MUTUALFIRST FINANCIAL INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operation

(Edgar Glimpses Via Acquire Media NewsEdge) Overview and Significant Events in 2012 MutualFirst is a Maryland corporation and a bank holding company headquartered in Muncie, Indiana, with operations in Delaware, Elkhart, Grant, Kosciusko, Randolph, St. Joseph and Wabash counties in Indiana. It owns MutualBank, an Indiana commercial bank with 31 bank branches in Indiana, trust offices in Carmel and Crawfordsville, Indiana and a loan origination office in New Buffalo, Michigan. The Company is subject to regulation, supervision and regulation by the FRB, and the Bank is subject to regulation, supervision and examinationby the IDFI and the FDIC.

Prior to 2012, the Bank was a federal savings bank required to maintain a certain portion of its assets in residential housing-related loans and investments, and the Company was a savings and loan holding company. In 2012, the Bank converted into an Indiana commercial bank regulated by the IDFI and the FDIC prior to its application being approved. As a result, the Bank was no longer subject to regulations requiring it to have a certain level of residential housing-related assets or limiting its level of consumer and commercial loans. In connection with that conversion, the Company was became a bank holding company regulated by the FRB, which subjected it to regulatory capital requirements similar to those imposed on the Bank.

At December 31, 2012, we had $1.4 billion in assets, $974.7 million in loans, $1.2 billion in deposits and $139.5 million in stockholders' equity. The Company's total risk-based capital ratio at December 31, 2012 was 14.4%, exceeding the 10.00% requirement for a well-capitalized institution. The ratio of tangible common equity increased to 7.62% as of year-end 2012 compared to 7.05% at year-end 2011. For the year ended December 31, 2012, net income available to common shareholders was $5.8 million, or $0.83 per basic and $0.82 per diluted share, compared with net income available to common shareholders of $1.4 million, or $0.20 per basic and diluted share for 2011. The details of our 2012 performance are below and in our Consolidated Audited Financial Statements contained in Item 8 of this Form 10-K.

Key aspects of our 2012 operations include: · Return on assets of 0.50% in 2012 compared to 0.24% in 2011.

· Return on average tangible common equity of 5.47% in 2012 compared to 1.39% in 2011.

· A $7.8 million, or 20.0%, decrease in non-performing assets and a $13.0 million, or 18.8%, decrease in classified assets.

· Net charge-offs to total loans of 0.71% in 2012 compared to 1.31% in 2011.

· A $6.0 million provision for loan losses in 2012 compared to $13.1 million in 2011.

Our principal business consists of attracting retail deposits from the general public, including some brokered deposits, and investing those funds primarily in loans secured by first mortgages on owner-occupied, one- to four-family residences, a variety of consumer loans, loans secured by commercial and multi-family real estate and commercial business loans. Funds not invested in loans generally are invested in investment securities, including mortgage-backed and mortgage-related securities. We also obtain funds from FHLB advances and other borrowings.

MutualWealth is the wealth management division of the Bank providing a variety of fee-based financial services, including trust, investment, insurance, broker advisory, retirement plan and private banking services, in the Bank's market area. MutualWealth produces non-interest income for the Bank that is tied primarily to the market value of the portfolios being managed. As of December 31, 2012, MutualWealth had $325.7 million of assets under management and generated $2.7 million in commission income. Decreases in market value could have a negative impact on the non-interest income generated by this division of the Bank.

MutualFinancial Services is the brokerage division of the Bank providing a variety of fee-based financial services related to securities and investment transactions. MutualFinancial Services produces non-interest income for the Bank that is tied primarily to the volume of the transactions being processed. As of December 31, 2012, MutualFinancial Services generated $1.0 million in commission income.

47 Our results of operations depend primarily on the level of our net interest income, which is the difference between interest income on interest-earning assets, such as loans, mortgage-backed securities and investment securities, and interest expense on interest-bearing liabilities, primarily deposits and borrowings. The structure of our interest-earning assets versus the structure of interest-bearing liabilities, along with the shape of the yield curve, has a direct impact on our net interest income. Historically, our interest-earning assets have been longer term in nature (i.e., fixed-rate mortgage loans) and interest-bearing liabilities have been shorter term (i.e., certificates of deposit, regular savings accounts, etc.). This structure would impact net interest income favorably in a decreasing rate environment, assuming a normally shaped yield curve, as the rates on interest-bearing liabilities would decrease more rapidly than rates on the interest-earning assets. Conversely, in an increasing rate environment, assuming a normally shaped yield curve, net interest income would be impacted unfavorably as rates on interest-earning assets would increase at a slower rate than rates on interest-bearing liabilities.

The Federal Funds rate set by the FRB decreased to a range of 0 to 25 basis points as of December 31, 2008 and was the same as of December 31, 2012. The Federal Funds rate remaining at this level decreases the ability to reprice deposits lower in future months due to the extended time of low interest rates.

Certificates of deposit and borrowings may, however, still reprice to lower rates at their maturities in future time periods, which could reduce the amount of interest expense assuming rates stay low. Interest income is expected to decrease without any changes in the current rate environment primarily due to the rates on newly originated interest-earning assets being lower than the rates on maturing interest-earning assets.

The Company continues to reduce the impact of interest rate changes on its net interest income by shortening the term of its interest-earning assets to better match the terms of our interest-bearing liabilities and by selling long-term fixed rate loans and increasing the term of certain liabilities. See "Item 7A - Quantitative and Qualitative Disclosures About Market Risk - Asset and Liability Management and Market Risk" in this Form 10-K. It has been the Company's strategic objective to change the repricing structure of its interest-earning assets from longer term to shorter term to better match the structure of our interest-bearing liabilities and therefore reduce the impact interest rate changes have on our net interest income. Strategies employed to accomplish this objective have been to increase the originations of variable rate commercial loans and shorter term consumer loans and to sell longer term mortgage loans.

The percentage of consumer and commercial loans to total loans has increased from 47.0% at the end of 2007 to 49.0% as of December 31, 2012. The current economic conditions within our market area have reduced the growth kept growth in commercial lending flat and has been a hindrance in achieving this objective.

As we continue to increase our investment in business-related loans, which are considered to entail greater risks than one- to four-family residential loans, in order to help offset the pressure on our net interest margin, our provision for loan losses has increased to reflect these increased risks. On the liability side of the balance sheet, the Company is employing strategies intended to increase the balance of core deposit accounts, such as low cost checking and money market accounts. The percentage of core deposits to total deposits was 51.2% at December 31, 2012 compared to 35.7% at the end of 2007. The remaining total deposits are mostly retail certificates of deposit, which continue to provide stable funding for the Company. These are ongoing strategies that are dependent on current market conditions and competition. The Company lengthens the term to maturity of FHLB advances when advantageous to lengthen repricing of the liability side of the balance sheet in order to reduce interest rate risk exposure.

During 2012, in keeping with our strategic objective to reduce interest rate risk exposure, the Company also sold $45.3 million of long-term fixed rate loans that had been held for sale including $3.5 million in loans transferred to held for sale, which reduced potential earning assets and therefore had a negative impact on net interest income. This was offset, in the short term, by recognizing a gain on the sale of these loans of $1.9 million. The Company also made the decision to sell investment securities to prepay $27.8 million in FHLB advances with a prepayment penalty of $804,000 to remove negative spread off the balance sheet 48 Results of operations also are dependent upon the level of the Company's non-interest income, including fee income and service charges, and the level of its non-interest expense, including general and administrative expenses.

Regulatory changes continued to have an impact on non-interest income in 2012 as the Company saw a decrease in overdraft fee income due to regulatory changes implemented in 2010. New regulatory requirements regarding interchange income could have an impact on the Company in the future; however, at this time these requirements are limited to larger institutions. During 2012, we experienced increased gains on the sale of securities as the decision was made to sell over $95.5 million in securities to reduce risks associated with rising prepayment speeds and decreased losses on the sale of other real estate and repossessed assets, which offset the decrease in service fee income.

Another factor that may lead to changes in net interest income is the level of non-performing assets. An increase in non-performing assets (i.e., loans, repossessed assets, or securities) would also decrease interest income and may decrease overall net interest income without additional decreases in interest-bearing liabilities. The recent recession, had a negative impact on our financial condition, operations, net income and stock price. We have begun to see some recovery; however, there is still slow economic growth in our market footprint and current troubled loans and securities may continue to incur losses during this recovery.

In 2011, the Company became a participant in the Small Business Lending Fund ("SBLF") of the United States Department of the Treasury ("Treasury"), which was created to encourage lending to small businesses by providing capital to qualified community banks. As part of that process, the Company adopted Articles Supplementary to the Company's Charter to provide for Senior Non-Cumulative Perpetual Preferred Stock, Series A that was subject to terms and conditions mandated by the Treasury (the "SBLF Preferred Stock"). On August 25, MutualFirst entered into a Small Business Lending Fund-Securities Purchase Agreement ("Purchase Agreement") with Treasury, pursuant to which it sold 28,923 shares of the SBLF Preferred Stock to Treasury for $28,923,000. The SBLF Preferred Stock qualifies as Tier 1 capital and is entitled to receive non-cumulative dividends, payable quarterly, on each January 1, April 1, July 1 and October 1. The dividend rate, as a percentage of the liquidation amount, can fluctuate on a quarterly basis during the first 10 quarters during which the SBLF Preferred Stock is outstanding, based upon changes in the level of "Qualified Small Business Lending" or "QBSL" (as defined in the Purchase Agreement) by the Bank.

The initial dividend rate of 5% has remained in place based on the Bank's level of QBSL over the baseline level calculated under the terms of the Purchase Agreement. We do not anticipate that the rate will fall below 5%, and the rate is expected to increase to 7% in 2014 and 9% in 2016.

The terms of the SBLF Preferred Stock impose limits on the ability of the Company to pay dividends on and repurchase shares of its common stock. Under the terms of the SBLF Preferred Stock, no repurchases may be effected, and no dividends may be declared or paid on preferred shares ranking pari passu with the SBLF Preferred Stock, junior preferred shares, or other junior securities (including the common stock) during the current quarter and for the next three quarters following the failure to declare and pay dividends on the SBLF Preferred Stock, except that, in any such quarter in which the dividend is paid, dividend payments on shares ranking pari passu may be paid to the extent necessary to avoid any resulting material covenant breach. In addition, the Company may only declare and pay a dividend on the common stock or other stock junior to the SBLF Preferred Stock, or repurchase shares of any such class or series of stock, if, after payment of such dividend, the dollar amount of the Company's Tier 1 Capital would be at least 90% of the Signing Date Tier 1 Capital, which was $88,712,387, excluding any subsequent net charge-offs and any redemption of the SBLF Preferred Stock (the "Tier 1 Dividend Threshold"). The Tier 1 Dividend Threshold is subject to reduction, beginning on the second anniversary of issuance and ending on the tenth anniversary, by 10% for each one percent increase in QSBL over the baseline level.

Recent Accounting Standards For discussion of recent accounting standards, please see Item 8 - Note 2: Impact of Accounting Pronouncements to our Consolidated Financial Statements in Item 8 of this Form 10-K.

Critical Accounting Policies The Notes to the Consolidated Financial Statements in Item 8 of this Form 10-K contain a summary of the Company's significant accounting policies. Certain of these policies are important to the portrayal of the Company's financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Management believes that its critical accounting policies include determining the allowance for loan losses, the valuation of foreclosed assets, mortgage servicing rights and real estate held for development, and the valuation of intangible assets and securities.

49 The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. A worsening or protracted economic decline would increase the likelihood of additional losses due to credit and market risk and could create the need for additional loss reserves.

Allowance for Loan Losses.The allowance for loan losses is a significant estimate that can and does change based on management's assumptions about specific borrowers and current general economic and business conditions, among other factors. Management reviews the adequacy of the allowance for loan losses on at least a quarterly basis. The evaluation by management includes consideration of past loss experience, changes in the composition of the loan portfolio, the current condition and amount of loans outstanding, identified problem loans and the probability of collecting all amounts due.

Foreclosed Assets. Foreclosed assets are carried at the lower of cost or fair value less estimated selling costs. Management estimates the fair value of the properties based on current appraisal information. Fair value estimates are particularly susceptible to significant changes in the economic environment, market conditions, and real estate market. A worsening or protracted economic decline would increase the likelihood of a decline in property values and could create the need to write down the properties through current operations.

Mortgage Servicing Rights.Mortgage servicing rights ("MSRs") associated with loans originated and sold, where servicing is retained, are capitalized and included in other assets in the consolidated balance sheet. The value of the capitalized servicing rights represents the fair value of the right to service loans in the portfolio. Critical accounting policies for MSRs relate to the initial valuation and subsequent impairment tests. The methodology used to determine the valuation of MSRs requires the development and use of a number of estimates, including anticipated principal amortization and prepayments of that principal balance. Events that may significantly affect the estimates used are changes in interest rates, mortgage loan prepayment speeds and the payment performance of the underlying loans. The carrying value of the MSRs is periodically reviewed for impairment based on a determination of fair value. For purposes of measuring impairment, the servicing rights are compared to a valuation prepared based on a discounted cash flow methodology, utilizing current prepayment speeds and discount rates. Impairment, if any, is recognized through a valuation allowance and is recorded as a reduction in loan servicing fee income.

Intangible Assets. MutualFirstperiodically assesses the impairment of its core deposit intangible. Impairment is the condition that exists when the carrying amount exceeds its implied fair value. If actual external conditions and future operating results differ from MutualFirst'sjudgments, impairment and/or increased amortization charges may be necessary to reduce the carrying value of these assets to the appropriate value.

Securities. Under FASB Codification Topic 320 (ASC 320), Investments-Debt and Equity Securities, investment securities must be classified as held-to-maturity, available-for-sale or trading. Management determines the appropriate classification at the time of purchase. The classification of securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Debt securities are classified as held-to-maturity and carried at amortized cost when management has the positive intent and the Company has the ability to hold the securities to maturity. 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 do not affect earnings until realized.

The fair values of the Company's securities are generally determined by reference to quoted prices from reliable independent sources utilizing observable inputs. Certain of the Company's fair values of securities are determined using models whose significant value drivers or assumptions are unobservable and are significant to the fair value of the securities. These models are utilized when quoted prices are not available for certain 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 rates, estimation of prepayment characteristics and implied volatilities.

50 The Company evaluates all 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. In evaluating the possible impairment of securities, consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the ability and intent of the Company to retain its 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, the Company may consider whether the 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.

If management determines that an investment experienced an OTTI, management must then determine the amount of the OTTI to be recognized in earnings. If management does not intend to sell the security and it is more likely than not that the Company will not be required to sell the 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 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 management intends to sell the security or more likely than not will be required to sell the 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 balance sheet date.

Any recoveries related to the value of these securities are recorded as an unrealized gain (as other comprehensive income (loss) in stockholders' equity) and not recognized in income until the security is ultimately sold.

The Company from time to time may dispose of an impaired 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.

Deferred Tax Asset. The Company has evaluated its deferred tax asset to determine if it is more likely than not that the asset will be utilized in the future. The Company's most recent evaluation indicated that it is more likely than not that the asset will be fully utilized. The Company has generated average positive pre-tax pre-provision earnings of $12.7 million, or 0.90% of pre-tax pre-provision ROA over the previous five years, after excluding the goodwill impairment in 2008. Over the last five years, the Company has grown and at its current asset size, the pre-tax pre-provision earnings would be approximately $12.8 million using the same historical pre-tax pre-provision ROA.

These earnings would be sufficient to utilize the net operating losses, tax credit carryforwards and temporary tax differences over the allowable periods.

The valuation allowances established from 2008 through 2012 were the result of capital losses sustained in those years with no tax benefit recorded. The analysis supports no additional valuation allowance is necessary.

At the end of 2012, the Company had $557,000 in capital losses, a decrease from $832,000 in capital losses in 2011 as capital gains from the sale of available for sale securities were generated. The Company has avoided and will continue to avoid taking any book tax benefit on future capital losses without capital gains to offset the current capital losses. See Note 14 of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K.

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 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.

51 Management Strategy Our strategy is to operate as an independent, retail-oriented financial institution dedicated to serving customers in our market areas. Our commitment is to provide a broad range of products and services to meet the needs of our customers. As part of this commitment, we are looking to increase our emphasis on commercial business products and services. We also operate a fully interactive transactional website that also allows consumers to open accounts.

In addition, we are continually looking at cost-effective ways to expand our market area. Financial highlights of our strategy have included: Continuing as a Diversified Lender.We have been successful in diversifying our loan portfolio to reduce our reliance on any one type of loan. Approximately 47.0% of our loan portfolio consisted of loans other than one- to four-family real estate loans at the end of 2007. At the end of 2012, that percentage has increased to 49.0%. Our conversion to an Indiana commercial bank charter eliminated legal requirements restricting our levels of consumer and commercial loans and mandating specific levels of investment in residential-related assets.

Continuing as a Leading One- to Four-Family Lender in Indiana. We are one of the largest originators of one- to four-family residential loans in our market area.

During 2012, we originated $231.2 million of one- to four-family residential loans. While the current economic environment has decreased real estate values, refinancing activity has still been steady.

Continuing To Focus On Asset Quality.Non-performing assets to total assets was 2.21% at December 31, 2012 compared to 2.75% at December 31, 2011. Though we have experienced some improvement, this continued high level of nonperforming assets reflects downward forces in our local economy and in other parts of the United States in which the Company has purchased loans. While the levels of non-performing assets are currently higher than we desire, we believe that our current underwriting standards will provide for a quality loan portfolio once economic activity and unemployment return to more normal levels.

Increasing Market Share and Mix of Deposits. We continue to be successful in the growth of core deposits. Over the last five years, we have increased core deposits by 15.5%, from 35.7% at the end of in 2007 to 51.2% at the end of 2012.

This includes an increase in non-interest bearing deposits of 193.1% duringthe same time period.

Continuing Our Strong Capital Position.As a result of our consistent operating profitability, we historically have maintained a strong capital position. At December 31, 2012, our ratio of stockholders' equity to total assets was 9.8%, compared to 9.3% at December 31, 2011. The Bank increased total risk-based capital to 15.1% at year-end 2012 from 14.3% at year-end 2011.

Decreasing Interest Rate Risk.It has been the Company's strategic objective to change the repricing structure of its interest-earning assets from longer term to shorter term to better match the structure of our interest-bearing liabilities and therefore reduce the impact interest rate changes have on our net interest income. Strategies employed to accomplish this objective have been to increase the originations of variable rate commercial loans and shorter term consumer loans and to sell longer term mortgage loans. When possible, extending liabilities may also be utilized to decrease interest rate risk.

Financial Condition at December 31, 2012 Compared to December 31, 2011 General. Total assets at year-end 2012 were $1.4 billion, reflecting a $4.7 million decrease during the year, primarily as a result of a 15.0% decrease in investment securities and a 40.6% decrease in our cash and cash-equivalents, which was partially offset by a 7.7 % increase in gross loans, excluding loans held for sale. Average interest-earning assets increased $25.7 million, or 2.0%, to $1.33 billion at December 31, 2012 from $1.30 billion at December 31, 2011.

Average interest-bearing liabilities increased by $5.5 million, or 0.5% to $1.17 billion at year-end 2012 from $1.16 billion at year-end 2011 reflecting an increase in FHLB advances. Average stockholders' equity increased by $4.3 million or 3.3% during 2012.

Cash and Securities. Although our cash and securities (including our bank deposits) decreased from $387.5 million at year-end 2011 compared to $314.0 million at year-end 2012 we still maintained a high liquidity position. The details of our cash and securities are as follows: 52 At December 31 Amount Percent 2012 2011 Change Change (Dollars in thousands) Cash $ 8,899 $ 7,710 $ 1,189 15.42 %Interest-bearing demand deposits 23,879 47,513 (23,634 ) -49.74 Interest-bearing deposits - 1,415 (1,415 ) -100.00 Securities available for sale (fair value) 281,197 330,878 (49,681 ) -15.01 Total $ 313,975 $ 387,516 $ (73,541 ) -18.98 % As of December 31, 2011 we were holding an increased level of bank deposits in money market funds that were invested shortly after the new year, primarily in mortgage-backed securities. The decrease in investment securities reflects the decision to sell lower yielding available for sale securities to pay off higher rate FHLB advances as well as reinvest in higher yielding new loan growth.

At December 31, 2012, our securities portfolio consisted of $244.6 million in government-sponsored agency mortgage-backed securities and collateralized mortgage obligations, $13.0 million in federal agency and Small Business Administration securities, $3.3 million in municipal securities and $20.3 million in corporate obligations. At December 31, 2012, all these securities, except for the corporate obligations, had aggregate unrealized gains of $8.7 million, and the corporate obligations had unrealized losses of $3.8 million, primarily due to unrealized losses on trust preferred securities of $4.3 million. We have the ability to hold the trust preferred securities until maturity and believe that we will be able to collect the adjusted amortized cost basis of the securities. See Note 4 of the Notes to Consolidated Financial Statements in Item 8 for additional information about our investment securities.

We expect to maintain this high level of liquid assets in 2013. We believe it is prudent to maintain higher liquidity while our local markets continue to experience uncertain economic times. In addition, until loan demand increases in our market, we expect to have more securities investments.

Loans. Our gross loan portfolio, excluding loans held for sale, increased $70.4 million or 7.7% to $990.6 million at year-end 2012 from $920.2 million at year-end 2011. The following table reflects the changes in the gross amount of loans, excluding loans held for sale, by type during 2012: At December 31 Amount Percent 2012 2011 Change Change (Dollars in thousands) Commercial Loans: Real Estate $ 203,613 $ 197,390 $ 6,223 3.2 % Construction and Development 17,462 20,831 (3,369 ) (16.2 ) Other 67,773 64,628 3,145 4.9 Total Commercial 288,848 282,849 5,999 2.1 Residential Mortgages 502,619 434,976 67,643 15.6 Consumer Loans: Home Equity Lines 100,516 96,864 3,652 3.8 Auto 15,572 15,203 369 2.4 Boat/RV 76,416 83,557 (7,141 ) (8.6 ) Other 6,598 6,760 (162 ) (2.4 ) Total Consumer 199,102 202,384 (3,282 ) (1.6 ) Total Loans $ 990,569 $ 920,209 $ 70,360 7.7 % 53 Although the Bank has an overall strategy to increase commercial and consumer loans it has been hindered by depressed economic conditions in Indiana as a result of the slow recovery from the recent recession. Due to higher unemployment and decreased real estate values, loan demand, especially for business loans, has remained relatively flat. We are seeking opportunities to provide refinancing opportunities to sound commercial borrowers currently served by other financial institutions. The decrease in the consumer portfolios was offset by the increase in the commercial and residential mortgage lending portfolios during the period. Lower rates have allowed consumers to refinance their mortgage loans, and the Bank continues to see this business as strong with less credit risk. The Bank continues to sell 30-year fixed-rate mortgage loans to reduce related interest rate.

Delinquencies and Non-performing Assets. As of December 31, 2012, our total loans delinquent 30-to-89 days was $22.2 million or 2.2% of total loans, compared to $26.2 million or 2.8% of total loans at the end of 2011.

At December 31, 2012, our non-performing assets totaled $31.4 million or 2.21% of total assets, compared to $39.2 million or 2.75% of total assets at December 31, 2011. This $7.8 million, or 20.0% decrease was primarily the result of the decrease in non-performing commercial real estate. The table below sets forth the amounts and categories of non-performing assets in our loan portfolio at the dates indicated.

At December 31 Amount Percent 2012 2011 Change Change (Dollars in thousands) Non-accruing loans $ 23,410 $ 30,711 $ (7,301 ) (23.8 )% Accruing loans delinquent 90 days or more 273 1,127 (854 ) (75.8 ) Foreclosed assets 7,700 7,392 308 4.2 Total $ 31,383 $ 39,230 $ (7,847 ) (20.0 )% Our non-performing assets decreased in 2012 as local economic conditions improved. The pace of non-performing assets has slowed and optimistically it has peaked. The Bank is diligently monitoring and writing down loans that appear to have irreversible weakness. The Bank works to ensure possible problem loans have been identified and steps have been taken to reduce loss by restructuring loans to improve cash flow or by increasing collateral. In addition to the decrease in non-performing assets, the Company has seen significant improvement during the year in total classified assets. Total classified assets decreased by 18.8% from $69.4 million at December 31, 2011 to $56.4 million at December 31, 2012.

At December 31, 2011, foreclosed commercial real estate totaled $2.2 million and consisted of 12 commercial buildings in our existing lending footprint. Due to improvements in our local economy and our sales efforts, at December 31, 2012, foreclosed commercial real estate totaled $1.1 million and consisted of eight commercial buildings or real estate for development; two in Kosciusko County, one in Grant County and five in Elkhart and St. Joseph Counties. At December 31, 2012, the Bank had 51 residential properties with a book value of $5.8 million.

All foreclosed real estate is currently for sale. At the end of 2012, the Bank also held $755,000 in other repossessed assets, such as autos, boats, RVs and horse trailers.

Non-accruing commercial real estate loans, including construction and development loans, decreased from $16.9 million at December 31, 2011, to $8.4 million at December 31, 2012. Non-accruing commercial business loans as well as one- to four-family loans increased slightly from $1.2 million and $10.1 million, respectively, at the end of 2011 to $1.3 million and $10.8 million, respectively, at the end of 2012. Management continues to monitor these non-accruing loans aggressively and it is management's opinion that the non-accruing loans are sufficiently reserved as of December 31, 2012.

In addition to the non-performing assets set forth in the table above, as of December 31, 2012, there was an aggregate of $8.3 million in loans with respect to which known information about the possible credit problems of the borrowers have caused management to have doubts as to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the non-performing asset categories. Due to improving economic conditions, we have seen a decrease in the amount of these loans during 2012. These loans have been considered in management's determination of the adequacy of our allowance for loan losses. Management reviews each of these relationships at least quarterly to determine if further downgrades and specific loan allocations are prudent.

54 Allowance for Loan Loss.Allowance for loan losses decreased $800,000 from $16.8 million at December 31, 2011 to $16.0 million December 31, 2012 as reflected below: Year Ended December 31, 2012 2011 (Dollars in thousands) Balance at beginning of period $ 16,815 $ 16,372 Charge-offs 8,002 13,818 Recoveries: 1,200 1,161 Net charge-offs 6,802 12,657Provisions charged to operations 6,025 13,100 Balance at end of period $ 16,038 $ 16,815 Ratio of net charge-offs during the period to average loans outstanding during the period 0.71 % 1.31 % Allowance as a percentage of non-performing loans 67.72 % 52.81 % Allowance as a percentage of total loans (end of period) 1.63 % 1.83 % Specific loan loss allocation related to loans that have been individually evaluated for impairment decreased $852,000, while general loan loss reserves have remained approximately the same even with increased loan balances. Net charge offs for the year 2012 were $6.8 million, or 0.71% of average loans on an annualized basis, compared to $12.7 million, or 1.31% of average loans for 2011.

The decrease was primarily due to management's ongoing evaluation of the loan portfolio conditions in our market areas. As of December 31, 2012, the allowance for loan losses as a percentage of loans receivable and non-performing loans was 1.63% and 67.72%, respectively, compared to 1.83% and 52.81%, respectively, at December 31, 2011. Allowance for loan losses as a percentage of loans receivable decreased primarily due to an increase in the net loan portfolio of $68.3 million. Allowance for loan losses as a percentage of non-performing loans increased due to the decrease in non-performing loans in the 2012.

Our non-accrual loans include five commercial loan relationships totaling $6.6 million, or 28.3% of the non-accrual loan total. These loans are primarily construction and development loans. These loans had a specific allocation of $599,000.

Other Assets. Other material changes in our assets during 2012 include: a reduction of $1.2 million in prepaid FDIC premiums; a $1.4 million increase in cash surrender value of BOLI; a $962,000 reduction in our core deposit and other intangible assets reflecting current amortization; and an aggregate $2.8 million reduction in deferred income tax benefit and income tax receivable reflecting lower taxable income and reduced low income housing tax credits.

55 Deposits. Total deposits increased $15.7 million to $1.18 billion at year-end 2012 compared to $1.17 billion at year-end 2011, primarily due to increased activity in new and existing core deposit relationships, as reflected in the table below, with corresponding weighted average rates partially offset by a decrease in certificates of deposit. The increase in non-interest bearing deposits reflects an increase in business checking. These changes are consistent with the Bank strategy to grow and strengthen core deposit relationships.

At December 31, 2012 2011 Weighted Weighted Average Average Amount Rate Amount Rate (Dollars in thousands) Type of Account: Non-interest Checking $ 138,269 0.00 % $ 123,936 0.00 % Interest-bearing NOW 259,220 0.27 218,915 0.49 Savings 110,211 0.01 98,122 0.05 Money Market 98,366 0.23 85,069 0.65 Certificates of Deposit 577,943 1.66 642,315 1.91 Total $ 1,184,009 0.89 % $ 1,168,357 1.22 % Borrowings. Total borrowings decreased $27.6 million, or 24.2%, to $86.3 million at year-end 2012 primarily due to a $26.8 million decrease in FHLB advances due to a $27.8 million prepayment in 2012. Other borrowings, consisting of a bank loan and trust preferred securities, decreased $804,000 to $11.6 million at year-end 2012 due to regular loan payments.

In 2009, the Company borrowed $10.0 million from First Tennessee Bank, N.A. to refinance existing long-term debt. At December 31, 2012, the loan bore a 5.9% interest rate, had a term expiring in December 2014 and was secured by Bank stock. The balance of that loan was $7.6 million at December 31, 2012. This loan was refinanced on January 4, 2013 with a new rate of 3.915% and a term expiring December 2017.

The Company acquired $5.0 million of issuer trust preferred securities in a 2008 acquisition of another financial institution, which had a net balance of $4.0 million December 31, 2012 due to the purchase accounting adjustment in the acquisition. These securities mature 30 years from the date of issuance or September 15, 2035. The securities bore a fixed rate of interest of 6.22% through July 2010 and thereafter were to reset quarterly at the prevailing three-month LIBOR rate plus 170 basis points. In December 2009, the Company entered into a cash flow hedge with FTN Financial to fix the floating portion of the issued trust preferred security at 5.15% for the next five years starting on September 15, 2010. The Company has had the right to redeem the trust preferred securities, in whole or in part, without penalty, since establishing the cash flow hedge; however, it does not expect to redeem these securities before it redeemed all of its SBLF preferred stock.

Stockholders' Equity. Stockholders' equity was $139.5 million at December 31, 2012, an increase of $6.9 million, or 5.2% from the equity of $132.6 million at December 31, 2011. The increase was a result of net income of $7.2 million, $1.6 million in other comprehensive income, $329,000 in ESOP shares earned and $804,000 in share-based compensation. These increases were partially offset by dividend payments of $1.4 million to preferred stockholders and $1.7 million to common stockholders. The Company's tangible book value per share as of December 31, 2012 increased to $15.33 compared to $14.38 as of December 31, 2011 and the tangible common equity ratio was 7.62% as of December 31, 2012 compared to7.05% as of December 31, 2011.

56 Average Balances, Net Interest Income, Yields Earned and Rates Paid The following table presents for the periods indicated the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. No tax equivalent adjustments were made.

All average balances are daily average balances. Non-accruing loans have been included in the table as loans carrying a zero yield.

Year ended December 31, 2012 2011 2010 Average Interest Average Average Interest Average Average Interest Average Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Balance Paid Rate Balance Paid Rate Balance Paid Rate (Dollars in thousands)Interest-Earning Assets Interest -bearing deposits $ 21,115 $ 52 0.25 % $ 37,894 $ 91 0.24 % $ 72,919 $ 185 0.25 % Mortgage-backed securities available-for sale(1) 296,877 7,929 2.67 263,298 7,475 2.84 179,901 5,923 3.29 Investment securities available-for-sale(1) 36,591 822 2.25 26,480 653 2.47 24,103 664 2.75 Investment securities held-to-maturity - - - - - 3,570 325 9.10 Loans(2) 963,215 46,095 4.79 963,947 52,728 5.47 1,026,199 59,952 5.84 Stock in FHLB of Indianapolis 14,391 450 3.13 14,897 406 2.73 18,177 349 1.66 Total interest-earning assets 1,332,189 55,348 4.15 1,306,516 61,353 4.70 1,324,869 67,398 5.09 Non-Interest Earning Assets (net of allowance for loan losses and unrealized gain/loss) 117,086 120,554 122,163 Total assets $ 1,449,275 $ 1,427,070 $ 1,447,032 Interest-Bearing Liabilities: Demand and NOW accounts $ 251,999 879 0.35 $ 214,062 1,177 0.55 $ 186,792 961 0.51 Savings deposits 107,207 45 0.04 96,847 111 0.11 89,622 139 0.16 Money market accounts 91,561 396 0.43 74,594 504 0.68 70,358 598 0.85 Certificate accounts 595,810 10,480 1.76 663,453 14,223 2.14 668,061 16,591 2.48 Total deposits 1,046,577 11,800 1.13 1,048,956 16,015 1.53 1,014,833 18,289 1.80 Borrowings 118,626 2,904 2.45 110,740 4,019 3.63 176,029 6,906 3.92 Total interest-bearing accounts 1,165,203 14,704 1.26 1,159,696 20,034 1.73 1,190,862 25,195 2.12 Non-Interest Bearing Accounts 131,115 121,623 108,316 Other Liabilities 15,296 12,432 14,196 Total Liabilities 1,311,614 1,293,751 1,313,374 Stockholders' Equity 137,661 133,319 133,658 Total liabilities and stockholders' equity $ 1,449,275 $ 1,447,070 $ 1,447,032 Net Earning Assets $ 166,986 $ 146,820 $ 134,007 Net Interest Income $ 40,644 $ 41,319 $ 42,203 Net Interest Rate Spread(3) 2.89 % 2.97 % 2.97 % Net Yield on Average Interest-Earning Assets(4) 3.05 % 3.16 % 3.19 % Average Interest-Earning Assets to Average Interest-Bearing Liabilities 114.33 % 112.66 % 111.25 % (1) Average balances were calculated using amortized cost, which excludes FASB 115 valuation allowances.

(2) Calculated net of deferred loan fees, loan discounts and loans in process.

(3) Interest rate spread is calculated by subtracting weighted average interest rate cost from weighted average interest rate yield for the period indicated.

(4) The net yield on weighted average interest-earning assets is calculated by dividing net interest income by weighted average interest-earning assets for the period indicated.

57 Rate/Volume Analysis The following table presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to changes in volume, which are changes in volume multiplied by the old rate, and changes in rate, which is a change in rate multiplied by the old volume. Changes attributable to both rate and volume, which cannot be segregated, are allocated proportionately to the change due to volume and the change due to rate.

Year Ended December 31, 2012 vs. 2011 2011 vs. 2010 Increase Increase (Decrease) Total (Decrease) Total Due to Increase Due to Increase Volume Rate (Decrease) Volume Rate (Decrease) (Dollars in thousands) Interest-earning assets: Interest-bearing deposits $ (41 ) 2 (39 ) $ (85 ) $ (9 ) $ (94 ) Investment securities available-for-sale 1,146 (524 ) 622 2,413 (1,197 ) 1,216 Loans receivable (40 ) (6,593 ) (6,633 ) (3,524 ) (3,700 ) (7,224 ) Stock in FHLB of Indianapolis (14 ) 59 45 (71 ) 128 57 Total interest-earning assets $ 1,051 (7,056 ) (6,005 ) $ (1,267 ) $ (4,778 ) $ (6,045 ) Interest-bearing liabilities: Savings deposits $ 184 (484 ) (300 ) $ 147 $ 69 $ 216 Money market accounts 11 (77 ) (66 ) 11 (39 ) (28 ) Demand and NOW accounts 99 (207 ) (108 ) 34 (128 ) (94 ) Certificate accounts (1,356 ) (2,387 ) (3,743 ) (114 ) (2,254 ) (2,368 ) Borrowings 269 (1,382 ) (1,113 ) (2,402 ) (485 ) (2,887 ) Total interest-bearing liabilities $ (793 ) (4,537 ) (5,330 ) $ (2,324 ) $ (2,837 ) $ (5,161 ) Change in net interest income $ (675 ) $ (884 ) 58 Comparison of Results of Operations for the Years Ended December 31, 2012 and 2011.

General. Net income available to common shareholders for the year ended December 31, 2012 was $5.8 million or $0.83 and $0.82 basic and diluted earnings per common share, respectively, compared to net income available to common shareholders of $1.4 million, or $0.20 basic and diluted earnings per common share for the year ended December 31, 2011. The primary reason for this increase was a $7.1 million reduction in the provision for loan losses compared to the level in 2011 due to credit stabilization in the loan portfolio. Our return on assets and on average tangible equity was 0.50% and 5.47%, respectively, in 2012 compared to 0.24% and 1.39% in 2011.

Interest Income. Total interest income decreased $6.0 million, or 9.8%, to $55.3 million during the year ended December 31, 2012 from $61.4 million during the year ended December 31, 2011, reflecting a decline in the net interest yield on interest-earning assets of 55 basis points, partially offset by an increase in average earning assets of $25.7 million comparing 2012 with 2011. The decline in yield was primarily due to the decline in national and local prevailing interest rates. Interest income on loans in 2012 was $46.1 million compared to $52.7 million in 2011, reflecting a 68 basis point decrease in the weighted average yield on loans in 2012 to 4.79%, compared to 5.47% in 2011. Interest income on investment securities in 2012 was $9.2 million compared to $8.5 million in 2011, reflecting a $667,000 increase in our average investment securities portfolio to $347.9 million in 2012.

Interest Expense. Interest expense decreased $5.3 million, or 26.6%, to $14.7 million during the year ended December 31, 2012 compared to $20.0 million during the year ended December 31, 2011. The primary reason for this decrease was a decline of 47 basis points in the average cost of interest-bearing liabilities from 1.73% during 2011 to 1.26% during 2012, which was primarily due to continued re-pricing of deposit accounts. Interest expense on deposits decreased $4.2 million, due to a 40 basis point decline in average rates paid. Interest expense on borrowings decreased $1.1 million as a result of a 118 basis point decline in average rates partially offset by a $7.9 million increase in average borrowings during 2012, to $118.6 million.

Net Interest Income. Net interest income decreased by $675,000 in 2012 to $40.6 million in 2012 compared to $41.3 million in 2011, primarily due to reduced earning assets and the impact of interest-earning assets re-pricing sooner than interest-bearing liabilities. For more information on our asset/liability management, especially as it relates to interest rate risk, see "Item 7A - Quantitative and Qualitative Disclosures About Market Risk" in this Form 10-K.

Provision for Loan Losses. Our provision for loan losses decreased significantly in 2012 from $13.1 million for 2011 to $6.0 million for 2012. The decrease was based on management's ongoing evaluation of the adequacy of the allowance for loan losses, which was partially attributable to net charge offs decreasing $5.9 million, to $6.8 million, or 0.71% of loans during 2012 compared to net charge-offs of $12.7 million, or 1.31% of loans during 2011. Net charge-offs exceeded the provision primarily due to charge-offs related to previously identified loans for which specific allocations had been previously established.

Non-performing loans to total loans at December 31, 2012 were 2.40% compared to 3.47% at December 31, 2011. Non-performing assets to total assets were 2.21% at December 31, 2012 compared to 2.75% at December 31, 2011. This $7.8 million decrease in non-performing assets reflects the stabilization of the local economies in which we serve.

59 Other Income. Other (non-interest) income decreased from 2012 compared to the levels earned in 2011 by $486,000, or 3.0%, to $15.5 million in 2012 compared to $16.0 million in 2011 as reflected below: Year Ended Amount Percent 12/31/2012 12/31/2011 Change Change (Dollars in thousands) Non-Interest Income: Service fee income $ 6,492 $ 6,987 $ (495 ) (7.08 )% Net realized gain (loss) on sale of securities 2,831 2,048 783 38.16 % Equity in losses of limited partnerships (498 ) (384 ) (114 ) (29.69 )% Commissions 3,894 3,691 203 5.50 % Net gains on sales of loans 1,870 2,723 (853 ) (31.33 )% Net servicing fees (203 ) (73 ) (130 ) (178.08 )% Increase in cash surrender value of life insurance 1,351 1,420 (69 ) (4.86 )% Loss on sale of other real estate and repossessed assets (564 ) (426 ) (138 ) (32.39 )% Net other-than-temporary losses on securities - (193 ) 193 100.00 % Other income 351 217 134 62.50 % Total $ 15,524 $ 16,010 $ (486 ) (3.04 )% The decrease in non-interest income was primarily due to a reduction in gain on sale of loans and related servicing by $983,000 primarily due to a $45 million mortgage loan sale that occurred in 2011 that was not repeated in 2012, as well as decreases in service fee income on deposits of $495,000, primarily related to reduced overdraft fee income. These decreases were partially offset by increases in gain on sale of investments of $783,000.

Other Expense. Other (non-interest) expense decreased in 2012 by $253,000 to $40.3 million, reflecting our continued efforts to control operating expenses.

Year Ended Amount Percent 12/31/2012 12/31/2011 Change Change (Dollars in thousands) Non-Interest Expense:Salaries and employee benefits $ 21,335 $ 21,690 $ (355 ) (1.64 )% Net occupancy expenses 2,339 2,385 (46 ) (1.93 )% Equipment expenses 1,846 1,889 (43 ) (2.28 )% Data processing fees 1,539 1,529 10 0.65 %Automated teller machine 977 1,014 (37 ) (3.65 )% Deposit insurance 1,260 1,491 (231 ) (15.49 )% Professional fees 1,616 1,641 (25 ) (1.52 )%Advertising and promotion 1,602 1,458 144 9.88 % Software subscriptions and publications 1,471 1,301 170 13.07 % Intangible amortization 962 1,160 (198 ) (17.07 )% Other real estate and repossessed assets 881 942 (61 ) (6.48 )% Other expenses 4,437 3,916 521 13.30 % Total $ 40,265 $ 40,416 $ (151 ) (0.37 )% 60 The decrease in non-interest expenses were primarily a result of the decreased salaries and benefits due to changes in employee health insurance and decreased deposit insurance expense of $231,000 due to the change in FDIC computation method. The increases were partially decreased by an increase in other expenses due to an $804,000 prepayment penalty for FHLB advances, increases in software subscriptions and maintenance of $170,000 and increases in marketing expense of $144,000.

Income Tax Expense. Income tax expense in 2012 increased $2.3 million compared to 2011. The Company's effective tax rate increased to 26.64% in 2012 from 8.63% in 2011, because of increased pre-tax income and decreased low income housing credits as a percentage of net income.

Comparison of Results of Operations for the Years Ended December 31, 2011 and 2010.

General. Net income available to common shareholders for the year ended December 31, 2011 was $1.4 million or $0.20 basic and diluted earnings per common share compared to net income available to common shareholders of $4.7 million, or $0.69 basic and diluted earnings per common share for the year ended December 31, 2010. The primary reason for this decrease is an increase in the provision for loan losses, lower net interest income and increased preferred stock dividends and accretion, which were partially offset by increased non-interest income. Our return on assets and on average tangible equity was 0.24% and 1.39%, respectively in 2011 compared to 0.45% and 4.96% in 2010.

Interest Income. Total interest income decreased $6.0 million, or 9.0%, to $61.4 million during the year ended December 31, 2011 from $67.4 million during the year ended December 31, 2010, reflecting the $18.4 million decline in interest-earning assets to $1.3 billion at year end 2011, primarily due to the decreases in our loan portfolio. In addition, our average yield on interest-earning assets decreased 39 basis points to 4.70% in 2011 compared to 5.09% in 2010 as national and local prevailing interest rates continued to decline and the mix of interest earning assets shifted towards lower yielding investment securities. Interest income on loans in 2011 was $52.7 million compared to $60.0 million in 2010, reflecting a $62.3 million decrease in the average loan portfolio to $963.9 million in 2011 and a 37 basis point decrease in the weighted average yield on loans in 2011 to 5.47%. Interest income on investment securities in 2011 was $8.5 million compared to $7.3 million in 2010, reflecting a $78.9 million increase in our average investment securities portfolio to $304.7 million in 2011 offset by a 42 basis point decrease in the weighted average yield on investment securities in 2011 to 2.80%.

Interest Expense. Interest expense decreased $5.2 million, or 20.5%, to $20.0 million during the year ended December 31, 2011 compared to $25.2 million during the year ended December 31, 2010. The primary reason for this decrease was a decline of 39 basis points on interest-bearing liabilities from 2.12% during 2010 to 1.73% during 2011, which was primarily due to continued re-pricing of deposit accounts. Interest expense on deposits decreased $2.3 million, due to a 27 basis point decline in average rates paid even with a $34.1 million increase in average interest-bearing deposits. Interest expense on borrowings decreased $2.9 million as a result of a 29 basis point decline in average rates and a $65.3 million decrease in average borrowing during 2011, as excess cash from deposits and proceeds from loan repayments was used to pay off maturing FHLB advances.

Net Interest Income. Net interest income before the provision for loan losses decreased by $884,000 in 2011 to $41.3 million in 2011 compared to $42.2 million in 2010, primarily due to reduced earning assets and the impact of interest earning assets re-pricing sooner than interest bearing liabilities. For more information on our asset/liability management especially as it relates to interest rate risk, see "Item 7A - Quantitative and Qualitative Disclosures About Market Risk" in this Form 10-K.

Provision for Loan Losses. Our provision for loan losses increased significantly in 2011 due to a slight increase in non-performing loans and an increase in net charge-offs from $7.1 million for 2010 to $12.7 million for 2011. The change in net charge-offs reflects the decline in current real estate values, primarily impacting the construction and development portfolio. In addition, non-performing loans at December 31, 2011 totaled $39.2 million, or 3.47% of total loans and 2.75% of total assets, compared to $37.9 million, or 3.19% of total loans and 2.69% of total assets at the end of 2010. This $1.3 million increase in non-performing assets reflects a $1.5 million increase in foreclosed real estate, partially offset by a $230,000 decline in other repossessed assets.

61 Other Income. Other (non-interest) income increased in 2011 over the levels earned in 2010 primarily as a result of increased realized gains on the sale of securities, decreased OTTI, real estate sales and equity partnership losses offset by decreased service fee income and lower increases in our BOLI cash surrender value as follows: Year Ended Amount Percent 12/31/2011 12/31/2010 Change Change (Dollars in thousands) Non-Interest Income: Service fee income $ 6,987 $ 7,229 $ (242 ) (3.3 )% Net realized gain (loss) on sale of securities 2,049 (53 ) 2,102 (3966.0 )% Equity in losses of limited partnerships (384 ) (510 ) 126 (24.7 )% Commissions 3,691 3,845 (154 ) (4.0 )% Net gains on sales of loans 2,723 2,275 448 19.7 % Net servicing fees (73 ) 139 (212 ) (152.5 )% Increase in cash surrender value of life insurance 1,420 1,556 (136 ) (8.7 )% Loss on sale of other real estate and repossessed assets (426 ) (1,012 ) 586 (57.9 )% Net other-than-temporary losses on securities (193 ) (841 ) 648 (77.0 )% Other income 216 451 (235 ) (52.1 )% Total $ 16,010 $ 13,079 $ 2,931 22.4 % The increases in gains on sales of securities reflects our increased sales activities in 2011, and the decrease in OTTI losses reflecting the stabilization in the values of our trust preferred securities. The reduction in service fees is primarily due to regulatory changes governing overdraft charges on ATM and debit cards. The increase in gains on loan sales reflects a bulk loan sale of seasoned loans in the amount of $44.5 million, which was partially offset by lower loan production due to depressed demand in our market area. The decrease in net servicing fees was primarily due to an impairment charge of $150,000 based on the current independent valuation of mortgage servicing rights.

Other Expense. Other (non-interest) expense slightly increased in 2011 by $400,000 to $40.4 million in 2011, reflecting our continued efforts to control operating expenses.

Year Ended Amount Percent 12/31/2011 12/31/2010 Change Change (Dollars in thousands) Non-Interest Expense:Salaries and employee benefits $ 21,690 $ 21,078 $ 612 2.9 % Net occupancy expenses 2,385 2,503 (118 ) (4.7 )% Equipment expenses 1,889 1,903 (14 ) (0.7 )% Data processing fees 1,529 1,569 (40 ) (2.5 )%Automated teller machine 1,014 1,169 (155 ) (13.3 )% Deposit insurance 1,491 1,831 (340 ) (18.6 )% Professional fees 1,641 1,141 500 43.8 %Advertising and promotion 1,458 1,224 234 19.1 % Software subscriptions and publications 1,301 1,554 (253 ) (16.3 )% Intangible amortization 1,160 1,348 (188 ) (13.9 )% Other real estate and repossessed assets 942 924 18 1.9 % Other expenses 3,916 3,761 155 4.1 % Total $ 40,416 $ 40,005 $ 411 1.0 % 62 Salaries and employee benefits expenses increased due to less deferred compensation because of decreased loan production, increased benefit expenses on stock option grants and significant increases in Indiana's unemployment tax.

FDIC deposit insurance expense decreased in 2011 due to the FDIC's new fee structure. Professional fees increased due to increased legal costs related to non-performing loans and one-time fees associated with the corporate charter change.

Income Tax Expense. Income tax expense in 2011 decreased $1.3 million compared to 2010. The Company's effective tax rate decreased to 8.63% in 2011 from 20.37% in 2010 because of the decrease in pre-tax income and the increased low income housing credits as a percentage of net income.

Liquidity We are required to have enough cash and investments that qualify as liquid assets in order to maintain sufficient liquidity to ensure safe and sound operation. Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans.

Historically, we have maintained liquid assets above levels believed to be adequate to meet the requirements of normal operations, including potential deposit outflows. Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is maintained. During 2012 and 2011, we maintained higher levels of liquidity as we grew our deposits and marketable equity securities and received paydowns within our loan portfolio.

Liquidity management involves the matching of cash flow requirements of customers, who may be either depositors desiring to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs and the ability of the Company to manage those requirements. The Company strives to maintain an adequate liquidity position by managing the balances and maturities of interest-earning assets and interest-bearing liabilities so that the balance it has in short-term investments at any given time will cover adequately any reasonably anticipated, immediate need for funds. Additionally, the Bank maintains relationships with correspondent banks, which could provide funds on short-term notice if needed. Our liquidity, represented by cash and cash-equivalents and investment securities, is a product of our operating, investing and financing activities.

Liquidity management is both a daily and long-term function of the management of the Company and the Bank. It is overseen by the Asset and Liability Management Committee. The Board of Directors required the Bank to maintain a minimum liquidity ratio of 10% of deposits. At December 31, 2012, our ratio was 25.0%.

The Company is currently in excess of the minimum liquidity ratio set by the Board due to a larger than historical investment portfolio. Management continues to seek to utilize liquidity off of the investment portfolio to fund loan growth over the new few years as demand for loans increases. Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds. On a longer term basis, we maintain a strategy of investing in various lending products and investment securities, including mortgage-backed securities. The Bank uses its sources of funds primarily to meet its ongoing commitments, pay maturing deposits, fund deposit withdrawals and fund loan commitments.

We maintain cash and investments that qualify as liquid assets to maintain adequate liquidity to ensure safe and sound operation and meet demands for funds (particularly withdrawals of deposits). At December 31, 2012, on a consolidated basis, the Company had $314.0 million in cash and investment securities available for sale and $5.1 million in loans held for sale generally available for its cash needs. We can also generate funds from borrowings, primarily FHLB advances, and, to a lesser degree, third party loans. At December 31, 2012, the Bank had the ability to borrow an additional $225.8 million in FHLB advances. In addition, we have historically sold 30-year fixed-rate mortgage loans in the secondary market in order to reduce interest rate risk and to create another source of liquidity. The Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its own operating expenses (many of which are paid to the Bank), the Company is responsible for paying SBLF dividends to the Treasury, amounts owed on its trust preferred securities, any dividends declared to its common stockholders, and interest and principal on outstanding debt. The Company's primary source of funds is Bank dividends, the payment of which is subject to regulatory limits. At December 31, 2012, the Company, on an unconsolidated basis, had $2.0 million in cash, interest-bearing deposits and liquid investments generally available for its cash needs.

63 Our liquidity, represented by cash and cash equivalents and investment securities, is a product of our operating, investing and financing activities.

Our primary sources of funds are deposits, amortization, prepayments and maturities of outstanding loans and mortgage-backed securities, maturities of investment securities and other short-term investments and funds provided from operations. While scheduled payments from the amortization of loans and mortgage-backed securities and maturing investment securities and short-term investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. In addition, we invest excess funds in short-term interest-earning assets, which provide liquidity to meet lending requirements.

We also generate cash through borrowings. We utilize FHLB advances to leverage our capital base and provide funds for our lending and investment activities, and to enhance our interest rate risk management.

We use our sources of funds primarily to meet ongoing commitments, pay maturing deposits and fund withdrawals, and to fund loan commitments. At December 31, 2012, the approved outstanding loan commitments, including unused lines of credit, amounted to $159.6 million. Certificates of deposit scheduled to mature in one year or less at December 31, 2012, totaled $286.8 million. It is management's policy to offer deposit rates that are competitive with other local financial institutions. Based on this management strategy, we believe that a majority of maturing deposits will remain with the Bank.

Except as set forth above, management is not aware of any trends, events, or uncertainties that will have, or that are reasonably likely to have a material impact on liquidity, capital resources or operations. Further, management is not aware of any current recommendations by regulatory agencies, which, if they were to be implemented, would have this effect.

Off-Balance Sheet Activities In the normal course of operations, the Bank engages in a variety of financial transactions that are not recorded in our financial statements. These transactions involve varying degrees of off-balance sheet credit, interest rate and liquidity risks. These transactions are used primarily to manage customers' requests for funding and take the form of loan commitments and lines of credit.

We also have off-balance sheet obligations to repay borrowings and deposits. For the year ended December 31, 2012, we engaged in no off-balance sheet transactions likely to have a material effect on our financial condition, results of operations or cash flows. At December 31, 2012, the Bank had $67.1 million in commitments to make loans, $8.7 million in undisbursed portions of closed loans, $80.5 million in unused lines of credit and $3.3 million in standby letters of credit. In addition, on a consolidated basis, at December 31, 2012, the Company had $86.3 million in outstanding non-deposit borrowings, of which $14.1 million is due during 2013.

Capital Resources The Bank is subject to minimum capital requirements imposed by the FDIC. See 'Item 1 - Business- How We Are Regulated - Regulatory Capital Requirements." The FDIC may require the Bank to have additional capital above the specific regulatory levels if it believes the Bank is subject to increased risk due to asset problems, high interest rate risk and other risks. The Company is subject to minimum capital requirements imposed by the FRB, which are substantially similar to those imposed on the Bank, including guidelines for bank holding companies to be considered well-capitalized. The FDIC and FRB have issued proposals to revise these capital requirements, which would increase the levels required particularly if the Bank and the Company want to continue paying dividends or executive bonuses.

During 2011, the Company redeemed $32.4 million in preferred shares issued to Treasury in the TARP and repurchased the related TARP warrant for 625,135 shares of common stock for $900,000. Contemporaneous with the redemption of the TARP preferred shares, the Company received $28.9 million from Treasury in exchange for 28,923 shares of preferred stock in the SBLF program, which was established to encourage community banks to lend to small businesses. The Company did not repurchase any common stock in 2012. The Company may begin to redeem its SBLF Preferred Stock in 2013 to decrease the impact of the scheduled dividend increases.

At December 31, 2012, the Bank's regulatory capital exceeded the FDIC regulatory requirements, and the Bank was well-capitalized under regulatory prompt corrective action standards. In addition, at December 31, 2012, the Company's capital levels exceeded the FRB's requirements, and the Company was considered well-capitalized under FRB guidelines. Consistent with our goals to operate a sound and profitable organization, our policy is for the Bank to maintain well-capitalized status.

64 Our capital ratios at December 31, 2012 are reflected below: Minimum Minimum Required Actual Regulatory To be Considered Capital Levels Capital Levels Well-Capitalized Amount Ratio Amount Ratio Amount Ratio Leverage Capital Level(1): MutualFirst Consolidated $ 125,770 8.8 % $ 57,137 4.0 % $ N/A N/A MutualBank 132,254 9.3 57,121 4.0 71,401 5.0 Tier 1 Risk-Based Capital Level (2) : MutualFirst Consolidated $ 125,770 13.2 % $ 38,248 4.0 % $ 57,372 6.0 % MutualBank 132,254 13.8 38,217 4.0 57,326 6.0 Total Risk-Based Capital Level (3) : MutualFirst Consolidated $ 137,764 14.4 % $ 76,496 8.0 % $ 95,620 10.0 % MutualBank 144,247 15.1 76,434 8.0 95,543 10.0 (1) Tier 1 Capital to Average Total Assets of $1.4 billion for the Bank and $1.4 billion for the Company at December 31, 2012 (2) Tier 1 Capital to Risk-Weighted Assets of $955.5 million for the Bank and $956.2 million for the Company at December 31, 2012.

(3) Total Capital to Risk-Weighted Assets.

Impact of Inflation The effects of price changes and inflation can vary substantially for most financial institutions. While management believes that inflation affects the economic value of total assets, it believes that it is difficult to assess the overall impact. Management believes this to be the case due to the fact that generally neither the timing nor the magnitude of the inflationary changes in the consumer price index ("CPI") coincides with changes in interest rates. For example, the price of one or more of the components of the CPI may fluctuate considerably and thereby influence the overall CPI without having a corresponding effect on interest rates or upon the cost of those goods and services normally purchased by us. In years of high inflation and high interest rates, intermediate and long-term interest rates tend to increase, thereby adversely impacting the market values of investment securities, mortgage loans and other long-term fixed rate loans. In addition, higher short-term interest rates caused by inflation tend to increase the cost of funds. In other years, the opposite may occur.

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