the operating entity’s ability to repay the debt. If the operating entity is capable of servicing the new debt service requirements and the underlying collateral value is believed to be sufficient to repay the debt in the event of a future default, the new loan is generally placed on accrual status. To date, there have been no commercial loans restructured and immediately placed on accrual status after the execution of the TDR.

For retail loans, an analysis of the individual’s ability to service the new required payments is performed. If the borrower is capable of servicing the newly restructured debt and the underlying collateral value is believed to be sufficient to repay the debt in the event of a future default, the new loan is generally placed on accrual status. The reason for the TDR is also considered, such as paying past due real estate taxes or payments caused by a temporary job loss, when determining whether a retail TDR loan could be returned to accrual status. Retail TDRs remain in non-accrual status until sufficient payments have been made to bring the past due principal and interest current, at which point the loan would be transferred to accrual status.

There were no loans that have been restructured as TDRs during the three months ended March 31, 2013. The following table summarizes the loans that have been restructured as TDRs during the three months ended March 31, 2012:



	Three Months Ended
	March 31, 2012
	Count	Balance prior to TDR		Balance after TDR
	(Dollars in thousands)
Commercial loans:
Commercial real estate:
Owner occupied	2	$	259	$	305
Non-owner occupied	1	66		83
Total commercial loans	3	325		388

Retail loans – one-to-four family residential	6	486		517
Total loans	9	$	811	$	905

A default is identified when a TDR is 90 days or more past due, transferred to non-accrual status, or transferred to other real estate owned within twelve months of restructuring. The Company had no TDRs that defaulted during the three months ended March 31, 2013 or 2012.

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



	March 31, 2013						December 31, 2012
	Accruing		Non- accruing		Total		Accruing		Non- accruing		Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	529	$	218	$	747	$	543	$	228	$	771
Commercial real estate:
Owner occupied	2,684		2,385		5,069		3,926		2,434		6,360
Non-owner occupied	2,642		2,962		5,604		11,524		3,057		14,581
Multifamily	251		—		251		253		—		253
Commercial construction and land development	—		250		250		—		250		250
Commercial participations	—		93		93		—		93		93
Total commercial loans	6,106		5,908		12,014		16,246		6,062		22,308

Retail loans – one-to-four family residential	1,226		3,393		4,619		1,370		3,307		4,677
Total troubled debt restructurings	$	7,332	$	9,301	$	16,633	$	17,616	$	9,369	$	26,985

At March 31, 2013 , TDRs totaled $16.6 million , of which $4.8 million were performing in accordance with their agreements and in non-accrual status.

Management monitors the TDRs based on the type of modification or concession granted to the borrower. These types of modifications may include rate reductions, payment/term extensions, forgiveness of principal, forbearance, and other applicable actions. Of the various noted concessions, management predominantly utilizes rate reductions and lower monthly payments, either from a longer amortization period or interest only repayment schedule, because these concessions provide needed payment relief without risking the loss of principal. Management will also agree to a forbearance agreement when it is deemed appropriate to avoid foreclosure. The Company did not restructure any loans as TDRs during the three months ended March 31, 2013. The following table sets forth the Company’s TDRs by portfolio segment to quantify the type of modification or concession provided for the three months ended March 31, 2012:



	Three Months Ended March 31, 2012
	Commercial Real Estate
	Owner Occupied		Non-Owner Occupied		One-to-four Family Residential		Total
	(Dollars in thousands)
Rate reduction	$	—	$	—	$	245	$	245
Payment extension	—		—		36		36
Rate reduction and payment extension	305		83		236		624
Total troubled debt restructurings	$	305	$	83	$	517	$	905

At March 31, 2013 , TDRs decreased $10.4 million to $16.6 million from $27.0 million at December 31, 2012 . The activity related to the Company ’ s TDRs is presented in the following table for the periods indicated:



	Three Months Ended March 31,
	2013			2012
	(Dollars in thousands)
Beginning balance	$	26,985		$	25,849
Restructured loans identified as TDRs	—			905
Protective advances and miscellaneous	42			449
Repayments and payoffs	(225		)	(1,320		)
Charge-offs	(101		)	—
Performing TDRs no longer considered impaired	(10,068		)	—
Ending balance	$	16,633		$	25,883

6. Fair Value of Assets and Liabilities

The Company measures fair value according to ASC 820-10: Fair Value Measurements and Disclosures. ASC 820-10 establishes a fair value hierarchy that prioritizes the inputs used in valuation techniques, but not the valuation techniques themselves. The fair value hierarchy is designed to indicate the relative reliability of the fair value measure. The highest priority is given to quoted prices in active markets and the lowest to unobservable data such as the Company’s internal information. ASC 820-10 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” There are three levels of inputs into the fair value hierarchy (Level 1 being the highest priority and Level 3 being the lowest priority):

Level 1 – Unadjusted quoted prices for identical instruments in active markets;

Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable; and

Level 3 – Instruments whose significant value drivers or assumptions are unobservable and that are significant to the fair value of the assets or liabilities.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The following tables set forth the Company’s financial assets by level within the fair value hierarchy that were measured at fair value on a recurring basis at the dates indicated:



			Fair Value Measurements at March 31, 2013
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Investment securities available-for-sale:
U.S. Treasury securities	$	32,818	$	—	$	32,818	$	—
GSE securities	46,317		—		46,317		—
Collateralized mortgage obligations	68,856		—		68,856		—
Commercial mortgage-backed securities	47,278		—		47,278		—
GSE residential mortgage-backed securities	2,316		—		2,316		—
Asset backed securities	3,975		—		3,975		—
Pooled trust preferred securities	18,636		—		—		18,636



			Fair Value Measurements at December 31, 2012
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Investment securities available-for-sale:
U.S. Treasury securities	$	17,363	$	—	$	17,363	$	—
GSE securities	46,468		—		46,468		—
Collateralized mortgage obligations	67,066		—		67,066		—
Commercial mortgage-backed securities	46,429		—		46,429		—
GSE residential mortgage-backed securities	2,368		—		2,368		—
Asset backed securities	4,053		—		4,053		—
Pooled trust preferred securities	19,542		—		—		19,542
GSE preferred stock	1		1		—		—

Level 1 investment securities are valued using quoted prices in active markets for identical assets. The Company used Level 1 prices for its GSE preferred stock at December 31, 2012. The GSE preferred stock was sold for a $20,000 gain during the first quarter of 2013.

Level 2 investment securities are valued by a third-party pricing service commonly used in the banking industry utilizing observable inputs. The pricing provider utilizes evaluated pricing models that vary based on asset class. These models incorporate available market information including quoted prices of investment securities with similar characteristics and, because many fixed-income investment securities do not trade on a daily basis, apply available information through processes such as benchmark yield curves, benchmarking of like investment securities, sector groupings, and matrix pricing. In addition, model processes, such as an option adjusted spread model, are used to develop prepayment estimates and interest rate scenarios for investment securities with prepayment features.

Management uses a recognized third-party pricing service to obtain market values for the Company’s fixed-income securities portfolio. Documentation is maintained as to the methodology and summary of inputs used by the pricing service for the various types of securities, and management notes that the servicer maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. Management does not have access to all of the individual specific assumptions and inputs used for each security. The significant observable inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including market research publications.

Management validates the market values against fair market curves and other available pricing sources. Two third-party pricing sources are used to compare the reasonableness of prices for U.S. Treasury securities and GSE bonds. For all securities, the Company’s Investment Officer, who is in the market on a regular basis, monitors the market and is familiar with where similar securities are trading and where specific bonds in specific sectors should be priced. All monthly output from the third-party providers is reviewed against expectations as to pricing based on fair market curves, ratings, coupon, structure, and recent trade reports or offerings.

Based on management’s review of the methodology and summary of inputs used, management has concluded these assets are properly classified as Level 2 assets.

Fair value determinations for Level 3 measurements of securities are the responsibility of the Company’s Investment Officer with review and approval by the Asset/Liability Management Committee. Level 3 models are utilized when quoted prices are not available for certain investment securities or in markets where trading activity has slowed or ceased. When quoted prices are not available and are not provided by third-party pricing services, management judgment is necessary to determine fair value. As such, fair value is determined using discounted cash flow analysis models, incorporating default rate assumptions, estimations of prepayment characteristics, and implied volatilities.

The Company determined that Level 3 pricing models should be utilized for valuing its pooled trust preferred investment securities. The markets for these securities and for similar securities at March 31, 2013 were illiquid. There have been a limited number of observable transactions in the secondary market; however, a new issue market does not exist. Management has determined a valuation approach that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be more representative of fair value than the market approach valuation technique.

For its Level 3 pricing model, the Company uses externally produced fair values provided by a third-party pricing service and compares them to other external pricing sources. Other external sources provided similar prices, both higher and lower, than those used by the Company. The external model uses observed prices from limited transactions on similar securities to estimate liquidation values.

The following is a reconciliation of the beginning and ending balances for the periods indicated of recurring fair value measurements recognized in the accompanying condensed consolidated statements of condition using Level 3 inputs:



	Pooled Trust Preferred Securities
	Three Months Ended March 31,
	2013			2012
	(Dollars in thousands)
Beginning balance	$	19,542		$	18,555
Total realized and unrealized gains (losses):
Included in accumulated other comprehensive income (loss)	(199		)	(2,531		)
Principal repayments	(835		)	(668		)
Discount accretion	128			111
Ending balance	$	18,636		$	15,467

The following tables set forth the Company’s financial and non-financial assets by level within the fair value hierarchy that were measured at fair value on a non-recurring basis at the dates indicated:



			Fair Value Measurements at March 31, 2013
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Impaired loans (collateral-dependent)	$	26,655	$	—	$	—	$	26,655
Other real estate owned	771		—		—		771



			Fair Value Measurements at December 31, 2012
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Impaired loans (collateral-dependent)	$	10,292	$	—	$	—	$	10,292
Other real estate owned	2,492		—		—		2,492

Loans for which it is probable that the Company will not collect all principal and interest due according to contractual terms are measured for impairment. Allowable methods for determining the amount of impairment include estimating fair value using the fair value of the collateral for collateral-dependent loans. If the impaired loan is identified as collateral-dependent, then the fair value method of measuring the amount of impairment is utilized. Impaired loans that are collateral-dependent are classified within Level 3 of the fair value hierarchy.

When the Company determines a loan is collateral-dependent, the Bank’s Asset Management Committee ( AMC ) obtains appraisals on the underlying collateral securing the loan. The Senior Credit Officer ( SCO ) reviews the appraisals for accuracy and consistency. Appraisers are selected from the list of approved appraisers maintained by the SCO with input from the Bank’s Loan Committee. For purchased participation loans, management is dependent upon the lead bank to order and provide appraisals, which occasionally are broker’s opinions.

In determining the estimated fair value of the real estate, senior liens such as unpaid and current real estate taxes and any perfected liens are subtracted from the appraised value. In addition, the Company generally applies a 10% discount to the current appraisal to allow for reasonable selling expenses, including sales commissions and closing costs.

Fair value measurements for impaired loans are performed pursuant to ASC 310-10, Receivables, and are measured on a non-recurring basis. Certain impaired loans were partially charged-off or re-evaluated during the first quarter of 2013 . These impaired loans were carried at fair value as estimated using current and prior appraisals, discounting factors, the borrowers’ financial results, estimated cash flows generated from the property, and other factors. The change in the fair value of impaired loans that were valued based upon Level 3 inputs was approximately $431,000 and $811,000 , respectively, for the three months ended March 31, 2013 and 2012 . These losses are not recorded directly as an adjustment to current earnings or other comprehensive income (loss), but rather as a component in determining the overall adequacy of the allowance for loan losses. These adjustments to the estimated fair value of impaired loans may result in increases or decreases to the provision for loan losses recorded in future earnings.

The estimated fair value of other real estate owned is based on current or prior appraisals, less estimated costs to sell of 10% . Other real estate owned is classified within Level 3 of the fair value hierarchy. Appraisals of other real estate owned are obtained when the real estate is acquired and subsequently as deemed necessary by the AMC. The SCO reviews the appraisals for accuracy and consistency. Appraisers are selected from the list of approved appraisers maintained by the SCO with input from the Bank’s Loan Committee. The reduction in fair value of other real estate owned was $108,000 and $485,000 , respectively, for the three months ended March 31, 2013 and 2012 . The changes were recorded as adjustments to current earnings through other real estate owned related expenses.

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



	March 31, 2013
	Fair Value		Valuation Technique	Unobservable Inputs	Range (Weighted Averages)
	(dollars in thousands)
Pooled trust preferred securities	$	18,636	Consensus pricing*	Default assumptions Discount Rates	Varies by security 4.80% - 5.71% (5.05%)
Impaired loans (collateral-dependent)	26,655		Market comparable properties	Marketability discount	10%
Other real estate owned	771		Market comparable properties	Marketability discount	10%



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

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

The value of the pooled trust preferred securities is determined using multiple pricing models or similar techniques from third-party sources as well as significant unobservable inputs such as judgment or estimations by the Company in the weighting of the models. The unobservable inputs used in the fair value measurement of the Company’s investment in pooled trust preferred securities are offered quotes and comparability adjustments. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, changes in either of those inputs will not affect the other input.

The Company has the option to measure financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis (the Fair Value Option ) according to ASC 825-10, Financial Instruments. The Company is not currently engaged in any hedging activities and, as a result, did not elect to measure any financial instruments at fair value under ASC 825-10.

Disclosure of fair value information about financial instruments for which it is practicable to estimate their value, whether or not recognized in the condensed consolidated statements of condition, is summarized in the following tables and identified within the fair value hierarchy at the dates indicated. The aggregate fair value amounts presented do not represent the underlying value of the Company.



	March 31, 2013
	Carrying Amount		Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Financial Assets :
Cash and cash equivalents	$	154,240	$	154,240	$	154,240	$	—	$	—
Investment securities, available-for-sale	220,196		220,196		—		201,560		18,636
Investment securities, held-to-maturity	14,981		15,222		—		15,222		—
Loans receivable, net of allowance for loan losses	652,284		653,790		—		—		653,790
Loans held for sale	955		955		—		955		—
Federal Home Loan Bank stock	6,188		6,188		6,188		—		—
Interest receivable	2,669		2,669		—		2,669		—
Total financial assets	$	1,051,513	$	1,053,260	$	160,428	$	220,406	$	672,426

Financial Liabilities :
Deposits	$	974,328	$	976,283	$	650,347	$	—	$	325,936
Borrowed funds	49,828		52,424		—		52,424		—
Advance payments by borrowers	4,542		4,542		—		4,542		—
Interest payable	88		88		—		88		—
Total financial liabilities	$	1,028,786	$	1,033,337	$	650,347	$	57,054	$	325,936



	December 31, 2012
	Carrying Amount		Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Financial Assets :
Cash and cash equivalents	$	134,699	$	134,699	$	134,699	$	—	$	—
Investment securities, available-for-sale	203,290		203,290		1		183,747		19,542
Investment securities, held-to-maturity	15,458		15,722		—		15,722		—
Loans receivable, net of allowance for loan losses	680,082		681,550		—		—		681,550
Loans held for sale	1,509		1,509		—		1,509		—
Federal Home Loan Bank stock	6,188		6,188		6,188		—		—
Interest receivable	2,528		2,528		—		2,528		—
Total financial assets	$	1,043,754	$	1,045,486	$	140,888	$	203,506	$	701,092

Financial Liabilities :
Deposits	$	965,791	$	968,115	$	628,858	$	—	$	339,257
Borrowed funds	50,562		53,360		—		53,360		—
Advance payments by borrowers	4,734		4,734		—		4,734		—
Interest payable	68		68		—		68		—
Total financial liabilities	$	1,021,155	$	1,026,277	$	628,858	$	58,162	$	339,257

The carrying amount is the estimated fair value for cash and cash equivalents, accrued interest receivable and payable, and advance payments by borrowers. Investment security fair values are based on quotes received from a third-party pricing source and discounted cash flow analysis models. The fair value of Federal Home Loan Bank stock is based on its redemption value. The fair values for loans receivable are estimated using discounted cash flow analyses. Cash flows are adjusted for estimated prepayments, where appropriate, and are discounted using interest rates currently being offered by the Company for loans with similar terms and collateral to borrowers of similar credit quality. The carrying amount of loans held for sale is the amount funded and approximates fair value due to the insignificant time between origination and date of sale.

The fair value of core deposits (checking, savings, and money market accounts) is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated by discounting the future cash flows using the rates currently offered by the Company for deposits of similar remaining maturities. The fair value of borrowed funds is estimated based on rates currently available to the Company for debt with similar terms and remaining maturities. The fair value of the Company’s off-balance sheet instruments, including lending commitments, letters of credit, and credit enhancements, approximates their book value and is not included in the above tables.


7.	Share-Based Compensation

The Company accounts for its share-based compensation in accordance with ASC 718-10, Compensation – Stock Based Compensation. ASC 718-10 addresses all forms of share-based payment awards, including shares under employee stock purchase plans, stock options, restricted stock, and stock appreciation rights. ASC 718-10 requires all share-based payments to be recognized as expense, based upon their fair values, in the condensed consolidated financial statements over the service period of the awards.

For additional details on the Company’s share-based compensation plans and related disclosures, see “Note 9. Share-Based Compensation” in the consolidated financial statements as presented in the Company’s 2012 Annual Report on Form 10-K.

Omnibus Equity Incentive Plan – The Company’s 2008 Omnibus Equity Incentive Plan ( Equity Incentive Plan ) authorized the issuance of 270,000 shares of its common stock. In addition, there were 64,500 shares that had not yet been issued or were forfeited, canceled, or unexercised at the end of the option term under the 2003 Stock Option Plan when it was frozen. These shares and any other shares that may be forfeited, canceled, or expired are available for any type of share-based awards in the future under the Equity Incentive Plan. At March 31, 2013 , shares available for future grants under the Equity Incentive Plan totaled 186,290 shares.

Restricted Stock – During the first quarter of 2013, the Compensation Committee and Chief Executive Officer, under authority delegated by the Compensation Committee, granted awards under the Equity Incentive Plan. A total of 67,430 shares of restricted stock were granted to officers and key employees of the Company. The grants included 33,548 of performance-based and 33,882 of service-based share awards. The Company reissued treasury shares to satisfy the granting of restricted stock awards.

The weighted-average fair market value of the restricted stock awards granted in the first quarter of 2013 was $7.66 per share and totaled $517,000 . These awards vest 33% , 33% , and 34% on May 1, 2015, 2016, and 2017, respectively. The expense for these awards is being recorded over their requisite service period from the grant date. The Company estimates that the impact of forfeitures based on its historical experience with previously granted restricted stock awards and will consider the impact of the forfeitures when determining the amount of expense to record for the restricted stock granted.

During the first quarter of 2013, 40,440 shares of performance-based restricted stock granted during 2012 were deemed unearned by the Compensation Committee of the Board of Directors and, accordingly, were forfeited. In addition, 3,529 grants were forfeited during the first quarter of 2013 due to an employee leaving the Company prior to the shares vesting. At the time of forfeiture, the Company reversed $52,000 of compensation expense related to the forfeited 2012 grants.

The following table presents the activity for restricted stock for the three months ended March 31, 2013 :



	Number of Shares		Weighted- Average Grant-Date Fair Value
Unvested at December 31, 2012	120,737		$	4.72
Granted	67,430		7.66
Vested	—		—
Forfeited	(43,969	)	5.75
Unvested at March 31, 2013	144,198		$	5.78

The compensation expense related to restricted stock for the three months ended March 31, 2013 totaled $37,000 , before the reversal of $52,000 for the unearned and forfeited 2012 grants. The compensation expense related to restricted stock for the three months ended March 31, 2012 was $21,000 . At March 31, 2013 , the remaining unamortized cost of the restricted stock awards was reflected as a reduction in additional paid-in capital and totaled $834,000 . This cost is expected to be recognized over a weighted-average period of 3.8 years, which is subject to the actual number of shares earned and vested.

Stock Options – The Company’s 2008 Equity Incentive Plan allows for the grant of both incentive and non-qualified stock options to directors, officers, and employees. The stock option vesting periods and exercise and expiration dates are determined by the Compensation Committee at the time of the grant. The exercise price of the stock options is equal to the fair market value of the common stock on the grant date.

The Company did not grant any stock options during the first quarter of 2013. During the first quarter of 2012, the Compensation Committee granted 20,000 non-qualified options to purchase shares of the Company’s common stock at an exercise price of $4.40 per share, which was the closing price of the Company’s common stock on that date. The options vest ratably over four years on each anniversary date of the award and have a ten -year term. The fair value of the options granted was $2.42 and was estimated using the Black-Scholes option value model with the following assumptions:



	2012
Dividend yield	.91	%
Expected volatility %	57.33
Risk-free interest rate	1.58	%
Original expected life	7.9 years

The following table presents the activity under the Company’s stock option plans for the three months ended March 31, 2013 :



	Number of Options	Weighted- Average Exercise Price
Options outstanding at December 31, 2012	407,795	$	13.59
Granted	—	—
Exercised	—	—
Forfeited	—	—
Expired unexercised	—	—
Options outstanding at March 31, 2013	407,795	$	13.59

For stock options outstanding at March 31, 2013 , the range of exercise prices was $4.40 to $14.76 , and the weighted-average remaining contractual term was 1.4 years. At March 31, 2013 , 387,595 of the Company’s outstanding stock options were fully vested and out-of-the-money with no intrinsic value. Of the remaining 20,000 stock options, 5,000 were exercisable at March 31, 2013. All of the 20,000 options were in-the-money with an intrinsic value of $71,800 , which represents the difference between the Company’s closing stock price on the last day of trading for the first quarter of 2013 and the exercise price multiplied by the number of in-the-money options, assuming all option holders had exercised their stock options on the last day of trading for the same period. Stock option expense for the three months ended March 31, 2013 and 2012 was $2,000 and $3,000 , respectively. There were no stock options exercised during the three months ended March 31, 2013 and 2012 . The Company reissues treasury shares, to the extent available, to satisfy option exercises.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement Regarding Forward Looking Statements

Certain statements contained in this Form 10-Q, in our other filings with the United States Securities and Exchange Commission (SEC), and in our press releases or other shareholder communications are “forward-looking statements,” as that term is defined in U.S. federal securities laws. Generally, these statements relate to our business plans or strategies; projections involving anticipated revenues, earnings, profitability, or other aspects of our operating results; or other future developments in our business or the industry in which we conduct our business. Forward-looking statements may be identified by reference to a future period or periods or by the use of forward-looking language such as “anticipate,” “believe,” “estimate,” “expect,” “indicate,” “intend,” “intend to,” “plan,” “project,” “should,” “would be,” “will,” or similar expressions or the negative thereof, as well as statements that include future events, tense or dates, or are not historical facts as they relate to us, our business, prospects, or our management.

You should not place undue reliance on any such forward-looking statements, which speak only as of the date made. These forward-looking statements include but are not limited to statements regarding our ability to successfully execute our strategy and Strategic Growth and Diversification Plan; the level and sufficiency of our current regulatory capital and equity ratios; our ability to continue to diversify the loan portfolio; our efforts at deepening client relationships, increasing our levels of core deposits, lowering our non-performing asset levels, managing and reducing our credit-related costs, increasing our revenue growth and levels of earning assets; the effects of general economic and competitive conditions nationally and within our core market area; our ability to sell other real estate owned properties and mortgage loans held for sale; the sufficiency of the levels of provision for and the allowance for loan losses, amounts of loan charge-offs, levels of loan and deposit growth, interest on loans, asset yields and cost of funds, net interest income, net interest margin, non-interest income, non-interest expense, the interest rate environment, and other risk factors identified in the filings we make with the SEC. For further discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements see “Part I. Item 1A. Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2012. Such forward-looking statements reflect our current views with respect to future events and are subject to certain risks, uncertainties, assumptions, and changes in circumstances. Forward-looking statements are not guarantees of future performance or outcomes, and actual results or events may differ materially from those included in these statements. We do not undertake, and specifically disclaim any obligation, to update any forward-looking statements to reflect occurrences, unanticipated events, or circumstances after the date of such statements unless required to do so under the federal securities laws.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles ( U.S. GAAP ), which require us to establish various accounting policies. Certain of these accounting policies require us to make estimates, judgments, or assumptions that could have a material effect on the carrying value of certain assets and liabilities. The estimates, judgments, and assumptions we use are based on historical experience, projected results, internal cash flow modeling techniques, and other factors which we believe are reasonable under the circumstances.

Significant accounting policies are presented in “Note 1. Summary of Significant Accounting Policies” in the notes to consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” of our Annual Report on Form 10-K for the year ended December 31, 2012. These policies, along with the disclosures presented in other financial statement notes and in this management’s discussion and analysis, provide information on the methodology used for the valuation of significant assets and liabilities in our financial statements. We view critical accounting policies to be those that are highly dependent on subjective or complex judgments, estimates, and assumptions, and where changes in those estimates and assumptions could have a significant impact on our consolidated financial statements. We currently view the determination of the allowance for loan losses, valuations and impairments of investment securities, and the accounting for income taxes to be critical accounting policies.

Allowance for Loan Losses. We maintain our allowance for loan losses at a level we believe is appropriate to absorb credit losses inherent in our loan portfolio. The allowance for loan losses represents our estimate of probable incurred losses in our loan portfolio at each statement of condition date and is based on our review of available and relevant information.

The first component of the allowance for loan losses contains allocations for probable incurred losses that management has identified relating to impaired loans pursuant to Accounting Standards Codification ( ASC ) 310-10, Receivables. We individually evaluate for impairment all loans classified substandard and over $375,000 to enable management to identify potential losses over a larger cross section of the loan portfolio. We also individually evaluate for impairment all loans for which we have initiated foreclosure proceedings. For all portfolio segments, loans are considered impaired when, based on current information and events, it is probable that the borrower will not be able to fulfill its obligation according to the contractual terms of the loan agreement. The impairment loss, if any, is generally measured based on the present value of expected cash flows discounted at the loan’s effective interest rate. As a practical expedient, impairment may be measured based on the loan’s observable market price, or the fair value of the collateral, if the loan is collateral-dependent. A loan is considered collateral-dependent when the repayment of the loan will be provided solely by the underlying collateral and there are no other available and reliable sources of repayment. If we determine a loan is collateral-dependent, we will charge-off any identified collateral shortfall against the allowance for loan losses.

If foreclosure is probable, we are required to measure the impairment based on the fair value of the collateral. The fair value of the collateral is generally obtained from the evaluation of the collateral, and one of the methods of evaluation is an independent third-party appraisal. When current appraisals are not available, we utilize other evaluation methods to estimate the fair value of the collateral giving consideration to several factors. These factors include for real estate properties the price at which an individual unit or unit(s) could be sold in the current market, the period of time over which the unit(s) would be sold, the estimated cost to complete the unit(s), the risks associated with completing and selling the unit(s), the required return on the investment a potential acquirer may have, and the current market interest rates. The analysis of each loan involves a high degree of judgment in estimating the amount of the loss associated with the loan, including the estimation of the amount and timing of future cash flows and collateral values.

The second component of our allowance for loan losses contains allocations for probable incurred losses within various pools of loans with similar characteristics pursuant to ASC 450-20, Contingencies: Loss Contingencies. This component is based in part on certain loss factors applied to various stratified loan pools excluding loans evaluated individually for impairment. In determining the appropriate loss factors for these loan pools, we consider historical charge-offs and recoveries; levels of and trends in delinquencies, impaired loans, and other classified loans; concentrations of credit within the commercial loan portfolios; volume and type of lending; and current and anticipated economic conditions. Our historical charge-offs are determined by evaluating the net charge-offs over the most recent eight quarters, including the current quarter.

Loan losses are charged-off against the allowance for loan losses when the loan balance or a portion of the loan balance is no longer covered by the repayment capacity of the borrower based on an evaluation of available and projected cash resources and collateral value. Recoveries of amounts previously charged-off are credited to the allowance. We assess the appropriateness of the allowance on a quarterly basis and adjust the allowance by recording a provision for loan losses in an amount sufficient to maintain the allowance at a level we deem appropriate. The evaluation of the appropriateness of the allowance is inherently subjective as it requires estimates that are susceptible to significant revision as additional information becomes available or as future events occur. To the extent that actual outcomes differ from our estimates, an additional provision for loan losses could be required which could adversely affect earnings or our financial position in future periods.

Investment Securities. Under ASC 320-10, Investments – Debt and Equity Securities, investment securities must be classified as held-to-maturity, available-for-sale, or trading. We determine the appropriate classification at the time of purchase. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on investment securities. Debt investment securities are classified as held-to-maturity and carried at amortized cost when we have the positive intent and the ability to hold the investment securities to maturity. Investment securities not classified as held-to-maturity are classified as available-for-sale and are carried at fair value, with the unrealized holding gains and losses, net of tax, reported in other comprehensive income and with no effect on earnings until realized. Investment in FHLB stock is carried at cost. We have no trading account investment securities.

The fair values of our investment securities are generally determined by reference to quoted prices from reliable independent sources utilizing observable inputs. Certain of the fair values of investment securities are determined using models whose significant value drivers or assumptions are unobservable and are significant to the fair value of the investment securities. These models are utilized when quoted prices are not available for certain investment securities or in markets where trading activity has slowed or ceased. When quoted prices are not available and are not provided by third-party pricing services, our judgment is necessary to determine fair value. As such, fair value is determined using discounted cash flow analysis models, incorporating default rates, estimation of prepayment characteristics, and implied volatilities.

We evaluate all investment securities on a quarterly basis, and more frequently when economic conditions warrant additional evaluations, for determining if an other-than-temporary impairment ( OTTI ) exists pursuant to guidelines established in ASC 320-10. In evaluating the possible impairment of investment securities, consideration is given to many factors including the length of time and the extent to which the fair value has been less than cost, whether the market decline was affected by macroeconomic conditions, the financial conditions and near-term prospects of the issuer, and management’s ability and intent to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, we may consider whether the investment securities are issued by the federal government or its agencies or government sponsored agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

If we determine that an investment experienced an OTTI, we must then determine the amount of the OTTI to be recognized in earnings. If we do not intend to sell the investment security and it is more likely than not that we will not be required to sell the investment security before recovery of its amortized cost basis less any current period loss, the OTTI will be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the OTTI related to other factors will be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings will become the new amortized cost basis of the investment. If we intend to sell the investment security or it is more likely than not we will be required to sell the investment security before recovery of its amortized cost basis less any current period credit loss, the OTTI will be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the statement of condition date. Any recoveries related to the value of these investment securities are recorded as an unrealized gain (as other comprehensive income (loss) in shareholders’ equity) and not recognized in income until the investment security is ultimately sold. From time to time, we may dispose of an impaired investment security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds can be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time.

Income Tax Accounting. We file a consolidated federal income tax return. The provision for income taxes is based upon income in our consolidated financial statements, rather than amounts reported on our income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on our deferred tax assets and liabilities is recognized as income or expense in the period that includes the enactment date.

Under U.S. GAAP, a valuation allowance is required to be recognized if it is more likely than not that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning our evaluation of both positive and negative evidence, our forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. The tax planning strategies the Company considered in its deferred tax asset analysis include, but are not limited to, the termination of the bank-owned life insurance program, the sale/leaseback of its owned office properties, and the sale of its municipal securities with reinvestment of the proceeds in taxable securities. Positive evidence includes current positive earning trends, the existence of taxes paid in available carryback years, and the probability that taxable income will continue to be generated in future periods, while negative evidence includes any cumulative losses in the current year and prior two years and general business and economic trends.

At March 31, 2013, based on the results of our regular assessment of the ability to realize our deferred tax assets, we concluded that, based on all available evidence, both positive and negative, approximately $6.5 million of our deferred tax assets did not meet the “more likely than not” threshold for realization. Although realization of the remaining net deferred tax assets of $11.0 million is not assured, we believe it is more likely than not that all of the recorded deferred tax assets will be realized based on available tax planning strategies and our projections of future taxable income. The positive evidence considered in our analysis of the remaining deferred tax assets included our long-term history of generating taxable income; the cyclical nature of the industry in which we operate; the fact that a portion of the losses realized in 2011 were partly attributable to syndicated/participation lending which we stopped investing in during 2007; our history of fully realizing net operating losses, including the federal net operating loss from a $45.0 million taxable loss in 2004; and the relatively long remaining tax loss carryforward periods (19 years for federal income tax purposes, seven years for the state of Indiana, and 12 years for the state of Illinois). The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during tax loss carryforward periods are reduced. Any reduction in estimated future taxable income may require us to record an additional valuation allowance against our deferred tax assets, which would result in additional income tax expense in the period and could have a significant impact on our future earnings.

Positions taken in our tax returns may be subject to challenge upon examination by the taxing authorities. The benefit of an uncertain tax position is initially recognized in the financial statements only when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are both initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with the tax authority, assuming full knowledge of the position and all relevant facts. Differences between our position and the position of tax authorities could result in a reduction of a tax benefit or an increase to a tax liability, which could adversely affect our future income tax expense.

We believe our tax policies and practices are critical accounting policies because the determination of our tax provision and current and deferred tax assets and liabilities have a material impact on our results of operations and the carrying value of our assets. We believe our tax assets and liabilities are adequate and are properly recorded in the consolidated financial statements at March 31, 2013.

Results of Operations for the Three Months Ended March 31, 2013 and 2012

Performance Overview

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



	Three Months Ended March 31,
	2013			2012
	(Dollars in thousands, except per share data)
Net income	$	1,502		$	490
Diluted earnings per share	.14			.05
Pre-tax, pre-provision earnings, as adjusted (1)	2,789			2,781
Return on average assets (2)	.53		%	.17		%
Return on average equity (2)	5.43			1.89
Average interest-earning assets	$	1,030,232		$	1,045,778
Net interest income	8,201			8,923
Net interest margin (2)	3.23		%	3.43		%
Non-interest income	$	2,854		$	2,824
Non-interest expense	8,455			10,207
Efficiency ratio (3)	77.78		%	90.10		%



	March 31, 2013			December 31, 2012			March 31, 2012
Book value per share	$	10.35		$	10.28		$	9.50
Shareholders’ equity to total assets	9.84		%	9.83		%	8.83		%
Bank Capital Ratios:
Tier 1 core capital ratio	8.92			8.81			8.11
Total risk-based capital ratio	13.61			12.81			11.98
Risk-based capital ratio	14.86			14.06			13.23


(1)	See “ Non-U.S. GAAP Financial Information ” on page 42.


(2)	Annualized.


(3)	The efficiency ratio is calculated by dividing non-interest expense by the sum of net interest income and non-interest income, excluding net gain on sale of investment securities.

The following discussion and analysis presents the more significant factors affecting our financial condition as of March 31, 2013 and results of operations for the three months ended March 31, 2013 . This discussion and analysis should be read in conjunction with our condensed consolidated financial statements and notes thereto included in this report.

We recorded net income of $1.5 million , or $.14 per diluted share for the first three months of 2013, which represents an increase of 207% from net income of $490,000 , or $.05 per diluted share, for the comparable 2012 period. Our earnings were favorably impacted by significant decreases in the provision for loan losses and non-interest expense. Non-interest expense decreased by $1.8 million , or 17.2%, to $8.5 million for the first quarter of 2013 from $10.2 million for the first quarter of 2012 due to decreases in other real estate owned expense, marketing expense, and severance and early retirement expense, which was related to the 2012 Voluntary Early Retirement Offering ( VERO ), two branch closings, and the outsourcing of certain support functions. The number of full time equivalent ( FTE ) employees was 262 at March 31, 2013 compared to 261 at December 31, 2012 and 273 at March 31, 2012 .

Our problem asset resolution efforts continue, reducing our level of non-performing assets to $48.7 million at March 31, 2013, a decrease of 3.1% from $50.3 million at December 31, 2012. The ratio of non-performing assets to total assets decreased to 4.25% at March 31, 2013 from 4.42% at December 31, 2012 . Driving the decrease in non-performing assets was a 7.0% decrease in non-performing loans to $25.0 million from $26.9 million at December 31, 2012. Our non-performing loans to total loans decreased to 3.77% at March 31, 2013 from 3.89% at December 31, 2012 , primarily due to the transfer to other real estate owned of one non-owner occupied and multifamily commercial real estate loan relationship totaling $2.1 million combined with repayments and payoffs totaling $839,000 and gross loan charge-offs totaling $878,000. Of the total non-performing loans at March 31, 2013, $5.9 million, or 23.4%, are current and performing in accordance with their loan agreements.

The targeted growth segments in our loan portfolio include commercial and industrial and owner occupied and multifamily commercial real estate, which in the aggregate comprised 59.3% of the commercial loan portfolio at March 31, 2013 , compared to 59.2% at December 31, 2012 and 54.5% at March 31, 2012 . In addition, our focus on deepening client relationships continues to emphasize core deposit growth. Total core deposits as a percentage of total deposits increased to 66.8% at March 31, 2013 from 65.1% at December 31, 2012 and 62.4% at March 31, 2012 . The increase was primarily due to an increase in non-interest bearing accounts and the continued shrinkage in certificates of deposit in this low interest rate environment.

At March 31, 2013 , our shareholders’ equity increased slightly to $112.8 million , or 9.84% of assets, compared to $111.8 million , or 9.83% of assets, at December 31, 2012 and $103.3 million , or 8.83% of assets, at March 31, 2012 . The increase from December 31, 2012 was primarily due to net income of $1.5 million partially offset by a decrease in accumulated other comprehensive income, net of tax, of $443,000 and dividends declared of $109,000.

The Bank’s Tier 1 capital ratio increased 11 basis points to 8.92% at March 31, 2013 from 8.81% at December 31, 2012 and 81 basis points from 8.11% at March 31, 2012 . The Bank’s total risk-based capital to risk-weighted assets ratio increased 80 basis points to 14.86% at March 31, 2013 from 14.06% at December 31, 2012 and 163 basis points from 13.23% at March 31, 2012 . The increase in the capital ratios are primarily related to the increase in shareholders’ equity combined with a decrease in risk-weighted assets. At March 31, 2013, the Bank was deemed to be “well capitalized” and in excess of the regulatory capital requirements set by the OCC in December 2012 for both Tier 1 capital and total risk-based capital to risk-weighted assets.

Non-U.S. GAAP Financial Information

Our accounting and reporting policies conform to U.S. GAAP and general practice within the banking industry. Management uses certain non-U.S. GAAP financial measures to evaluate our financial performance and has provided the non-U.S. GAAP financial measures of pre-tax, pre-provision earnings, as adjusted, and pre-tax, pre-provision earnings, as adjusted, to average assets. In these non-U.S. GAAP financial measures, the provision for loan losses, other real estate owned related income and expense, loan collection expense, and certain other items, such as gains and losses on sales of investment securities and other assets, and severance and early retirement expense, are excluded. Management believes that these measures are useful because they provide a more comparable basis for evaluating financial performance excluding certain credit-related costs and other non-recurring items period to period and allows management and others to assess our ability to generate pre-tax earnings to cover our provision for loan losses and other credit-related costs. Although these non-U.S. GAAP financial measures are intended to enhance investors understanding of our business performance, these operating measures should not be considered as an alternative to U.S. GAAP.

The risks associated with utilizing operating measures (such as the pre-tax, pre-provision earnings, as adjusted) are that various persons might disagree as to the appropriateness of items included or excluded in these measures and that other companies might calculate these measures differently. Management compensates for these limitations by providing detailed reconciliations between U.S. GAAP information and our pre-tax, pre-provision earnings, as adjusted, as noted above.

The following table reconciles income before income taxes in accordance with U.S. GAAP to the non-U.S. GAAP measurement of pre-tax, pre-provision earnings, as adjusted:



	Three Months Ended March 31,
	2013			2012
	(Dollars in thousands)
Reconciliation of Income Before Income Taxes to Pre-Tax, Pre-Provision Earnings, as adjusted :
Income before income taxes	$	2,090		$	490
Provision for loan losses	510			1,050
Pre-tax, pre-provision earnings	2,600			1,540

Add back (subtract):
Net gain (loss) on sale of:
Investment securities	(184		)	(418		)
Other real estate owned	(10		)	47
Other real estate owned related expense, net	250			618
Loan collection expense	133			118
Severance and early retirement expense	—			876
Pre-tax, pre-provision earnings, as adjusted	$	2,789		$	2,781

Pre-tax, pre-provision earnings, as adjusted, to average assets (annualized)	.99		%	.96		%

Pre-tax, pre-provision earnings, as adjusted, were relatively stable at $2.8 million for the first quarter of 2013 compared to $2.8 million for the first quarter of 2012 . Favorable variances from the first quarter of 2012 include increases in gains on the sale of loans held for sale and lower compensation and employee benefits and marketing expense during the first quarter of 2013. These favorable variances were offset by lower net interest income and income from bank-owned life insurance.

Average Balances/Rates

The following table reflects the average yield on assets and average cost of liabilities for the periods indicated. Average balances are derived from average daily balances.



	Three Months Ended March 31,
	2013						2012
	Average Balance		Interest		Average Yield/Cost		Average Balance		Interest		Average Yield/Cost
	(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)	$	676,181	$	7,700	4.62	%	$	708,713	$	8,386	4.76	%
Investment securities (2)	229,120		1,593		2.78		258,882		2,130		3.25
Other interest-earning assets (3)	124,931		124		.40		78,183		93		.48
Total interest-earning assets	1,030,232		9,417		3.71		1,045,778		10,609		4.08
Non-interest earning assets	110,800						113,419
Total assets	$	1,141,032					$	1,159,197
Interest-bearing liabilities:
Deposits:
Checking accounts	$	188,486	$	52	.11	%	$	178,370	$	83	.19	%
Money market accounts	182,314		93		.21		196,117		171		.35
Savings accounts	156,037		73		.19		136,109		67		.20
Certificates of deposit	331,001		713		.87		378,047		1,069		1.14
Total deposits	857,838		931		.44		888,643		1,390		.63
Borrowed funds:
Other short-term borrowed funds	11,058		3		.11		13,339		5		.15
FHLB advances	39,460		282		2.86		39,821		291		2.89
Total borrowed funds	50,518		285		2.26		53,160		296		2.20
Total interest-bearing liabilities	908,356		1,216		.54		941,803		1,686		.72
Non-interest bearing deposits	108,832						101,645
Other non-interest bearing liabilities	11,701						11,464
Total liabilities	1,028,889						1,054,912
Shareholders’ equity	112,143						104,285
Total liabilities and shareholders’ equity	$	1,141,032					$	1,159,197
Net interest-earning assets	$	121,876					$	103,975
Net interest income / interest rate spread			$	8,201	3.17	%			$	8,923	3.36	%
Net interest margin					3.23	%					3.43	%
Ratio of average interest-earning assets to average interest-bearing liabilities					113.42	%					111.04	%




(1)	The average balance of loans receivable includes loans held for sale and non-performing loans, interest on which is recognized on a cash basis.
(2)	Average balances of investment securities are based on amortized cost.
(3)	Includes FHLB stock and interest-earning bank deposits.

Rate/Volume Analysis

The following table shows the impact of changes in the volume of interest-earning assets and interest-bearing liabilities and changes in interest rates on our interest income and interest expense for the period indicated. Changes attributable to the combined impact of rate and volume have been allocated proportionally to the changes due to rate and changes due to volume.



	Three Months Ended March 31,
	2013 Compared to 2012
	Change due to Rate			Change due to Volume			Total Change
	(Dollars in thousands)
Interest income:
Loans receivable	$	(309	)	$	(377	)	$	(686	)
Investment securities	(308		)	(229		)	(537		)
Other interest-earning assets	(18		)	49			31
Total interest income	(635		)	(557		)	(1,192		)

Interest expense:
Deposits:
Checking accounts	(36		)	5			(31		)
Money market accounts	(67		)	(11		)	(78		)
Savings accounts	(4		)	10			6
Certificates of deposit	(234		)	(122		)	(356		)
Total deposits	(341		)	(118		)	(459		)
Borrowed funds:
Other short-term borrowed funds	(1		)	(1		)	(2		)
FHLB advances	(6		)	(3		)	(9		)
Total borrowed funds	(7		)	(4		)	(11		)
Total interest expense	(348		)	(122		)	(470		)
Net change in net interest income	$	(287	)	$	(435	)	$	(722	)

Net Interest Income

Net Interest Income. Net interest income decreased 8.1% to $8.2 million for the three months ended March 31, 2013 compared to $8.9 million for the three months ended March 31, 2012 . The net interest margin for the three months ended March 31, 2013 decreased 20 basis points to 3.23% from 3.43% for the comparable 2012 period. Our net interest margin was negatively impacted by loans comprising a smaller proportion of interest-earning assets and the maintenance of a higher level of liquidity. We believe that higher levels of liquidity, modest loan demand, reduced but still elevated levels of non-performing assets, the continued low interest rate environment, and significant narrowing of spreads on new investment securities purchases will continue to pressure our net interest margin for the foreseeable future.

Interest Income. Interest income decreased 11.2% to $9.4 million for the three months ended March 31, 2013 from $10.6 million for the comparable 2012 period. The weighted-average rate on interest-earning assets decreased 37 basis points to 3.71% for the three months ended March 31, 2013 from 4.08% for the comparable 2012 period. The decrease is primarily related to the reinvestment of proceeds from sales and maturities of investment securities in lower-yielding investments, lower loan balances, and maintaining higher levels of short-term liquid investments due to the lack of suitable higher-yielding investment alternatives in the current low interest rate environment combined with modest loan demand.

Interest Expense . Interest expense decreased 27.9% to $1.2 million for the three months ended March 31, 2013 from $1.7 million for the comparable 2012 period. The average cost of interest-bearing liabilities decreased 18 basis points to .54% for the three months ended March 31, 2013 from .72% for the 2012 period. Our continuing success in increasing the proportion of low-cost core deposits to total deposits and continued disciplined pricing on new and renewing certificates of deposit contributed to the decrease in interest expense during the 2013 period.

Interest expense on interest-bearing deposits decreased 33.0% to $931,000 for the three months ended March 31, 2013 from $1.4 million for the comparable 2012 period. The weighted-average cost of deposits decreased 19 basis points to .44% for the three months ended March 31, 2013 from .63% for the comparable 2012 period. The decreases are primarily the result of lower rates on increased balances of core deposits and the repricing of maturing certificates of deposit at lower interest rates.

Interest expense on borrowed funds decreased 3.7% to $285,000 for the three months ended March 31, 2013 from $296,000 for the comparable 2012 period primarily due to lower average balances on borrowed funds during the first quarter of 2013 . The weighted-average cost of borrowed funds increased six basis points to 2.26% for the three months ended March 31, 2013 compared to 2.20% for the 2012 period as a result of lower average balances on lower-cost other short-term borrowed funds.

Provision for Loan Losses

The Company’s provision for loan losses was $510,000 for the three months ended March 31, 2013 compared to $1.05 million for the 2012 period. For more information, see “ Changes in Financial Condition – Allowance for Loan Losses ” below in this “ Management’s Discussion and Analysis of Financial Condition and Results of Operations. ”

Non-Interest Income

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



	Three Months Ended March 31,
	2013		2012			$ Change			% Change
	(Dollars in thousands)
Deposit related fees	$	1,520	$	1,469		$	51		3.5	%
Income from bank-owned life insurance	330		540			(210		)	(38.9	)
Net gain (loss) on sale of:
Investment securities	184		418			(234		)	(56.0	)
Loans held for sale	463		159			304			191.2
Other real estate owned	10		(47		)	57			121.3
Other income	347		285			62			21.8
Total non-interest income	$	2,854	$	2,824		$	30		1.1

Deposit related fees include service charges, card-based fees, and other fees related to deposit accounts. Deposit related fees increased during the year due to a modest increase in card-based fees due to the success of the High Performance Checking ( HPC ) program in growing the number of checking accounts in a younger demographic that is more inclined to debit card usage. Income from bank-owned life insurance during the first quarter of 2013 decreased from the comparable 2012 period due to $218,000 received from the death of an insured during the first quarter of 2013 compared to $378,000 received from the death of an insured during the first quarter of 2012. The decrease in net gains on sales of investment securities was primarily due to a decrease in the amount of securities sold during the first quarter of 2013 compared to the 2012 period. The increase in gains on sales of loans held for sale was related to our expanded residential loan origination and mortgage banking activities.

Non-Interest Expense

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



	Three Months Ended March 31,
	2013		2012		$ Change			% Change
	(Dollars in thousands)
Compensation and mandatory benefits	$	3,752	$	4,003	$	(251	)	(6.3	)%
Retirement and stock related compensation	237		272		(35		)	(12.9	)
Medical and life benefits	360		425		(65		)	(15.3	)
Other employee benefits	21		13		8			61.5
Subtotal compensation and employee benefits	4,370		4,713		(343		)	(7.3	)
Net occupancy expense	694		708		(14		)	(2.0	)
Data processing	513		438		75			17.1
FDIC insurance premiums and regulatory assessments	481		488		(7		)	(1.4	)
Furniture and equipment expense	403		457		(54		)	(11.8	)
Professional fees	328		253		75			29.6
Marketing	269		404		(135		)	(33.4	)
Other real estate owned related expense, net	250		618		(368		)	(59.5	)
Loan collection expense	133		118		15			12.7
Severance and early retirement expense	—		876		(876		)	(100.0	)
Other general and administrative expenses	1,014		1,134		(120		)	(10.6	)
Total non-interest expense	$	8,455	$	10,207	$	(1,752	)	(17.2	)

Total non-interest expense decreased $1.8 million , or 17.2% , for the three months ended March 31, 2013 from the comparable 2012 period as we continue to make progress in reducing our cost structure. Compensation and employee benefits expense decreased for the three months ended March 31, 2013 from the 2012 period primarily due to a 4.0% decrease in the number of FTE employees to 262 at March 31, 2013 from 273 at March 31, 2012 , which was a result of our VERO program, branch closings, and outsourcing during the first quarter of 2012. In addition, medical and life benefits were lower during the 2013 period due to lower self-insurance claims. Marketing expense decreased during 2013 due to the absence of the start-up costs related to the implementation of the HPC program during the first quarter of 2012. Other real estate owned expense decreased due to lower holding costs, including real estate taxes, attorney fees, maintenance expense, and management fees, during the first quarter of 2013. Severance and early retirement expense during the first quarter of 2012 was related to the previously mentioned VERO program, branch closings, and outsourcing.

Income Tax Expense

Income tax expense for the three months ended March 31, 2013 totaled $588,000 , which was equal to an effective tax rate of 28.1% , and increased from the 2012 period due to an increase in pre-tax income combined with the deferred tax asset valuation allowance recorded totaling $166,000 for the 2012 period.

Changes in Financial Condition

Our total assets increased modestly to $1.15 billion at March 31, 2013 from $1.14 billion at December 31, 2012 with higher levels of cash and investment securities offset by lower loan balances.



	March 31, 2013		December 31, 2012		$ Change			% Change
	(Dollars in thousands)
Assets:
Cash and cash equivalents	$	154,240	$	134,699	$	19,541		14.5	%
Investment securities available-for-sale, at fair value	220,196		203,290		16,906			8.3
Investment securities held-to-maturity, at cost	14,981		15,458		(477		)	(3.1	)
Loans receivable, net of deferred fees	652,284		680,082		(27,798		)	(4.1	)
Federal Home Loan Bank stock, at cost	6,188		6,188		—			—
Bank-owned life insurance	36,233		36,604		(371		)	(1.0	)
Other real estate owned	23,698		23,347		351			1.5
Other	38,548		38,441		107			.3
Total assets	$	1,146,368	$	1,138,109	$	8,259		.7

Liabilities and Shareholders’ Equity:
Deposits	$	974,328	$	965,791	$	8,537		.9	%
Borrowed funds	49,828		50,562		(734		)	(1.5	)
Other	9,435		9,934		(499		)	(5.0	)
Total liabilities	1,033,591		1,026,287		7,304			.7
Shareholders’ equity	112,777		111,822		955			.9
Total liabilities and shareholders’ equity	$	1,146,368	$	1,138,109	$	8,259		.7

Loans Receivable

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



	March 31, 2013					December 31, 2012
	Amount			% of Total		Amount			% of Total		% Change
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	91,649		13.8	%	$	102,628		14.8	%	(10.7	)%
Commercial real estate:
Owner occupied	99,030			14.9		98,046			14.2		1.0
Non-owner occupied	159,414			24.0		164,392			23.7		(3.0	)
Multifamily	71,630			10.8		75,228			10.9		(4.8	)
Commercial construction and land development	15,335			2.3		20,228			2.9		(24.2	)
Commercial participations	5,137			.8		5,311			.8		(3.3	)
Total commercial loans	442,195			66.6		465,833			67.3		(5.1	)
Retail loans:
One-to-four family residential	172,540			25.9		175,943			25.4		(1.9	)
Home equity lines of credit	45,616			6.9		46,477			6.7		(1.9	)
Retail construction	1,370			.2		1,176			.2		16.5
Consumer	3,025			.5		3,305			.5		(8.5	)
Total retail loans	222,551			33.5		226,901			32.8		(1.9	)
Total loans receivable	664,746			100.1		692,734			100.1		(4.0	)
Net deferred loan fees	(438		)	(.1	)	(467		)	(.1	)	(6.2	)
Total loans receivable, net of deferred loan fees	$	664,308		100.0	%	$	692,267		100.0	%	(4.0	)

Total loans receivable, net of deferred loan fees decreased $28.0 million, or 4.0%, at March 31, 2013 from December 31, 2012 primarily due to loan payoffs and repayments totaling $26.6 million, including $10.8 million of lower commercial and industrial line net paydowns, sales of one-to-four family loans totaling $11.7 million, transfers to other real estate owned totaling $2.2 million and gross loan charge-offs totaling $878,000. Partially offsetting these decreases, loan fundings during the three months ended March 31, 2013 totaled $12.8 million, down 70.5% from $43.5 million for the three months ended December 31, 2012. The decrease in loan fundings is primarily due to the competitive market for loans as well as the decrease in commercial lines of credit of usage.

Commercial and industrial loans decreased $11.0 million, or 10.7%, during the first quarter of 2013 due to the net paydowns of $10.8 million mentioned above. In addition, non-owner occupied commercial real estate loans decreased $5.0 million, or 3.0%, primarily due to four large loan payoffs totaling $4.1 million, transfers to other real estate owned totaling $649,000, and gross loan charge-offs of $435,000. Multifamily loans decreased $3.6 million, or 4.8%, due to two loan payoffs totaling $1.3 million and transfers to other real estate owned totaling $1.4 million. Commercial construction and land development loans decreased $4.9 million, or 24.2%, due to a $4.0 million loan completing the construction phase and transferring to an amortizing owner-occupied commercial real estate loan.

As more fully discussed in our Annual Report on Form 10-K for the year ended December 31, 2012 , we began a shift in mid-2007 to diversify our loan portfolio to reduce our focus on commercial real estate lending, including non-owner occupied, commercial construction and land development, and purchased participation and syndication loans. We have identified and segregated the remaining credit risk related to our deemphasized loan categories that were originated prior to our current risk tolerances, credit policy, and underwriting standards, by segregating our loan portfolio based upon each loan’s initial origination date. Loans that were renewed or modified subsequent to their initial origination are included for disclosure purposes based on their initial loan origination date. The categories of the loan portfolio that we continue to focus on growing, which are commercial and industrial and commercial real estate owner occupied and multifamily, comprised 59.3% of the commercial loan portfolio at March 31, 2013 compared to 59.2% at December 31, 2012 and 54.5% at March 31, 2012 . Over 84% of the loans outstanding at March 31, 2013 in these growth categories were originated after January 1, 2008 ( Post-1/1/08 ). During the first quarter of 2013 , these targeted growth categories decreased by $13.6 million due to $21.9 million in loan repayments which were partially offset by $6.4 million in new fundings. At March 31, 2013 , our total commercial loans outstanding originated prior to January 1, 2008 ( Pre-1/1/08 ) decreased $12.7 million, or 8.3%, to $139.8 million , or 31.6% of our total commercial loan portfolio primarily due to normal amortization, charge-offs, and repayments.

The following tables present the categories of our commercial loan portfolio at the dates indicated segregated by the origination date of the lending relationship, and highlights the shift in our lending focus to those growth categories in accordance with our strategic plan:



	March 31, 2013
	Pre-1/1/08 Loans		Post-1/1/08 Loans		Total		% of Pre-1/1/08 to Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	4,920	$	86,729	$	91,649	5.4	%
Commercial real estate:
Owner occupied	29,927		69,103		99,030		30.2
Non-owner occupied	93,467		65,947		159,414		58.6
Multifamily	5,261		66,369		71,630		7.3
Commercial construction and land development	2,387		12,948		15,335		15.6
Commercial participations	3,800		1,337		5,137		74.0
Total commercial loans	$	139,762	$	302,433	$	442,195	31.6



	December 31, 2012
	Pre-1/1/08 Loans		Post-1/1/08 Loans		Total		% of Pre-1/1/08 to Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	7,233	$	95,395	$	102,628	7.0	%
Commercial real estate:
Owner occupied	34,193		63,853		98,046		34.9
Non-owner occupied	97,019		67,373		164,392		59.0
Multifamily	6,704		68,524		75,228		8.9
Commercial construction and land development	3,316		16,912		20,228		16.4
Commercial participations	3,973		1,338		5,311		74.8
Total commercial loans	$	152,438	$	313,395	$	465,833	32.7

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



	March 31, 2013				December 31, 2012
	Amount		% of Total		Amount		% of Total		% Change
	(Dollars in thousands)
Commercial and industrial	$	1,320	25.7	%	$	1,333	25.1	%	(1.0	)%
Commercial real estate:
Owner occupied	95		1.8		97		1.8		(2.1	)
Non-owner occupied	3,477		67.7		3,636		68.5		(4.4	)
Commercial construction and land development	245		4.8		245		4.6		—
Total commercial participations	$	5,137	100.0	%	$	5,311	100.0	%	(3.3	)



	March 31, 2013				December 31, 2012
	Amount		% of Total		Amount		% of Total		% Change
	(Dollars in thousands)
Illinois	$	1,079	21.0	%	$	1,085	20.4	%	(.6	)%
Indiana	522		10.2		530		10.0		(1.5	)
Michigan	1,241		24.1		1,241		23.4		—
Florida	245		4.8		245		4.6		—
Colorado	788		15.3		909		17.1		(13.3	)
Texas	1,262		24.6		1,301		24.5		(3.0	)
Total commercial participations	$	5,137	100.0	%	$	5,311	100.0	%	(3.3	)

Asset Quality and Allowance for Loan Losses

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



	March 31, 2013			December 31, 2012
	(Dollars in thousands)
Non-performing loans:
Commercial loans:
Commercial and industrial	$	1,532		$	449
Commercial real estate:
Owner occupied	5,484			5,417
Non-owner occupied	7,698			9,083
Multifamily	1,314			2,775
Commercial construction and land development	2,357			2,366
Commercial participations	339			339
Total commercial loans	18,724			20,429
Retail loans:
One-to-four family residential	5,557			5,671
Home equity lines of credit	675			683
Retail construction	85			150
Consumer	7			—
Total retail loans	6,324			6,504
Total non-performing loans	25,048			26,933

Other real estate owned:
Commercial	22,793			22,595
Retail	905			752
Total other real estate owned	23,698			23,347
Total non-performing assets	48,746			50,280

90 days past due loans still accruing interest	917			—
Total non-performing assets plus 90 days past due loans still accruing interest	$	49,663		$	50,280

Accruing troubled debt restructurings	$	7,332		$	17,616

Non-performing assets to total assets	4.25		%	4.42		%
Non-performing loans to total loans, net of deferred fees	3.77			3.89

Total non-performing loans decreased $1.9 million , or 7.0% , to $25.0 million at March 31, 2013 from $26.9 million at December 31, 2012 primarily due to the transfer to other real estate owned of one non-owner occupied and multifamily commercial real estate relationship totaling $2.1 million and the transfer out of non-accrual of five one-to-four family residential loans totaling $202,000. Non-performing loans also decreased due to repayments and payoffs totaling $839,000 and gross loan charge-offs totaling $878,000. These decreases were partially offset by new non-performing loans totaling $2.0 million, including one commercial and industrial and owner occupied commercial real estate relationship totaling $1.4 million. Of the total non-performing loans at March 31, 2013 , $5.9 million , or 23.4% were current and performing in accordance with their loan agreements.

The additional disclosure required with respect to impaired loans and troubled debt restructurings is contained in “Note 5. Allowance for Loan Losses” in the notes to the condensed consolidated financial statements in “Item 1. Financial Statements” of this Quarterly Report on Form 10-Q.

Included in the non-performing loan totals are non-performing syndications and purchased participations as identified by loan category and states in the following table:



	March 31, 2013			December 31, 2012			% change
	(Dollars in thousands)
Commercial real estate – non-owner occupied	93			93			—	%
Commercial construction and land development	246			246			—
Total non-performing commercial participations	$	339		$	339		—

Indiana	93			93			—	%
Florida	246			246			—
Total non-performing commercial participations	$	339		$	339		—

Percentage of total non-performing loans	1.35		%	1.26		%
Percentage of total commercial participations	6.60			6.38

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



	March 31, 2013
	Unpaid Principal Balance		Partial Charge- offs to Date		Interest Paid to Principal		Recorded Investment		Related Allowance		Recorded Investment less Related Allowance		Recorded Investment as a % of Unpaid Principal
	(Dollars in thousands)
Non-performing loans:
Commercial loans:
Commercial and industrial	$	2,115	$	501	$	82	$	1,532	$	—	$	1,532	72.4	%
Commercial real estate:
Owner occupied	7,695		2,034		177		5,484		54		5,430		71.3
Non-owner occupied	9,778		1,688		392		7,698		217		7,481		78.7
Multifamily	1,809		377		118		1,314		—		1,314		72.6
Commercial construction and land development	2,467		61		49		2,357		215		2,142		95.5
Commercial participations	5,583		5,103		141		339		—		339		6.1
Total commercial loans	29,447		9,764		959		18,724		486		18,238		63.6
Retail loans:
One-to-four family residential	5,704		147		—		5,557		—		5,557		97.4
Home equity lines of credit	804		129		—		675		—		675		84.0
Retail construction	150		65		—		85		—		85		56.7
Consumer	9		2		—		7		—		7		77.8
Total retail loans	6,667		343		—		6,324		—		6,324		94.9
Total non-performing loans	$	36,114	$	10,107	$	959	$	25,048	$	486	$	24,562	69.4



	December 31, 2012
	Unpaid Principal Balance		Partial Charge- offs to Date		Interest Paid to Principal		Recorded Investment		Related Allowance		Recorded Investment less Related Allowance		Recorded Investment as a % of Unpaid Principal
	(Dollars in thousands)
Non-performing loans:
Commercial loans:
Commercial and industrial	$	946	$	423	$	74	$	449	$	—	$	449	47.5	%
Commercial real estate:
Owner occupied	9,262		3,160		685		5,417		—		5,417		58.5
Non-owner occupied	11,184		1,740		361		9,083		217		8,866		81.2
Multifamily	3,403		532		96		2,775		—		2,775		81.5
Commercial construction and land development	2,467		61		40		2,366		180		2,186		95.9
Commercial participations	5,583		5,103		141		339		—		339		6.1
Total commercial loans	32,845		11,019		1,397		20,429		397		20,032		62.2
Retail loans:
One-to-four family residential	5,836		165		—		5,671		—		5,671		97.2
Home equity lines of credit	778		95		—		683		—		683		87.8
Retail construction	150		—		—		150		—		150		100.0
Total retail loans	6,764		260		—		6,504		—		6,504		96.2
Total non-performing loans	$	39,609	$	11,279	$	1,397	$	26,933	$	397	$	26,536	68.0

Non-performing assets decreased to $48.7 million at March 31, 2013 from $50.3 million at December 31, 2012 primarily due to the aforementioned decreases in non-performing loans. The activity for the three months ended March 31, 2013 for our other real estate owned is set forth in the following table:



	Three Months Ended March 31, 2013
	(Dollars in thousands)
Balance at beginning of period	$	23,347
Transfers to other real estate owned	2,222
Net repayments and improvements of properties	(26		)
Sales of other real estate owned	(1,737		)
Valuation allowances recorded for declines in net realizable value	(108		)
Balance at end of period	$	23,698

The following table identifies our other real estate owned properties based on the loan category in which they were originated:



	March 31, 2013		December 31, 2012		% Change
	(Dollars in thousands)
Commercial loans:
Commercial real estate:
Non-owner occupied	$	8,294	$	7,950	4.3	%
Multifamily	1,715		340		404.4
Commercial construction and land development	6,285		7,416		(15.3	)
Commercial participations:
Commercial real estate – non-owner occupied	2,361		2,361		—
Commercial construction and land development	4,138		4,528		(8.6	)
Total commercial loans	22,793		22,595		.9
Retail loans:
One-to-four family residential	653		500		30.6
Home equity lines of credit	63		63		—
Retail construction	189		189		—
Total retail loans	905		752		20.3
Total other real estate owned	$	23,698	$	23,347	1.5

The increase in the multifamily other real estate owned properties was primarily due to the transfer of four multifamily properties from one owner occupied and multifamily commercial real estate loan relationship totaling $1.4 million.

As more fully discussed in our Annual Report on Form 10-K for the year ended December 31, 2012, we believe that our loans that were originated Pre-1/1/08 have a higher degree of risk of loss due to the nature of the types of these loans and the credit environment under which they were originated, particularly given the downturn in the economic environment over the last six years. Since January 1, 2008, $50.6 million, or 92.2%, of total commercial charge-offs were from the Pre-1/1/08 portfolio. The following tables illustrate that a large portion of our non-performing loans and other real estate owned were originated Pre-1/1/08 and that we have experienced a significantly higher level of charge-offs and other real estate owned writedowns in the Pre-1/1/08 portfolios. As presented in the following tables, 56.5% of our non-performing commercial loans and 89.8% of our commercial other real estate owned portfolio at March 31, 2013 were originated Pre-1/1/08:



	March 31, 2013
	Pre-1/1/08 Loans			Post-1/1/08 Loans			Total			% of Pre-1/1/08 to Total
	(Dollars in thousands)
Non-performing commercial loans:
Commercial and industrial	$	385		$	1,147		$	1,532		25.1	%
Commercial real estate:
Owner occupied	3,770			1,714			5,484			68.7
Non-owner occupied	5,308			2,390			7,698			69.0
Multifamily	64			1,250			1,314			4.9
Commercial construction and land development	706			1,651			2,357			30.0
Commercial participations	339			—			339			100.0
Total non-performing commercial loans	$	10,572		$	8,152		$	18,724		56.5

Total commercial loans outstanding at March 31, 2013	$	139,762		$	302,433		$	442,195
Non-performing commercial loans to total commercial loans	7.56		%	2.70		%	4.23		%



	March 31, 2013
	Pre-1/1/08 Loans		Post-1/1/08 Loans		Total		% of Pre-1/1/08 to Total
	(Dollars in thousands)
Other real estate owned – commercial:
Commercial real estate:
Non-owner occupied	$	7,078	$	1,216	$	8,294	85.3	%
Multifamily	599		1,116		1,715		34.9
Commercial construction and land development	6,285		—		6,285		100.0
Commercial participations:
Commercial real estate – non-owner occupied	2,361		—		2,361		100.0
Commercial construction and land development	4,138		—		4,138		100.0
Total other real estate owned – commercial	$	20,461	$	2,332	$	22,793	89.8

During the first quarter of 2013, we recorded gross loan charge-offs and other real estate owned writedowns related to our commercial loan portfolio totaling $687,000 , of which $234,000 , or 34.1% , were related to loans originated Pre-1/1/08. The breakdown of gross charge-offs of commercial loans and other real estate owned writedowns on commercial properties are identified in the following table:



	Three Months Ended March 31, 2013
	Pre-1/1/08 Loans		Post-1/1/08 Loans		Total		% of Pre-1/1/08 to Total
	(Dollars in thousands)
Commercial loan charge-offs:
Commercial and industrial	$	—	$	80	$	80	—	%
Commercial real estate:
Non-owner occupied	132		303		435		30.3
Multifamily	—		70		70		—
Total commercial loan charge-offs	132		453		585		22.6

Writedowns on other real estate owned – commercial properties:
Commercial real estate:
Non-owner occupied	57		—		57		100.0
Multifamily	39		—		39		100.0
Commercial construction and land development	6		—		6		100.0
Total writedowns on other real estate owned – commercial properties	102		—		102		100.0
Total commercial loan charge-offs and writedowns on other real estate owned	$	234	$	453	$	687	34.1

Potential Problem Assets. Potential problem assets, defined as loans classified substandard pursuant to our internal loan grading system that do not meet the definition of a non-performing loan, increased to $22.1 million at March 31, 2013 from $5.7 million at December 31, 2012 . This increase is due to the substandard classification of one non-owner occupied commercial real estate relationship totaling $13.2 million, one commercial and industrial loan relationship totaling $4.5 million, one commercial and industrial relationship totaling $1.1 million, and one owner occupied commercial real estate relationship totaling $249,000. These loan relationships were classified as substandard due to changes in the borrowers’ financial condition and all but the commercial and industrial relationship were current at March 31, 2013. Partially offsetting these increases is the transfer to non-accrual status of one owner occupied commercial real estate and commercial and industrial loan relationship totaling $1.4 million and three retail loans totaling $289,000, all of which were previously considered potential problem assets. In addition, a non-owner occupied commercial real estate previous potential problem asset totaling $933,000 was repaid in full during the first quarter of 2013.

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



	Three Months Ended March 31,
	2013			2012
	(Dollars in thousands)
Balance at beginning of period	$	12,185		$	12,424
Loan charge-offs:
Current period loan charge-offs	(878		)	(1,041		)
Previously established specific reserves	—			(718		)
Total loan charge-offs	(878		)	(1,759		)
Recoveries of loans previously charged-off	207			53
Net loan charge-offs	(671		)	(1,706		)
Provision for loan losses	510			1,050
Balance at end of period	$	12,024		$	11,768



	March 31, 2013			December 31, 2012			March 31, 2012
	(Dollars in thousands)
Allowance for loan losses	$	12,024		$	12,185		$	11,768
Total loans receivable, net of unearned fees	664,308			692,267			706,938
Allowance for loan losses to total loans	1.81		%	1.76		%	1.66		%
Allowance for loan losses to non-performing loans	48.00			45.24			25.43
Ratio of net loans charged-off to average loans outstanding for the quarter ended, annualized	.40			.58			.97

The allowance for loan losses decreased modestly to $12.0 million at March 31, 2013 from $12.2 million at December 31, 2012 and increased 2.2% from $11.8 million at March 31, 2012 . The ratio of the allowance for loan losses to total loans increased to 1.81% at March 31, 2013 from 1.76% at December 31, 2012 and from 1.66% at March 31, 2012 primarily due to the decrease in total loans.

The provision for loan losses decreased 51.4% to $510,000 for the first quarter of 2013 from $1.1 million for the comparable 2012 period primarily due to the lower level of charge-offs combined with $207,000 of loan loss recoveries received during the first quarter of 2013. Total recoveries during the quarter included $98,000 of a previous $266,000 charge-off recorded in 2009 on a non-owner occupied commercial real estate loan.

When we determine that a non-performing collateral-dependent loan has a collateral shortfall, we will immediately charge-off the collateral shortfall. As a result, we are not required to maintain an allowance for loan losses on these loans as the loan balance has already been written down to its net realizable value (fair value less estimated costs to sell the collateral). As such, the ratio of the allowance for loan losses to total loans and the ratio of the allowance for loan losses to non-performing loans has continued to be negatively affected by cumulative partial charge-offs of $9.3 million recorded through March 31, 2013 on $9.4 million (net of charge-offs) of non-performing collateral-dependent loans. At March 31, 2013 , the ratio of the allowance for loan losses to non-performing loans, excluding the $9.4 million of non-performing collateral-dependent loans with partial charge-offs, was 76.9%.

Investment Securities

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

We adjust the size and composition of our investment securities portfolio according to a number of factors including expected loan and deposit growth, the interest rate environment, and projected liquidity. The amortized cost of investment securities and their fair values were as follows at the dates indicated:



	March 31, 2013
	Par Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
Available-for-sale investment securities:
U.S. Treasury securities	$	32,000	$	32,408	$	414	$	(4	)	$	32,818
Government sponsored entity ( GSE ) securities	45,000		45,592		726		(1		)	46,317
Collateralized mortgage obligations	69,345		65,437		3,439		(20		)	68,856
Commercial mortgage-backed securities	45,417		46,237		1,042		(1		)	47,278
GSE residential mortgage-backed securities	2,213		2,385		—		(69		)	2,316
Asset backed securities	3,995		3,721		254		—			3,975
Pooled trust preferred securities	23,673		21,701		—		(3,065		)	18,636
Total available-for-sale investment securities	$	221,643	$	217,481	$	5,875	$	(3,160	)	$	220,196

Held-to-maturity investment securities:
Asset backed securities	$	5,995	$	6,101	$	187	$	—		$	6,288
Municipal securities	8,880		8,880		54		—			8,934
Total held-to-maturity investment securities	$	14,875	$	14,981	$	241	$	—		$	15,222



	December 31, 2012
	Par Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
Available-for-sale investment securities:
U.S. Treasury securities	$	17,000	$	16,964	$	405	$	(6	)	$	17,363
Government sponsored entity ( GSE ) securities	45,000		45,628		848		(8		)	46,468
Collateralized mortgage obligations	67,902		63,367		3,735		(36		)	67,066
Commercial mortgage-backed securities	44,267		45,178		1,251		—			46,429
GSE residential mortgage-backed securities	2,224		2,400		—		(32		)	2,368
Asset backed securities	4,182		3,876		177		—			4,053
Pooled trust preferred securities	24,508		22,409		—		(2,867		)	19,542
GSE preferred stock	200		—		1		—			1
Total available-for-sale investment securities	$	205,283	$	199,822	$	6,417	$	(2,949	)	$	203,290

Held-to-maturity investment securities:
Asset backed securities	$	6,446	$	6,578	$	219	$	—		$	6,797
Municipal securities	8,880		8,880		45		—			8,925
Total held-to-maturity investment securities	$	15,326	$	15,458	$	264	$	—		$	15,722

At March 31, 2013, the amortized cost of our collateralized mortgage obligation portfolio totaled $65.4 million, with 82% of the portfolio maintaining a lowest credit rating of A or higher. The composition of this portfolio includes $11.2 million backed by Ginnie Mae and $54.2 million of non-agency securities mainly backed by both floating- and fixed-rate residential mortgages originated prior to 2006. In addition, $57.2 million within this portfolio are floating-rate bonds indexed to 30 day LIBOR with unaccreted discounts totaling $3.9 million at March 31, 2013.

Our commercial mortgage-backed investment securities portfolio consists mainly of short-term, fixed-rate, senior tranches of seasoned issues with extensive subordination and limited balloon risk. All bonds in this portfolio are AAA-rated.

All of our pooled trust preferred investments were AAA-rated when they were purchased in late 2007 and early 2008 at discounts in excess of 10%. In 2009, the market for this type of investment was severely impacted by the credit crisis leading to increased deferrals and defaults. Credit ratings were also negatively affected in 2009, and all of these securities in our portfolio have at least one rating below investment grade. Rating agencies have started to note the improving collateral statistics, limited number of new deferrals, number of cures, lack of defaults, and rapidly increasing redemptions and coverage ratios. Additionally, rating agencies are increasingly analyzing deferring issuers for probability of default instead of treating all, or nearly all, deferring issuers as defaulted issuers. All of the Bank’s holdings received ratings upgrades by at least one rating agency in 2012. Two of our investments, representing approximately 46% of our total pooled trust preferred investments, currently have composite investment-grade ratings.

We utilize extensive external and internal analysis on the pooled trust preferred investments. Our internal model stress tests all underlying issuers in the pools to project probabilities of deferral or default. Management’s internal modeling runs multiple stress scenarios. The high-stress scenario utilizes immediate defaults for all deferring collateral. Any collateral that management believes may be at risk for deferring or defaulting, based upon its review of the underlying issuers’ most recent financial and regulatory information, is assumed to default immediately. Despite a recent trend of recoveries from previously defaulted trust preferred collateral, the high-stress scenario assumes no recoveries on defaulted collateral. All external and internal stress testing at March 31, 2013 currently projects no loss of principal or interest on any of our pooled trust preferred investments.

All of our pooled trust preferred investments are floating rate “Super Senior” tranches indexed to 90 day LIBOR with unaccreted discounts of $2.0 million at March 31, 2013. The “Super Senior” tranches are the most senior tranches. Due to the structure of the securities, as deferrals and defaults on the underlying collateral increase, cash flows are increasingly diverted from mezzanine and subordinate tranches to pay down principal on the “Super Senior” tranches. If certain senior coverage tests are not met, all interest is diverted from subordinate classes to pay down principal on the “Super Senior” tranche. Four of the five issues we own are failing the senior coverage test. This test is structured to protect the holders of the “Super Senior” tranches if deferrals or defaults exceed a specific threshold as a percent of the outstanding senior tranches. As such, the proceeds of any early redemptions, successful tenders, or cures will be used to further pay down principal of the “Super Senior” tranches on these issues. In the first quarter of 2013, the annualized principal pay down rate on these investments was 13.6% and has averaged 12.0% for the past four quarters. Management expects additional cure and redemption announcements in the near term.

A number of previously deferring issuers of our pooled trust preferred investments are resuming payments. At March 31, 2013, 11.0% of these issuers “cured,” or resumed payments since the beginning of 2013. When an issuer cures, all past due interest and accrued interest on the past due interest is paid to the trust.

Management is expecting redemption activity to remain strong over the near term as call windows are now open on all of the securities, certain issuers evaluate the impact of Dodd-Frank changes to Tier 1 capital treatment for these securities, and issuers consider the high cost of this capital in the current low interest rate environment.

Due to the current ratings on the pooled trust preferred investments being below investment grade, the aggregate amortized cost of $21.7 million is classified as substandard in accordance with regulatory requirements.

Deposits

The following table sets forth the dollar amount of deposits and the percentage of total deposits in each category offered at the dates indicated:



	March 31, 2013				December 31, 2012
	Amount		% of Total		Amount		% of Total		% Change
	(Dollars in thousands)
Checking accounts:
Non-interest bearing	$	114,897	11.8	%	$	107,670	11.1	%	6.7	%
Interest-bearing	192,051		19.7		185,388		19.2		3.6
Money market accounts	183,766		18.9		182,001		18.9		1.0
Savings accounts	159,633		16.4		153,799		15.9		3.8
Core deposits	650,347		66.8		628,858		65.1		3.4
Certificates of deposit accounts	323,981		33.2		336,933		34.9		(3.8	)
Total deposits	$	974,328	100.0	%	$	965,791	100.0	%	.9

Total deposits increased $8.5 million , or .9% , to $974.3 million at March 31, 2013 from $965.8 million at December 31, 2012 . This increase was primarily due to a $21.5 million , or 3.4% , increase in core deposits partially offset by a $13.0 million , or 3.8% , decrease in certificates of deposit.

We continue to make progress on our strategic initiative to grow low-cost core deposits. Our HPC program targets both retail and business clients. This direct mail marketing program represents a redirection and expansion of our marketing expense and is designed to attract a younger demographic, enhance growth in core deposits and related fee income, and provide additional cross-selling opportunities. Core deposits also benefited during the first quarter of 2013 due in part to our disciplined pricing strategies which led to clients moving maturing certificates of deposit into money market and savings accounts due to the current low interest rate environment.

In addition, we offer a repurchase sweep agreement ( Repo Sweep ) account which allows public entities and other business depositors to earn interest with respect to checking and savings deposit products offered. The depositor’s excess funds are swept from a deposit account and are used to purchase an interest in investment securities that we own. The swept funds are not recorded as deposits and instead are classified as other short-term borrowed funds which generally provide a lower-cost funding alternative to FHLB advances. At March 31, 2013 , we had $10.4 million in Repo Sweeps compared to $11.1 million at December 31, 2012 . The Repo Sweeps are included in the table under “ Borrowed Funds ” and are treated as financings, and the obligations to repurchase investment securities sold are reflected as short-term borrowed funds. The investment securities underlying these Repo Sweeps continue to be reflected as assets.

Borrowed Funds

Borrowed funds consisted of the following at the dates indicated:



	March 31, 2013				December 31, 2012
	Amount		Weighted- Average Contractual Rate		Amount		Weighted- Average Contractual Rate
	(Dollars in thousands)
Advances from FHLB of Indianapolis:
Fixed rate advances due in:
2013	$	15,000	2.22	%	$	15,000	2.22	%
2014 (1)	1,038		6.71		1,038		6.71
2015	15,000		1.42		15,000		1.42
2018 (1)	2,360		5.54		2,360		5.54
2019 (1)	6,053		6.29		6,111		6.29
Total FHLB advances	39,451		2.86		39,509		2.86
Short-term variable-rate borrowed funds - Repo Sweep accounts	10,377		.10		11,053		.10
Total borrowed funds	$	49,828	2.28		$	50,562	2.26


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

At March 31, 2013 the Bank had a borrowing relationship with the Federal Reserve Bank (FRB) discount window. This line was not utilized during the three months ended March 31, 2013 or 2012.

Shareholders’ Equity

Shareholders’ equity at March 31, 2013 increased slightly to $112.8 million , or 9.84% of total assets, from $111.8 million , or 9.83% of total assets, at December 31, 2012 . The increase was primarily due to net income of $1.5 million for the period partially offset by a decrease in accumulated other comprehensive income, net of tax, of $443,000 and dividends declared of $109,000 .

Liquidity and Capital Resources

Liquidity, represented by cash and cash equivalents, is a product of operating, investing, and financing activities. Our primary sources of funds are:


•	deposits and Repo Sweeps;


•	scheduled payments of amortizing loans and mortgage-backed investment securities;


•	prepayments and maturities of outstanding loans and mortgage-backed investment securities;


•	maturities of investment securities and other short-term investments;


•	funds provided from operations;


•	federal funds line of credit; and


•	borrowed funds from the FHLB and FRB.

The Asset/Liability Management Committee is responsible for measuring and monitoring our liquidity profile. We manage our liquidity to ensure stable, reliable, and cost-effective sources of funds to satisfy demand for credit, deposit withdrawals, and investment opportunities. Our general approach to managing liquidity involves preparing a monthly “funding gap” report which forecasts cash inflows and outflows over various time horizons and rate scenarios to identify potential cash imbalances. We supplement our funding gap report with the monitoring of several liquidity ratios to assist in identifying any trends that may have an effect on available liquidity in future periods.

We maintain a contingency funding plan that outlines the process for addressing a liquidity crisis. The plan assigns specific roles and responsibilities for effectively managing liquidity through a problem period.

Scheduled payments from the amortization of loans, maturing investment securities, and short-term investments are relatively predictable sources of funds, while deposit flows and loan prepayments are greatly influenced by market interest rates, economic conditions, and competitive rate offerings.

At March 31, 2013 , we had cash and cash equivalents of $154.2 million , an increase of $19.5 million, or 14.5%, from $134.7 million at December 31, 2012 . The increase was mainly the result of proceeds received from repayments and prepayments of loans totaling $25.0 million; proceeds received from sales, maturities, and paydowns of investment securities totaling $11.4 million; and increases in deposit accounts totaling $8.5 million. The cash inflows were partially offset by cash outflows related to $28.2 million of investment securities purchases.

We use our sources of funds primarily to meet our ongoing commitments; to fund loan commitments, maturing certificates of deposit, and savings withdrawals; and to maintain an investment securities portfolio. We anticipate that we will continue to have sufficient funds to meet our current commitments.

The parent company’s liquidity needs consist primarily of operating expenses and dividend payments to shareholders. The primary sources of liquidity are cash and cash equivalents and dividends from the Bank. We are prohibited from repurchasing shares or incurring any debt at the parent company without the prior approval of the FRB under our informal regulatory agreement.

Additionally, the Bank requires the prior approval of the Office of the Comptroller of the Currency ( OCC ) before paying dividends to the Company. Absent such restriction, OCC regulations provide various standards under which the Bank may declare and pay dividends to the parent company without prior approval. The dividends from the Bank are limited to the extent of its cumulative earnings for the year plus the net earnings (adjusted by prior distributions) of the prior two calendar years. At March 31, 2013 , under current regulations, the Bank had no net earnings available for dividend declarations to the parent company. At March 31, 2013 , the parent company had $1.6 million in cash and cash equivalents. We do not anticipate that these restrictions will have a material adverse impact on our liquidity or ability to continue to pay dividends.

Contractual Obligations

The following table presents our contractual obligations to third parties at March 31, 2013 by maturity:



	Payments Due By Period
	One Year or less		Over One through Three Years		Over Three Through Five Years		Over Five Years		Total
	(Dollars in thousands)
Certificates of deposit	$	241,310	$	68,782	$	13,615	$	274	$	323,981
FHLB advances (1)	15,385		16,789		896		6,381		39,451
Short-term borrowed funds (2)	10,377		—		—		—		10,377
Service bureau contract	1,809		3,617		3,617		—		9,043
Operating leases	362		468		307		1,709		2,846
Dividends payable on common stock	109		—		—		—		109
	$	269,352	$	89,656	$	18,435	$	8,364	$	385,807


(1)	Does not include interest expense at the weighted-average contractual rate of 2.86% for the periods presented.


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

See the “ Borrowed Funds ” section for further discussion surrounding FHLB advances. The operating lease obligations reflected above include the future minimum rental payments, by year, required under the lease terms for premises and equipment. Many of these leases contain renewal options, and certain leases provide options to purchase the leased property during or at the expiration of the lease period at specific prices.

Off-Balance-Sheet Obligations

We are party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our clients. These financial instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the statement of condition. Our exposure to credit loss in the event of non-performance by the third-party to the financial instrument for commitments to extend credit and letters of credit is represented by the contractual notional amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments.

The following table details the amounts and expected maturities of significant commitments at March 31, 2013 :



	One Year or Less		Over One through Three Years		Over Three through Five Years		Over Five Years		Total
	(Dollars in thousands)
Commitments to extend credit:
Commercial and industrial	$	6,085	$	—	$	—	$	—	$	6,085
Commercial real estate:
Owner occupied	3,585		135		—		—		3,720
Non-owner occupied	4,571		—		—		—		4,571
Multifamily	3,494		21		—		—		3,515
Commercial construction and land development	1,797		—		—		—		1,797
Commercial participations	—		—		250		—		250
Retail	4,450		—		—		—		4,450
Commitments to fund unused:
Equity lines of credit	—		—		—		36,986		36,986
Commercial business lines	48,879		6,031		—		—		54,910
Construction loans	298		527		—		—		825
Consumer overdraft lines	125		—		—		—		125
Credit enhancements	2,075		—		4,249		8,512		14,836
Letters of credit	1,739		33		5		—		1,777
	$	77,098	$	6,747	$	4,504	$	45,498	$	133,847

The commitments listed above do not necessarily represent future cash requirements, in that these commitments often expire without being drawn upon. Credit enhancements expire at various dates through 2018. Letters of credit expire at various dates through 2016.

We also have commitments to fund community investments through investments in various limited partnerships, which represent future cash outlays for the construction and development of properties for low-income housing, small business real estate, and historic tax credit projects that qualify under the Community Reinvestment Act. These commitments include $376,000 to be funded over one year. The timing and amounts of these commitments are projected based upon the financing arrangements provided in each project’s partnership agreement, and could change due to variances in the construction schedule, project revisions, or the cancellation of the project. These commitments are not included in the commitment table above.

Credit enhancements are related to the issuance by municipalities of taxable and nontaxable revenue bonds. The proceeds from the sale of such bonds are loaned to for-profit and not-for-profit companies for economic development projects. In order for the bonds to receive AAA ratings, which provide for a lower interest rate, the FHLB issues, in favor of the bond trustee, an Irrevocable Direct Pay Letter of Credit ( IDPLOC ) for our account. Since we, in accordance with the terms and conditions of a Reimbursement Agreement with the FHLB, would be required to reimburse the FHLB for draws against the IDPLOC, these facilities are analyzed, appraised, secured by real estate mortgages, and monitored as if we had funded the project initially.

Regulatory Capital

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to quantitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios set forth in the below table of total risk-based, tangible, and core capital, as defined in the regulations. In addition, in accordance with its most recent examination, the OCC established higher individual minimum capital ratios for the Bank. Specifically, the Bank must maintain a Tier 1 capital to adjusted total assets ratio of at least 8% and a total risk-based capital to risk-weighted assets ratio of at least 12%. At March 31, 2013 and December 31, 2012, the Bank was deemed to be “well-capitalized” and in excess of the higher individual minimum capital requirements established for the Bank by the OCC.

The total amount of deferred tax assets not included for regulatory capital purposes was $8.6 million and $9.0 million , respectively, at March 31, 2013 and December 31, 2012 . Determining the amount of deferred tax assets included or excluded in periodic regulatory capital calculations requires significant judgment when assessing a number of factors. In assessing the amount of the deferred tax assets includable in capital, management considers a number of relevant factors including the amount of deferred tax assets dependent on future taxable income, the amount of taxes that could be recovered through loss carrybacks, the reversal of temporary book/tax differences, projected future taxable income within one year, available tax planning strategies, and OCC limitations. Using all information available to us at each statement of condition date, these factors are reviewed and can and do vary from period to period.

The current regulatory capital requirements and the actual capital levels of the Bank at March 31, 2013 and December 31, 2012 are presented in the following table. There are no conditions or events that have occurred since March 31, 2013 that management believes have changed the Bank’s category.



	Actual				For Capital Adequacy Purposes			To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Amount		Ratio	Amount		Ratio
	(Dollars in thousands)
At March 31, 2013:
Tangible capital to adjusted total assets	$	101,269	8.92	%	$	17,035	>= 1.5	$	22,713	>= 2.0
Tier 1 (core) capital to adjusted total assets	101,269		8.92		45,427		>= 4.0	56,784		>= 5.0
Tier 1 (core) capital to risk-weighted assets	101,269		13.61		29,772		>= 4.0	44,658		>= 6.0
Total risk-based capital to risk-weighted assets	110,607		14.86		59,544		>= 8.0	74,430		>= 10.0

At December 31, 2012:
Tangible capital to adjusted total assets	$	99,279	8.81	%	$	16,896	>= 1.5	$	22,527	>= 2.0
Tier 1 (core) capital to adjusted total assets	99,279		8.81		45,055		>= 4.0	56,319		>= 5.0
Tier 1 (core) capital to risk-weighted assets	99,279		12.81		31,008		>= 4.0	46,512		>= 6.0
Total risk-based capital to risk-weighted assets	109,000		14.06		62,016		>= 8.0	77,520		>= 10.0

The following table reflects the adjustments required to reconcile the Bank’s shareholders’ equity to the Bank’s regulatory capital at March 31, 2013 :



	Tangible			Core			Risk-Based
	(Dollars in thousands)
Shareholders’ equity of the Bank	$	112,374		$	112,374		$	112,374
Disallowed deferred tax asset	(8,599		)	(8,599		)	(8,599		)
Adjustment for unrealized gains on certain available-for-sale securities	(1,669		)	(1,669		)	(1,669		)
Other	(837		)	(837		)	(837		)
General allowance for loan losses	—			—			9,338
Regulatory capital of the Bank	$	101,269		$	101,269		$	110,607

Total adjusted assets for Tangible and Tier 1 (core) capital purposes	$	1,135,674		$	1,135,674
Total risk-weighted assets for risk-based capital purposes							$	744,301

The increase in the Bank’s regulatory capital ratios from December 31, 2012 is primarily a result of an increase in the Bank’s shareholders’ equity from net income for the three months ended March 31, 2013 combined with a decrease in total risk-weighted assets due to a decrease in 100% risk-weighted loans and an increase in 0% risk-weighted U.S. Treasury securities.

In June 2012, the FRB and other federal banking agencies issued three joint notices of proposed rulemakings ( Basel III ) that would revise each agency’s risk-based and leverage capital requirements consistent with agreements reached by the Basel Committee on Banking Supervision, including implementation of a new common equity Tier 1 minimum capital requirement and a higher minimum Tier 1 capital requirement. In addition, the Basel III rulemakings propose to apply limits on a binding organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a specified “buffer” of common equity Tier 1 capital in addition to the minimum risk-based capital requirements. The Basel III rulemakings also would revise the agencies’ prompt corrective action framework by incorporating the new regulatory capital minimums and updating the definition of tangible common equity. Until the Basel III rulemakings are finalized, we cannot predict the impact that such proposals, once implemented, would have upon the financial condition or results of operations of the Company or the Bank.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Our primary market risk is considered to be interest rate risk. Interest rate risk on our balance sheet arises from the maturity mismatch of interest-earning assets versus interest-bearing liabilities, as well as the potential for maturities to shorten or lengthen on our interest-earning assets, and to a lesser extent on our interest-bearing liabilities due to the exercise of options. The most common of these are prepayment options on mortgage loans and commercial mortgage-backed securities, and to a lesser extent rate jump features in certain of our certificates of deposit. Management’s goal, through policies established by the Asset/Liability Management Committee of the Bank’s Board of Directors ( ALCO ), is to maximize net interest income while achieving adequate returns on equity capital and managing our balance sheet within the established interest rate risk policy limits prescribed by the ALCO.

We maintain a comprehensive integrated Asset/Liability Management Policy that establishes written guidelines for the asset/liability management function, including the management of net interest margin, interest rate risk, investment security purchases, liquidity, and contingency funding plans. The Asset/Liability Management Policy falls under the authority of the Board of Directors which in turn assigns its formulation, revision, and administration to the ALCO. The ALCO schedules monthly meetings and consists of certain senior officers and one outside director. The results of the meetings are reported to the Board of Directors. The primary duties of the ALCO are to develop reports and establish procedures to measure and monitor interest rate risk, verify compliance with Board approved interest rate risk tolerance limits, take appropriate actions to mitigate those risks, monitor and discuss the status and results of implemented strategies and tactics, monitor our capital position, review the current and prospective liquidity positions, and monitor alternative funding sources. The policy requires management to measure overall interest rate risk exposure using Net Present Value analysis and net interest income-at-risk analysis.

We use Net Portfolio Value Analysis as the primary measurement of our interest rate risk. We measure our interest rate risk assuming various increases and decreases in general interest rates and their effect on our market value of portfolio equity. The Board of Directors has established limits to changes in Net Portfolio Value ( NPV ), (including limits regarding the change in net interest income discussed below), across a range of hypothetical interest rate changes. If estimated changes to NPV and net interest income are not within these limits, the Board may direct management to adjust its asset/liability mix to bring its interest rate risk within Board limits. NPV is computed as the difference between the market value of assets and the market value of liabilities, adjusted for the value of off-balance-sheet items.

At March 31, 2013, we are reporting interest rate risk ( IRR ) results based on output from our internal IRR model implemented during 2012. The goals of bringing the third-party IRR model in-house were: to increase the ability to model multiple scenarios and on a more timely basis; to improve securities cash flow projections and shocked economic values for securities; and to allow for improved modeling for rate caps and floors on individual loans, investments, or deposits.

NPV measures our IRR by calculating the estimated change in NPV of our cash flows from interest-sensitive assets and liabilities, as well as certain off-balance-sheet items, in the event of a shock in interest rates ranging down 100 to up 300 basis points. The following table shows the change in NPV applying the various instantaneous rate shocks to the Bank’s interest-earning assets and interest-bearing liabilities as of March 31, 2013 and December 31, 2012 :



		Net Portfolio Value
		At March 31, 2013							At December 31, 2012
		$ Amount		$ Change			% Change		$ Amount		$ Change			% Change
		(Dollars in thousands)
Assumed Change in Interest Rates (Basis Points):
+	300	$	133,389	$	8,654		6.9	%	$	128,789	$	7,244		6.0	%
+	200	132,581		7,846			6.3		127,834		6,289			5.2
+	100	128,904		4,169			3.3		125,419		3,874			3.2
	0	124,735		—			—		121,545		—			—
-	100	120,012		(4,723		)	(3.8	)	117,995		(3,550		)	(2.9	)

The increase in the base NPV from December 31, 2012 to March 31, 2013 was caused mainly by an increase in the market value of investment securities and longer durations on non-maturity deposits.

Our reported earnings at risk analysis models the impact of instantaneous parallel shifts in yield curve changes in interest rates (assuming interest rates rise and fall in increments of 100 basis points), on anticipated net interest income over a twelve-month horizon. These models are modeling underlying cash flows in each of our interest-sensitive portfolios under these changing rate environments. This includes adjusting anticipated prepayments as well as modeling anticipated changes in interest rates paid on core deposit accounts, whose rates do not necessarily move in any relationship to movements in U.S. Treasury rates. We compare these results to our results assuming flat interest rates.

The following table presents the projected changes in net interest income over a twelve-month period for the various interest rate change (rate shocks) scenarios at March 31, 2013 and December 31, 2012 , respectively:



		Change in Net Interest Income Over a Twelve-Month Period
		March 31, 2013					December 31, 2012
		$ Change			% Change		$ Change		% Change
		(Dollars in thousands)
Assumed Change in Interest Rates (Basis Points):
+	300	$	4,088		13.2	%	$	3,685	11.5	%
+	200	2,821			9.1		2,402		7.5
+	100	1,374			4.4		1,004		3.1
-	100	(21		)	(.1	)	39		.1

The preceding table indicates that if interest rates were to move up 200 basis points, net interest income would be expected to increase 9.1% in year one; and if interest rates were to move down 100 basis points, net interest income would be expected to remain relatively stable in year one. The primary causes for the changes in net interest income over the twelve-month period were a result of the changes in the composition of interest-earning assets and interest-bearing liabilities, their repricing characteristics and frequencies, and related interest rates. The net interest income projections for the rising interest rate scenarios have improved since December 31, 2012 as the Bank has maintained higher levels of liquid interest-earning deposits that reprice daily, a higher percentage of its investment portfolio in floating rate securities, less long term fixed-rate one-to-four family residential mortgages, and $21.5 million of additional low-cost core deposits, which represents 66.8% of deposits at March 31, 2013 versus 65.1% at December 31, 2012. Actual results will differ from the above model results due to timing, magnitude, and frequency of interest rate changes, as well as changes in market conditions and management strategies. The table above does not reflect any actions we might take in response to changes in interest rates.

We manage our IRR position by holding assets with various desired IRR characteristics, implementing certain pricing strategies for loans and deposits, and implementing various investment securities portfolio strategies. On a quarterly basis, the ALCO reviews the calculations of all IRR measures for compliance with the Board approved tolerance limits. At March 31, 2013, we were in compliance with all of our Board approved NPV and net interest income at risk tolerance limits.

The above IRR analyses include the assets and liabilities of the Bank only. Inclusion of the parent company assets and liabilities would not have a material impact on the results presented.

Item 4. Controls and Procedures

No change in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) or 15d-15(f) under the Securities Exchange Act of 1934, as amended) occurred during the quarter ended March 31, 2013 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Management evaluated, with the participation of the Chief Executive Officer and Chief Financial Officer, the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) or 15(d)-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based on such evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and regulations and are operating in an effective manner as of such date.

Part II. OTHER INFORMATION

Item 1. Legal Proceedings

The Company is involved in routine legal proceedings occurring in the ordinary course of business, which, in the aggregate, are believed to be immaterial to the financial condition, results of operations, and cash flows of the Company.

Item 1A. Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in “ Item 1A. Risk Factors ” contained in our Annual Report on Form 10-K for the year ended December 31, 2012 (the 2012 Form 10-K ), which could materially affect our business, financial condition, or future results. There have been no material changes from the risk factors as disclosed in the 2012 Form 10-K.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds


(a)	Not applicable.


(b)	Not applicable.


(c)	We did not repurchase any shares of our common stock during the quarter ended March 31, 2013 . Under our repurchase plan publicly announced on March 20, 2008 for 530,000 shares, we have 448,612 shares that may yet be purchased. We are currently prohibited from repurchasing our common stock without prior approval of the FRB pursuant to an informal regulatory agreement with the FRB.

Item 3. Defaults Upon Senior Securities


(a)	None.


(b)	Not applicable.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information


(a)	Not applicable.


(b)	None.

Item 6. Exhibits



(a)	List of exhibits (filed herewith unless otherwise noted).
3.1	Articles of Incorporation of CFS Bancorp, Inc. (1)
3.2	Amended and Restated Bylaws of CFS Bancorp, Inc. (2)
4.0	Form of Stock Certificate of CFS Bancorp, Inc. (3)
10.21	Change in Control Agreement between Citizens Financial Bank and Rebecca D. Rees (4)
31.1	Rule 13a-14(a) Certification of Chief Executive Officer
31.2	Rule 13a-14(a) Certification of Chief Financial Officer
32.0	Section 1350 Certifications
101.0	The following financial statements from the CFS Bancorp, Inc. Quarterly Report on Form 10-Q for the quarter ended March 31, 2013, filed on May 9, 2013, formatted in Extensive Business Reporting Language (XBRL): (i) condensed consolidated statements of condition, (ii) condensed consolidated statements of income, (iii) condensed consolidated statements of comprehensive income, (iv) condensed consolidated statements of changes in shareholders’ equity, (v) condensed consolidated statements of cash flows, and (vi) the notes to condensed consolidated financial statements (5)


(1)	Incorporated herein by reference to the Company’s Definitive Proxy Statement from the 2005 Annual Meeting of Shareholders filed with the SEC on March 25, 2005 (File No. 000-24611).


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


(3)	Incorporated herein by reference to the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 filed with the SEC on March 15, 2007.


(4)	Incorporated herein by reference to the Company’s Form 8-K filed with the SEC on April 26, 2013.


(5)	As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

CFS BANCORP, INC.



Date:	May 9, 2013	By:	/s/ Daryl D. Pomranke
			Daryl D. Pomranke President and Chief Executive Officer

Date:	May 9, 2013	By:	/s/ Jerry A. Weberling
			Jerry A. Weberling Executive Vice President and Chief Financial Officer

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