PRINCETON NATIONAL BANCORP INC - FORM 10-Q

Attached files

file	filename
EX-31.1 - EXHIBIT 31.1 - PRINCETON NATIONAL BANCORP INC	ex31-1.htm
EX-32.1 - EXHIBIT 32.1 - PRINCETON NATIONAL BANCORP INC	ex32-1.htm
EX-31.2 - EXHIBIT 31.2 - PRINCETON NATIONAL BANCORP INC	ex31-2.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the Quarterly Period Ended June 30, 2012

Commission File Number: 0-20050

PRINCETON NATIONAL BANCORP, INC.

(Exact name of Registrant as specified in its charter.)

Delaware	36-3210283
(State or other jurisdiction of	(I.R.S. Employer Identification Number)
incorporation or organization)

606 S. Main St.
Princeton, Illinois	61356
(Address of principal executive offices)	(Zip code)

(815) 875-4444

(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 R No £

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 R No £

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 £	Accelerated filer £	Non-accelerated filer £	Smaller reporting company R

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No R

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class	Outstanding at September 6, 2012
Common, par value $5.00	3,377,010

Part I: FINANCIAL INFORMATION

The unaudited condensed consolidated financial statements of Princeton National Bancorp, Inc. and Subsidiary and management’s discussion and analysis of financial condition and results of operation are presented in the schedules as follows:

Schedule 1: Condensed Consolidated Balance Sheets

Schedule 2: Condensed Consolidated Statements of Operations

Schedule 3: Condensed Consolidated Statements of Comprehensive Income (Loss)

Schedule 4: Condensed Consolidated Statements of Changes in Stockholders’ Equity (Deficit)

Schedule 5: Condensed Consolidated Statements of Cash Flows

Schedule 6: Notes to Condensed Consolidated Financial Statements

Schedule 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations

Schedule 8: Controls and Procedures

Part II: OTHER INFORMATION

Item 1A. Risk Factors

Smaller reporting companies are not required to provide the information required by this item.

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

(a)

None.

Item 3. Defaults Upon Senior Securities

(a)

None.

Item 4. Mine Safety Disclosures

(a)

None.

Item 5. Reserved.

Item 6. Exhibits

31.1 Certification of Chief Executive Officer required by Rule 13a-14(a).

31.2 Certification of Chief Financial Officer required by Rule 13a-14(a).

32.1 Certification of Chief Executive Officer and Chief Financial Officer required by Rule 13a-14(b)

and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.

** XBRL information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, as amended, and otherwise is not subject to liability under these sections.

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.

PRINCETON NATIONAL BANCORP, INC.


By	/s/ Thomas D. Ogaard 9/6/2012	By	/s/ Louis Casto 9/6/2012
	Thomas D. Ogaard		Louis Casto
	President & Chief Executive Officer September 6, 2012		Interim Chief Financial Officer September 6, 2012

Schedule 1

Princeton National Bancorp, Inc.

Condensed Consolidated Balance Sheets

(dollars in thousands except share data)	June 30, 2012			December 31, 2011
	(unaudited)
ASSETS
Cash and due from banks	$	16,221		$	16,307
Interest-bearing deposits with financial institutions		125,008			46,988
Total cash and cash equivalents		141,229			63,295

Loans held-for-sale, at lower of cost or market		2,336			2,220

Investment securities:
Available-for-sale, at fair value		215,881			251,747
Held-to-maturity, at amortized cost (fair value of $7,734 and $9,942)		7,643			9,836
Total investment securities		223,524			261,583

Loans:
Loans, net of unearned interest		520,649			621,021
Allowance for loan losses		(22,472	)		(30,413	)
Net loans		498,177			590,608

Premises and equipment, net of accumulated depreciation		25,429			25,850
Land held for sale, at lower of cost or market		2,084			2,164
Federal Reserve and Federal Home Loan Bank stock		3,279			4,500
Bank-owned life insurance		24,727			24,330
Accrued interest receivable		3,800			6,453
Other real estate owned		21,141			21,848
Intangible assets, net of accumulated amortization		1,603			1,877
Other assets		6,821			9,588

TOTAL ASSETS	$	954,150		$	1,014,316

LIABILITIES
Deposits:
Demand	$	152,741		$	171,939
Interest-bearing demand		324,892			353,462
Savings		87,480			84,599
Time		312,058			307,295

Total deposits		877,171			917,295

Borrowings:
Customer repurchase agreements		50,743			54,835
Advances from the Federal Home Loan Bank		0			5,000
Trust preferred securities		25,000			25,000

Total borrowings		75,743			84,835

Other liabilities		5,752			7,251

TOTAL LIABILITIES		958,666			1,009,381

COMMITMENTS AND CONTINGENT LIABILITIES		-			-

STOCKHOLDERS' EQUITY (DEFICIT)
Preferred stock: no par value, 100,000 shares authorized: 25,083 shares issued and outstanding at June 30, 2012 and December 31, 2011		25,031			25,016
Common stock: $5 par value, 7,000,000 shares authorized: 4,478,295 shares issued at June 30, 2012 and December 31, 2011		22,391			22,391
Common stock warrants		150			150
Surplus		17,991			18,126
Accumulated deficit		(47,924	)		(42,791	)
Accumulated other comprehensive income, net of tax		984			5,378
Less: cost of 1,125,770 and 1,137,266 treasury shares at June 30, 2012 and December 31, 2011		(23,139	)		(23,335	)

TOTAL STOCKHOLDERS' EQUITY (DEFICIT)		(4,516	)		4,935

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)	$	954,150		$	1,014,316

See accompanying notes to unaudited condensed consolidated financial statements.

Schedule 2

Princeton National Bancorp, Inc.

Condensed Consolidated Statements of Operations (unaudited)

(dollars in thousands except share data)	THREE MONTHS ENDED June 30, 2012			THREE MONTHS ENDED June 30, 2011			SIX MONTHS ENDED June 30, 2012			SIX MONTHS ENDED June 30, 2011


Interest Income:
Interest and fees on loans	$	6,299		$	8,186		$	13,120		$	17,045
Interest and dividends on investment securities:
Taxable		1,357			1,591			2,892			3,107
Tax-exempt		477			763			1,028			1,661
Interest on interest-bearing deposits in other banks		48			34			95			56
Total interest income		8,181			10,574			17,135			21,869

Interest Expense:
Interest on deposits		914			1,634			1,932			3,372
Interest on borrowings		208			184			424			384
Total interest expense		1,122			1,818			2,356			3,756

Net interest income		7,059			8,756			14,779			18,113

Provision for loan losses		10,025			8,050			10,100			9,925

Net interest income after provision for loan losses		(2,966	)		706			4,679			8,188

Non-interest income:
Trust and farm management fees		316			269			606			559
Service charges on deposit accounts		966			1,002			1,936			1,945
Other service charges		395			421			882			826
Gains on sales of securities available-for-sale		5,098			1,598			5,652			2,682
Brokerage fee income		167			207			321			346
Mortgage banking income, net		74			288			441			740
Bank-owned life insurance income		221			225			441			446
Other operating income		1,112			17			1,213			83
Total non-interest income		8,349			4,027			11,492			7,627

Non-interest expense:
Salaries and employee benefits		4,373			4,529			9,147			9,145
Occupancy		645			623			1,297			1,312
Equipment expense		788			781			1,551			1,562
Federal insurance assessments		1,056			447			1,972			1,087
Intangible assets amortization		141			175			281			369
Data processing		417			349			789			715
Marketing		122			139			298			294
Other real estate expense, net		1,282			1,433			935			2,015
Loan collection expenses		1,265			371			2,175			534
Other operating expense		1,419			1,386			2,791			2,635
Total non-interest expense		11,508			10,233			21,236			19,668

Loss before income taxes		(6,125	)		(5,500	)		(5,065	)		(3,853	)
Income tax expense (benefit)		0			(2,575	)		53			(2,663	)

Net loss		(6,125	)		(2,925	)		(5,118	)		(1,190	)

Dividends in arrears on preferred shares		314			0			627			0
Accretion of preferred stock discount		7			7			15			15

Net loss available to common stockholders	$	(6,446	)	$	(2,932	)	$	(5,760	)	$	(1,205	)

Loss per share available to common stockholders:
Basic net loss per common share available to common stockholders	$	(1.92	)	$	(0.88	)	$	(1.72	)	$	(0.36	)
Diluted net loss per common share available to common stockholders	$	(1.92	)	$	(0.88	)	$	(1.72	)	$	(0.36	)

Basic weighted average shares outstanding		3,354,896			3,328,035			3,352,167			3,327,005
Diluted weighted average shares outstanding		3,354,896			3,328,035			3,352,167			3,327,005

See accompanying notes to unaudited condensed consolidated financial statements.

Schedule 3

Princeton National Bancorp, Inc.

Condensed Consolidated Statements of Comprehensive Income (Loss) (unaudited)

(dollars in thousands)	THREE MONTHS ENDED June 30, 2012			THREE MONTHS ENDED June 30, 2011			SIX MONTHS ENDED June 30, 2012			SIX MONTHS ENDED June 30, 2011


Net Loss	$	(6,125	)	$	(2,925	)	$	(5,118	)	$	(1,190	)

Other Comprehensive Income (Loss)
Net unrealized gains on securities available for sale	$	949		$	2,039		$	1,258		$	1,541
Reclassification adjustment for realized gains included in income		(5,098	)		(1,598	)		(5,652	)		(2,682	)
Post Retirement Obligation		(116	)		-			(116	)
Other comprehensive income (loss), before tax effect		(4,265	)		441			(4,510	)		(1,141	)
Tax expense (benefit)		(116	)		171			(116	)		(442	)
Other comprehensive income (loss)		(4,149	)		270			(4,394	)		(699	)

Comprehensive Loss	$	(10,274	)	$	(2,655	)	$	(9,512	)	$	(1,889	)

See accompanying notes to unaudited condensed consolidated financial statements.

Schedule 4

Princeton National Bancorp, Inc.

Condensed Consolidated Statements of Changes in Stockholders' Equity (Deficit) (unaudited)

(dollars in thousands except share data) For the Six Months Ended June 30, 2012	Preferred Stock		Common Stock		Common Stock Warrants		Surplus			Retained Earnings (Accumulated Deficit)			Accumulated Other Comprehensive Income, net of tax effect			Treasury Stock			Total


Balance, January 1, 2012	$	25,016	$	22,391	$	150	$	18,126		$	(42,791	)	$	5,378		$	(23,335	)	$	4,935

Net loss											(5,118	)								(5,118	)
Accretion on preferred stock discount		15									(15	)								0
Sale of 2,496 shares of treasury common stock								(35	)								43			8
Award of 12,500 shares of nonvested common stock out of treasury common stock								(195	)								214			19
Forfeiture of 3,500 shares of common stock out of treasury common stock								55									(61	)		(6	)
Amortization of unearned compensation expense
Other comprehensive loss														(4,394	)					(4,394	)

Balance, June 30, 2012	$	25,031	$	22,391	$	150	$	17,991		$	(47,924	)	$	984		$	(23,139	)	$	(4,516	)


For the Six Months Ended
June 30, 2011

Balance, January 1, 2011	$	24,986	$	22,391	$	150	$	18,275		$	11,589		$	3,064		$	(23,594	)	$	56,861

Net loss											(1,190	)								(1,190	)
Accretion on preferred stock discount		15									(15	)								0
Sale of 4,097 shares of treasury common stock								(49	)								70			21
Amortization of unearned compensation expense
Other comprehensive loss														(699	)					(699	)

Balance, June 30, 2011	$	25,001	$	22,391	$	150	$	18,259		$	10,384		$	2,365		$	(23,524	)	$	55,026

See accompanying notes to unaudited condensed consolidated financial statements.

Schedule 5

Princeton National Bancorp, Inc.

Condensed Consolidated Statements of Cash Flows (unaudited)

(dollars in thousands)		SIX MONTHS ENDED June 30, 2012			SIX MONTHS ENDED June 30, 2011
Operating activities:
Net loss		$	(5,118	)	$	(1,190	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation			878			966
Provision for loan losses			10,100			9,925
Deferred income tax benefit			0			(2,503	)
Amortization of intangible assets and other purchase accounting adjustments, net			274			368
Amortization of premiums and discounts on investment securities, net			1,958			767
Gains on sales of securities available-for-sale, net			(5,652	)		(2,682	)
Gain on sale of land held-for-sale			(75	)		0
Compensation expense for vested stock options			40			33
Forfeiture of stock options			(6	)		0
Sales of treasury stock			8			21
Loss on sales of other real estate owned, net			72			1,069
Loans originated for sale			(31,545	)		(27,245	)
Proceeds from sales of loans originated for sale			31,429			30,145
Increase in accrued interest payable			569			140
Decrease in accrued interest receivable			2,653			1,366
Decrease in other assets			763			595
Increase (decrease) in other liabilities			(2,068	)		803

Net cash provided by operating activities			4,280			12,578

Investing activities:
Proceeds from sales of investment securities available-for-sale			83,670			83,036
Proceeds from maturities of investment securities available-for-sale			24,703			10,622
Purchase of investment securities available-for-sale			(71,466	)		(78,445	)
Proceeds from maturities of investment securities held-to-maturity			2,059			1,267
Proceeds from sale of land held-for-sale			155			0
Proceeds from sales of other real estate owned			14,473			3,245
Proceeds from sale of Federal Reserve stock			1,221			0
Net decrease in loans			68,493			23,895
Purchases of premises and equipment			(457	)		(277	)

Net cash provided by investing activities			122,851			43,343

Financing activities:
Net decrease in deposits			(40,124	)		(23,546	)
Net decrease in short-term borrowings			(9,092	)		(2,272	)
Award of nonvested stock from treasury stock			19			0

Net cash used in financing activities			(49,197	)		(25,818	)

Increase in cash and cash equivalents			77,934			30,103
Cash and cash equivalents at beginning of period			63,295			43,880

Cash and cash equivalents at end of period		$	141,229		$	73,983


Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest		$	1,786		$	3,616
Income taxes		$	16		$	896

Supplemental disclosures of non-cash flow activities:
Loans transferred to other real estate owned		$	13,838		$	1,970

See accompanying notes to unaudited condensed consolidated financial statements.

Interest expense	3,756,009
less accrued interest payable 6/30/11	1,475,021
Cash paid during the period for interest	3,616,003

Schedule 6

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

The accompanying unaudited Condensed Consolidated Financial Statements reflect all adjustments, which, in the opinion of management, are necessary for a fair presentation of the results of the interim periods ended June 30, 2012 and 2011, and all such adjustments are of a normal recurring nature. The 2011 year-end Condensed Consolidated Balance Sheet data was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles.

The unaudited Condensed Consolidated Financial Statements have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information required by accounting principles generally accepted in the United States of America for complete financial statements and related footnote disclosures. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered for a fair presentation of the results for the interim period have been included. For further information, refer to the Consolidated Financial Statements and notes included in the Registrant's 2011 Annual Report on Form 10-K. Results of operations for interim periods are not necessarily indicative of the results that may be expected for the year. Certain amounts in the 2011 Consolidated Financial Statements have been reclassified to conform to the 2012 presentation.

NOTE 1 -- CAPITAL PURCHASE PROGRAM

On January 23, 2009, the Corporation received $25,083,000 of equity capital by issuing to the United States Department of Treasury 25,083 shares of the Corporation’s 5.00% Series B Non-voting Cumulative Preferred Stock, par value $0.01 per share, with a liquidation preference of $1,000 per share and a ten-year warrant to purchase up to 155,025 shares of the Corporation’s common stock, par value $5.00 per share, at an exercise price of $24.27 per share. The proceeds received were allocated to the preferred stock and additional paid-in capital based on their relative fair values. The resulting discount on the preferred stock is amortized against retained earnings and is reflected in the Corporation’s Condensed Consolidated Statements of Income as “Dividends on preferred shares,” resulting in additional dilution to the Corporation’s earnings per share. The warrants are exercisable, in whole or in part, over a term of 10 years. The warrants were included in the Corporation’s diluted average common shares outstanding (subject to anti-dilution). Both the preferred securities and warrants were accounted for as additions to the Corporation’s regulatory Tier 1 and total capital.

The Series B Preferred Stock is not mandatorily redeemable and will pay cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter. The Corporation can redeem the preferred securities at any time with Federal Reserve approval. The Series B Preferred Stock ranks on equal priority with the Corporation’s currently authorized Series A Preferred Stock.

A company that participates must adopt certain standards for executive compensation, including (a) prohibiting “golden parachute” payments as defined in the Emergency Economic Stabilization Act of 2008 (EESA) to senior Executive Officers; (b) requiring recovery of any compensation paid to senior Executive Officers based on criteria that is later proven to be materially inaccurate; (c) prohibiting incentive compensation that encourages unnecessary and excessive risks that threaten the value of the financial institution; and (d) accepting restrictions on the payment of dividends and the repurchase of common stock.

On January 24, 2011, the Corporation notified the U.S. Treasury that it will defer regularly scheduled payments on the Corporation’s 25,083 shares in Series B Preferred Stock. As of June 30, 2012 and June 30, 2011, “dividends in arrears” on the preferred stock, which must be paid prior to the payment of dividends on the common shares, total approximately $1,881,000 and $627,000, respectively.

NOTE 2 -- EARNINGS PER SHARE

The following table sets forth the computation for basic and diluted loss per share for the periods indicated:

(in thousands, except share data)	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011

Numerator:
Net loss available to common stockholders	$	(6,446)	$	(2,932)	$	(5,760)	$	(1,2050

Denominator:
Basic earnings per share - weighted average common shares		3,354,896		3,328,035		3,352,167		3,327,005

Net loss per share available to common stockholders:
Basic	$	(1.92)	$	(0.88)	$	(1.72)	$	(0.36)
Diluted	$	(1.92)	$	(0.88)	$	(1.72)	$	(0.36)

The following shares were not considered in computing diluted earnings per share for the three and six month periods ended June 30, 2012 and 2011 because they were anti-dilutive:

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
Stock options to purchase shares of common stock		360,308		555,277		360,308		555,277

Average dilutive potential common shares associated with common stock warrants		155,025		155,025		155,025		155,025

NOTE 3 -- INTANGIBLE ASSETS

The balance of intangible assets, net of accumulated amortization, totaled $1,603,000 and $1,877,000 at June 30, 2012 and December 31, 2011, respectively.

The following table summarizes the Corporation’s intangible assets, which are subject to amortization, as of June 30, 2012 and December 31, 2011:

(in thousands)	June 30, 2012					December 31, 2011
	Gross Carrying Amount		Accumulated Amortization			Gross Carrying Amount		Accumulated Amortization

Core deposit intangible	$	9,004	$	(7,437	)	$	9,004	$	(7,168	)
Other acquisition costs		234		(198	)		234		(193	)
Total	$	9,238	$	(7,635	)	$	9,238	$	(7,361	)

Amortization expense of all intangible assets totaled $274,000 and $369,000 for the six months ended June 30, 2012 and 2011, respectively. The amortization expense of these intangible assets will be approximately $274,000 for the remaining six months of 2012.

NOTE 4 -- ORIGINATED MORTGAGE SERVICING RIGHTS

Mortgage servicing rights, which are included in other assets on the Condensed Consolidated Balance Sheets, are accounted for on an individual loan-by-loan basis. Accordingly, amortization is recorded in proportion to the amount of principal payment received on loans serviced. The mortgage servicing rights are subject to periodic impairment testing. Changes in the carrying value of capitalized mortgage servicing rights are summarized as follows:

(in thousands)

Balance, January 1, 2012	$	2,437
Servicing rights capitalized		206
Amortization of servicing rights		(302	)
Valuation adjustment		(195	)
Balance, June 30, 2012	$	2,146

Activity in the valuation allowance for mortgage servicing rights was as follows:

(in thousands)

Balance, January 1, 2012	$	1,312
Additions		195
Reductions		-

Balance, June 30, 2012	$	1,507

The following table shows the future estimated amortization expense for mortgage servicing rights based on existing balances as of June 30, 2012. The Corporation’s actual amortization expense in any given period may be significantly different from the estimated amounts displayed, depending on the amount of additional mortgage servicing rights, changes in mortgage interest rates, estimated prepayment speeds and market conditions. Estimated Amortization Expense:

	Amount (in thousands)
For the six months ended December 31, 2012	$	142
For the year ending December 31, 2013		267
For the year ending December 31, 2014		251
For the year ending December 31, 2015		235
For the year ending December 31, 2016		221
For the year ending December 31, 2017		207
Thereafter		823

The Corporation services loans for others with unpaid principal balances at June 30, 2012 and December 31, 2011 of approximately $392.6 million and $403.5 million, respectively. The Corporation entered into an agreement with First State Bank to sell its entire servicing portfolio for 0.550% of total serviced assets equaling approximately $2,146,000 as of June 30, 2012.

NOTE 5 -- OTHER COMPREHENSIVE INCOME (LOSS)

Other comprehensive income (loss) components and related taxes for the six months ended June 30, 2012 and 2011 were as follows:

(in thousands)	2012			2011
Net unrealized gains on securities available-for-sale	$	1,258		$	1,541
Reclassification adjustment for realized gains included in income		(5,652	)		(2,682	)

Post retirement benefit obligation		(116	)		-
Other comprehensive income (loss), before tax effect		(4,510	)		(1,141	)
Tax expense (benefit)		(116	)		(442	)
Other comprehensive income (loss)	$	(4,394	)	$	(699	)

The components of accumulated other comprehensive income, included in stockholders’ equity at June 30, 2012 and 2011, are as follows:

(in thousands)	2012			2011
Net unrealized gains on securities available-for-sale	$	4,915		$	4,391
Net unrealized benefit obligations		(646	)		(530	)
		4,269			3,861
Deferred tax valuation allowance		(1,652	)		-
Tax effect		(1,633	)		(1,496	)
Net-of-tax amount	$	984		$	2,365

NOTE 6 -- FEDERAL RESERVE BANK AND FEDERAL HOME LOAN BANK STOCK

The subsidiary bank held $2,373,000 in Federal Home Loan Bank stock at June 30, 2012 and December 31, 2011. The subsidiary bank also held $906,000 and $2,127,000 in Federal Reserve Bank stock at June 30, 2012 and December 31, 2011, respectively. The decrease in Federal Reserve Bank stock outstanding was the result of stock redemptions during 2012. Federal Home Loan Bank stock is a required investment for institutions that are members of the Federal Home Loan Bank system. The required investment is based on a predetermined formula. The Federal Home Loan Bank of Chicago (FHLB) was operating under a Consent Order (the “FHLB Consent Order”) from its regulator, the Federal Housing Finance Board. However, on April 18, 2012, they announced that the Federal Housing Financing Agency (the “FHFA”) had agreed to terminate the FHLB Consent Order effective immediately. The FHLB’s new capital structure and repurchase plan were approved by the FHFA. This new capital structure established two subclasses of stock effective January 1, 2012 and the repurchase plan allows members to request that the FHLB repurchase all or a portion of their excess FHLB stock. The FHLB continues to provide liquidity and funding through advances. With regard to dividends, the FHLB will continue to assess its dividend capacity each quarter and make appropriate request for approval. The FHLB did not pay a dividend in calendar year 2010; however, in calendar year 2011 the FHLB declared and paid four quarterly dividends at an annualized rate of 10 basis points per share. Management performed an analysis as of June 30, 2012 and December 31, 2011 and deemed the cost method of investment in FHLB stock was ultimately recovered. For the first quarter of 2012, the FHLB declared a cash dividend at an annualized rate of 0.25% per share. For the second quarter of 2012, the FHLB declared a cash dividend at an annualized rate of .30% per share.

NOTE 7 -- INVESTMENT SECURITIES

The amortized cost, gross unrealized gains, gross unrealized losses and estimated fair value of available-for-sale and held-to-maturity securities by major security type at June 30, 2012 and December 31, 2011 were as follows:

June 30, 2012

(in thousands)	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
Available-for-sale:
United States Government and federal agency and U.S. Government sponsored enterprises (GSEs)	$	65,058	$	1,117	$	(2	)	$	66,173
State and Municipal		48,669		2,814		(21	)		51,462
Collateralized mortgage obligations: GSE residential		94,039		1,198		(191	)		95,046
Mutual funds		3,200		-		-			3,200
Total		210,966		5,129		(214	)		215,881
Held-to-maturity:
State and Municipal		7,643		97		(6	)		7,734
Total	$	218,609	$	5,226	$	(220	)	$	223,615

December 31, 2011

(in thousands)	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
Available-for-sale:
United States Government and federal agency and U.S. Government sponsored enterprises (GSEs)	$	76,694	$	1,374	$	(46	)	$	78,022
State and Municipal		89,264		6,274		(55	)		95,483
Collateralized mortgage obligations: GSE residential		76,480		1,796		(34	)		78,242
Total		242,438		9,444		(135	)		251,747
Held-to-maturity:
State and Municipal		9,836		114		(8	)		9,942
Total	$	252,274	$	9,558	$	(143	)	$	261,689

Securities with unrealized losses at June 30, 2012 and December 31, 2011 not recognized in income are as follows:

	June 30, 2012
(in thousands)	Less Than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
United States government and federal agency and U.S. government-sponsored entities (GSEs)	$	2,927	$	(2	)	$	-	$	-		$	2,927	$	(2	)
State and municipal		490		(5	)		711		(22	)		1,201		(27	)
Collateralized mortgage obligations: GSE residential		22,367		(191	)		-		-			22,367		(191	)
Mutual funds		-		-			-		-			-		-
Temporarily impaired securities	$	25,784	$	(198	)	$	711	$	(22	)	$	26,495	$	(220	)

	December 31, 2011
(in thousands)	Less Than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
United States government and federal agency and U.S. government-sponsored entities (GSEs)	$	4,932	$	(46	)	$	0	$	0		$	4,932	$	(46	)
State and municipal		505		(8	)		1,597		(55	)		2,102		(63	)
Collateralized mortgage obligations: GSE residential		6,083		(34	)		0		0			6,083		(34	)
Temporarily impaired securities	$	11,520	$	(88	)	$	1,597	$	(55	)	$	13,117	$	(143	)

There are 6 securities in an unrealized loss position in the investment portfolio at June 30, 2012 all due to interest rate changes and not credit events. These unrealized losses are considered temporary and, therefore, have not been recognized into income because the issuers are of high credit quality and management has the intent and ability to hold for the foreseeable future and it is more likely than not that the Corporation will not be required to sell the security before recovery. The fair value is expected to recover as the investments approach their maturity date or there is a downward shift in interest rates.

Maturities of investment securities classified as available-for-sale and held to maturity were as follows at June 30, 2012:

(in thousands)	Adjusted Carrying Value		Fair Value
Available-for-sale:
Due in one year or less	$	855	$	867
Due after one year through five years		21,639		22,476
Due after five years through ten years		29,268		30,870
Due after ten years		10,517		11,005
		62,279		65,218
Mortgage-backed securities		51,448		52,417
Collateralized mortgage obligations		94,039		95,046
Mutual funds		3,200		3,200
	$	210,966	$	215,881

Held-to-maturity:
Due in one year or less	$	2,656	$	2,670
Due after one year through five years		3,231		3,293
Due after five years through ten years		1,756		1,771
Due after ten years		-		-
	$	7,643	$	7,734

Proceeds from sales of investment securities available-for sale were $83.7 million and $83.0 million for the first six months of 2012 and 2011, respectively. Net gains were realized of $5,652,000 and $2,682,000 for the six months ended June 30, 2012 and 2011, respectively. The carrying value of securities pledged as collateral, to secure public deposits and for other purposes were $199.3 million at June 30, 2012 and $201.4 million at December 31, 2011.

NOTE 8 -- LOANS AND THE ALLOWANCE FOR LOAN LOSSES

The composition of the loan portfolio was as follows:

	June 30, 2012		December 31, 2011

Commercial	$	50,914	$	62,609

Agricultural		22,392		61,251

Agricultural Real Estate		53,328		60,523
Commercial Real Estate		230,902		235,103
Commercial Real Estate Development		30,124		58,279
Residential Real Estate		91,793		97,172

Total real estate		406,147		451,077

Consumer		41,196		46,084

Total	$	520,649	$	621,021

At June 30, 2012 and December 31, 2011, the Corporation held $230,902 and $235,103 in commercial real estate loans and $30,124 and $58,279 in commercial real estate development loans, respectively. Generally, those loans are collateralized by the real estate being financed. The loans are expected to be repaid from cash flows or from proceeds of sale of the real estate of the borrowers.

At June 30, 2012 and December 31, 2011, the Corporation held $22,392 and $61,251 in agricultural production loans and $53,328 and $60,523 in agricultural real estate loans, respectively. Generally, those loans are collateralized by the assets of the borrower. The loans are expected to be repaid from cash flows or from proceeds of sale of selected assets of the borrowers.

The primary lending market includes the Illinois counties of Aurora, Bureau, DeKalb, Henry, Kane, Kendall, LaSalle, McHenry and Will as well as adjacent counties in Illinois. Generally, loans are collateralized by assets, primarily real estate, of the borrowers and guaranteed by individuals. The loans are expected to be repaid from cash flows of the borrowers or from proceeds from the sale of selected assets of the borrowers.

Management reviews and approves the Corporation’s lending policies and procedures on a regular basis. Management regularly (at least quarterly) reviews the allowance for loan losses and reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. The Corporation’s underwriting standards are designed to encourage relationship banking rather than transactional banking. Relationship banking implies a primary banking relationship with the borrower that includes, at minimum, an active deposit banking relationship in addition to the lending relationship. The integrity and character of the borrower are significant factors in the Corporation’s loan underwriting. As a part of underwriting, tangible positive or negative evidence of the borrower’s integrity and character are sought out. Additional significant underwriting factors beyond location, duration, the sound and profitable cash flow basis underlying the loan and the borrower’s character are the quality of the borrower’s financial history, the liquidity of the underlying collateral and the reliability of the valuation of the underlying collateral.

The Corporation’s policies and loan approval limits are established by the Board of Directors. The loan officers generally have authority to approve secured loans up to $100,000 and unsecured loans or exposures up to $50,000. Managing Officers (those with designated loan approval authority) generally have authority to approve secured loans up to $250,000 and unsecured loans or exposures up to $100,000. The Senior Commercial Banking Officer has authority to approve new secured loans up to $750,000 and unsecured loans or exposures up to $250,000. The Chief Credit Officer has authority to approve new secured loans up to $1,500,000 and unsecured loans or exposures up to $250,000. In addition, in certain circumstances any two consumer officers may combine their loan authority limits to approve a loan, while only the President and Chief Executive Officer, Chief Credit Officer and Senior Commercial Banking Manager may combine their loan authority limits to approve a commercial loan. The Executive Loan Committee may approve new secured one-to-four family residential mortgage loans up to $2,500,000, commercial real estate loans, multi-family real estate loans and land loans up to $3,500,000 in aggregate, and unsecured loans or exposures up to $1,000,000. All loans above the established limits must be approved by the Directors Loan Committee, consisting of the Chairman, the President and Chief Executive Officer and up to three other Board members. At no time will the Corporation originate a loan where a borrower's total borrowing relationship exceeds the Corporation’s regulatory lending limit. Loans to related parties, including executive officers and the Corporation’s directors, are reviewed for compliance with regulatory guidelines by the board of directors at least quarterly.

The Corporation conducts internal loan reviews that validate the loans against the Corporation’s loan policy quarterly for mortgage, consumer, and small commercial loans on a sample basis, and all larger commercial loans on an annual basis. Beginning in 2011, the Corporation also began receiving independent loan reviews performed by a third party on larger commercial loans to be performed annually. In addition to compliance with the Corporation’s policy, the loan review process reviews the risk assessments made by its credit department, lenders and loan committees. Results of these reviews are presented to management and the board of directors.

The Corporation’s lending can be summarized into six primary areas; one- to four-family residential mortgage loans, commercial real estate and multi-family real estate loans, home equity lines of credits, real estate construction, commercial business loans, and consumer loans. The primary lending market includes the Illinois counties of Aurora, Bureau, DeKalb, Henry, Kane, Kendall, LaSalle, McHenry and Will as well as the adjacent counties in Illinois.

One-to-Four Family Residential Mortgage Loans

The Corporation offers one-to-four family residential mortgage loans that conform to Fannie Mae and Freddie Mac underwriting standards (conforming loans) as well as non-conforming loans. In recent years there has been an increased demand for long-term fixed-rate loans, as market rates dropped and remained near historic lows. As a result, the Corporation has sold a substantial portion of fixed-rate one-to-four family residential mortgage loans with terms of 15 years or greater. Generally, the Corporation retains fixed-rate one-to-four family residential mortgage loans with terms of less than 15 years, although this has represented a small percentage of the fixed-rate loans originated in recent years due to the favorable long-term rates for borrower.

In addition, the Corporation also offers home equity loans that are secured by a second mortgage on the borrower’s primary or secondary residence. Home equity loans are generally underwritten using the same criteria used to underwrite one-to-four family residential mortgage loans.

As one-to-four family residential mortgage and home equity loan underwriting are subject to specific regulations, the Corporation typically underwrites its one-to-four family residential mortgage loans and home equity loans to conform to generally accepted standards. Several factors are considered in underwriting including the value of the underlying real estate and the debt to income and credit history of the borrower. The Corporation has established minimum standards and underwriting guidelines for all residential real estate loan collateral types.

Commercial Real Estate and Multi-Family Real Estate Loans

Commercial real estate mortgage loans are primarily secured by office buildings, owner-occupied businesses, strip mall centers, farms and churches. In underwriting commercial real estate loans and multi-family real estate loans, the Corporation considers a number of factors which include the projected net cash flow to the loan’s debt service requirement, the age and condition of the collateral, the financial resources and income level of the borrower and the borrower’s experience in owning or managing similar properties. Personal guarantees are typically obtained from commercial real estate and multi-family real estate borrowers. In addition, the borrower’s financial information on such loans is monitored on an ongoing basis by requiring periodic financial statement updates. The repayment of these loans is primarily dependent on the cash flows of the underlying property; however, the commercial real estate loan generally must be supported by an adequate underlying collateral value. The performance and the value of the underlying property may be adversely affected by economic factors or geographical and/or industry specific factors. These loans are subject to other industry guidelines that are closely monitored by the Corporation.

Home Equity Lines of Credit

In addition to traditional one-to-four family residential mortgage loans and home equity loans, the Corporation offers home equity lines of credit that are secured by the borrower’s primary or secondary residence. Home equity lines of credit are generally underwritten using the same criteria used to underwrite one-to-four family residential mortgage loans. As home equity line of credit underwriting is subject to specific regulations, the Corporation typically underwrites its home equity lines of credit to conform to widely accepted standards. Several factors are considered in underwriting including the value of the underlying real estate and the debt to income and credit history of the borrower.

Commercial Business Loans

The Corporation originates commercial non-mortgage business (term) loans and adjustable lines of credit. These loans are generally originated to small and medium sized companies in the Corporation’s primary market area. Commercial business loans (including agricultural loans) are generally used for working capital purposes or for acquiring equipment, inventory or furniture, and are primarily secured by business assets other than real estate, such as business equipment and inventory, accounts receivable or stock.

The commercial business loan portfolio consists primarily of secured loans. When making commercial business loans, the Corporation considers the financial statements, lending history and debt service capabilities of the borrower, the projected cash flows of the business and the value of collateral. The cash flows of the underlying borrower, however, may not perform consistent with historical or projected information. Further, the collateral securing the loans may fluctuate in value due to individual economic or other factors. Virtually all of the Corporation’s loans are guaranteed by the principals of the borrower. The Corporation has established minimum standards and underwriting guidelines for all commercial loan types.

Real Estate Construction Loans

The Corporation originates construction loans for one-to-four family residential properties and commercial real estate properties, including multi-family properties. The Corporation generally requires that a commitment for permanent financing be in place prior to closing the construction loan. The repayment of these loans is typically through permanent financing following completion of the construction. Real estate construction loans are inherently more risky than loans on completed properties as the unimproved nature and the financial risks of construction significantly enhance the risks of commercial real estate loans. These loans are closely monitored and subject to other industry guidelines.

Consumer Loans

Consumer loans consist of installment loans to individuals, primarily automotive loans. These loans are centrally underwritten utilizing the borrower’s financial history, including the Fair Isaac Corporation (“FICO”) credit scoring and information as to the underlying collateral. Repayment is expected from the cash flow of the borrower. Consumer loans may be underwritten with terms up to seven years, fully amortized. Unsecured loans are limited to twenty four months. Loan-to-value ratios vary based on the type of collateral. The Corporation has established minimum standards and underwriting guidelines for all consumer loan types.

The following table presents the balance in the allowance for loan losses and the recorded investment in loans based on portfolio segment and impairment method for the six months ended June 30, 2012:

	Commercial		Agricultural			Agricultural Real Estate		Commercial Real Estate			Commercial Real Estate Development		Residential Real Estate		Consumer		Unallocated		Total
Allowance for Loan Losses
Balance, beginning of year	$	5,240	$	55		$	548	$	11,606		$	8,771	$	2,855	$	1,338	$	-	$	30,413
Provision charged to expense		225		(39	)		920		(60	)		7,362		1,173		510		9		10,100
Less: loans charged off		1,544		-			911		1,956			13,474		1,194		667		-		19,746
Recoveries		120		-			-		342			1,114		35		94		-		1,705
Balance, end of period	$	4,041	$	16		$	557	$	9,932		$	3,773	$	2,869	$	1,275	$	9	$	22,472
Ending Balance: individually evaluated for impairment	$	1,290	$	-		$	173	$	2,004		$	1,512	$	1,727	$	187	$	0	$	6,892
Ending Balance: collectively evaluated for impairment	$	2,751	$	16		$	384	$	7,928		$	2,261	$	1,142	$	1,088	$	9	$	15,580
Loans
Ending Balance	$	50,914	$	22,392		$	53,328		230,837		$	30,124	$	94,129	$	41,196	$	-	$	520,649
Ending Balance: individually evaluated for impairment	$	4,413	$	-		$	3,545	$	33,590		$	20,393	$	9,547	$	1,067	$	-	$	72,555
Ending Balance: collectively evaluated for impairment	$	46,501	$	22,392		$	49,783	$	197,247		$	9,731	$	84,582	$	40,129	$	-	$	448,094

The following table presents the changes in the allowance for loan losses for the three months ended June 30, 2012:

	Commercial		Agricultural			Agricultural Real Estate		Commercial Real Estate		Real Estate Development		Commercial Residential Real Estate		Consumer		Unallocated			Total
Allowance for Loan Losses
Balance, beginning of year	$	5,055	$	28		$	284	$	10,189	$	10,297	$	2,555	$	1,316	$	16		$	29,740
Provision charged to expense		268		(12	)		1,184		713		6,781		753		346		(7	)		10,026
Less: loans charged off		1,303		-			911		1,292		13,455		457		445		-			17,863
Recoveries		21		-			-		322		150		18		58		-			569
Balance, end of period	$	4,041	$	16		$	557	$	9,932	$	3,773	$	2,869	$	1,275	$	9		$	22,472

The following table presents the balance in the allowance for loan losses and the recorded investment in loans based on portfolio segment and impairment method as of December 31, 2011:

	Commercial		Agricultural			Agricultural Real Estate			Commercial Real Estate		Commercial Real Estate Development		Residential Real Estate		Consumer		Unallocated			Total
Allowance for Loan Losses
Balance, beginning of year	$	4,435	$	99		$	107		$	6,029	$	15,526	$	1,897	$	1,595	$	38		$	29,726
Provision charged to expense		4,494		(35	)		(2,675	)		24,479		14,564		4,489		1,175		(38	)		51,803
Less: loans charged off		4,059		16			2,242			18,951		21,401		3,541		1,667		-			51,877
Recoveries		370		7			8			49		82		10		235		-			761
Balance, end of period	$	5,240	$	55		$	548		$	11,606	$	8,771	$	2,855	$	1,338	$	-		$	30,413
Ending Balance: individually evaluated for impairment	$	2,632	$	-		$	229		$	2,337	$	8,215	$	1,584	$	219	$	-		$	15,216
Ending Balance: collectively evaluated for impairment	$	2,608	$	55		$	319		$	9,269	$	556	$	1,271	$	1,119	$	-		$	15,197
Loans
Ending Balance	$	62,609	$	61,251		$	60,523			235,103	$	58,279	$	97,172	$	46,084	$	-		$	621,021
Ending Balance: individually evaluated for impairment	$	4,803	$	-		$	5,530		$	35,042	$	45,944	$	11,291	$	1,680	$	-		$	104,290
Ending Balance: collectively evaluated for impairment	$	57,806	$	61,251		$	54,993		$	200,661	$	12,335	$	85,881	$	44,404	$	-		$	516,731

The following table presents the balance in the allowance for loan losses and the recorded investment in loans based on portfolio segment and impairment method as of June 30, 2011:

	Commercial			Agricultural			Agricultural Real Estate		Commercial Real Estate		Commercial Real Estate Development		Residential Real Estate		Consumer		Unallocated			Total
Allowance for Loan Losses
Balance, beginning of year	$	4,435		$	99		$	107	$	6,029	$	15,526	$	1,897	$	1,595	$	38		$	29,726
Provision charged to expense		(592	)		(26	)		24		7,812		1,182		1,461		124		(12	)		9,925
Less: loans charged off		1,556			16			22		8,481		8,462		1,438		682		-			20,657
Recoveries		44			-			-		-		-		8		83		-			135
Balance, end of period	$	2,331		$	57		$	61	$	5,360	$	8,246	$	1,928	$	1,120	$	26		$	19,129
Ending Balance: individually evaluated for impairment	$	1,879		$	-		$	-	$	1,169	$	4,722	$	757	$	298	$	-		$	8,825
Ending Balance: collectively evaluated for impairment	$	452		$	57		$	61	$	4,191	$	3,524	$	1,171	$	822	$	26		$	10,304
Loans
Ending Balance	$	129,771		$	64,354		$	49,391		201,571	$	75,126	$	86,673	$	50,801	$	-		$	657,687
Ending Balance: individually evaluated for impairment	$	11,477		$	1,822		$	1,078	$	31,919	$	40,345	$	9,899	$	1,066	$	-		$	97,606
Ending Balance: collectively evaluated for impairment	$	118,294		$	62,532		$	48,313	$	169,652	$	34,781	$	76,774	$	49,735	$	-		$	560,081

Management’s opinion as to the ultimate collectability of loans is subject to estimates regarding future cash flows from operations and the value of property, real and personal, pledged as collateral. These estimates are affected by changing economic conditions and the economic prospects of borrowers.

Allowance for Loan Losses

The allowance for loan losses represents an estimate of the amount of losses believed inherent in the Corporation’s loan portfolio at the balance sheet date. The allowance calculation involves a high degree of estimation that management attempts to mitigate through the use of objective historical data where available. Loan losses are charged against the allowance for loan losses when management believes the uncollectability of the loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Overall, management believes the reserve to be consistent with prior periods and adequate to cover the estimated losses in the Corporation’s loan portfolio.

The Corporation’s methodology for assessing the appropriateness of the allowance for loan losses consists of two key elements: (1) specific allowances for estimated credit losses on individual loans that are determined to be impaired through the Corporation’s review for identified problem loans; and (2) a general allowance based on estimated credit losses inherent in the remainder of the loan portfolio.

The specific allowance is measured by determining the present value of expected cash flows, the loan’s observable market value, or for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expense. Factors used in identifying a specific problem loan include: (1) the strength of the customer’s personal or business cash flows; (2) the availability of other sources of repayment; (3) the amount due or past due; (4) the type and value of collateral; (5) the strength of the collateral position; (6) the estimated cost to sell the collateral; and (7) the borrower’s effort to cure the delinquency. In addition for loans secured by real estate, the Corporation also considers the extent of any past due and unpaid property taxes applicable to the property serving as collateral on the mortgage.

The Corporation establishes a general allowance for loans that are not deemed impaired to recognize the inherent losses associated with lending activities, but which, unlike specific allowances, has not been allocated to particular problem assets. The general valuation allowance is determined by segregating the loans by loan category and assigning allowance percentages based on the Corporation’s historical loss experience, delinquency trends, and management’s evaluation of the collectability of the loan portfolio. The allowance is then adjusted for significant factors that, in management’s judgment, affect the collectability of the portfolio as of the evaluation date. These significant factors may include: (1) Management’s assumptions regarding the minimal level of risk for a given loan category; (2) changes in lending policies and procedures, including changes in underwriting standards, and charge-off and recovery practices not considered elsewhere in estimating credit losses; (3) changes in international, national, regional and local economics and business conditions and developments that affect the collectability of the portfolio, including the conditions of various market segments; (4) changes in the nature and volume of the portfolio and in the terms of loans; (5) changes in the experience, ability, and depth of the lending officers and other relevant staff; (6) changes in the volume and severity of past due loans, the volume of non-accrual loans, and the volume and severity of adversely classified loans; (7) changes in the quality of the loan review system; (8) changes in the value of the underlying collateral for collateral-dependent loans; (9) the existence and effect of any concentrations of credit, and changes in the level of such concentrations; and (10) the effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio.

The applied loss factors are re-evaluated quarterly to ensure their relevance in the current environment.

Although the Corporation’s policy allows for a general valuation allowance on certain smaller-balance, homogenous pools of loans classified as substandard, the Corporation has historically evaluated every loan classified as substandard, regardless of size, for impairment as part of the review for establishing specific allowances. The Corporation’s policy also allows for general valuation allowance on certain smaller-balance, homogenous pools of loans which are loans criticized as special mention or watch. A separate general allowance calculation is made on these loans based on historical measured weakness, and which is a multiple of the amount of the general allowance calculated on the non-classified loans.

During 2011, in evaluating the adequacy of the allowance for loan losses, the Corporation implemented loan migration analysis to further analyze the risk in the loan portfolio based on previous loan risk rating, current loan risk rating and charge off history associated with each individual loan pool. The loans with risk rating 1 through 4 (“pass loan pools”) that have experienced high historical losses during the past three years of economic downturn have been adjusted with negative qualitative adjustments to reflect the estimation of future losses within these pools based on the most recent migration analysis. The loss migration analysis of these pass loan pools reflected less than a 1% charge off rate compared to a significantly higher charge off rate for loans with risk rating of 5 and 6 (“substandard loan pools”). These qualitative adjustments to the pass loan pool component of the allowance for loan losses analysis reflect the results of this migration analysis, as well as the seasoned nature of the loans comprising the pass loan pool that have been evaluated by an independent loan review process with over 80% loan review penetration.

The Corporation also utilizes migration analysis to analyze the risk in the substandard loan pools. The migration analysis tracks all classified loans and the resulting charge offs that have resulted from these classified loans. In certain loan sectors, the qualitative adjustment factors have been increased due to the risks reflected in the most recent migration analysis. This is primarily in loan sectors, such as commercial real estate, where the Corporation has experienced recent elevated charge off history.

Credit Quality Indicators

The Corporation categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, credit documentation, public information and current economic trends among other factors. The Corporation analyzes loans individually by classifying the loans as to credit risk. This analysis is performed on all loans at origination. Subsequently, analyses are reviewed on an annual basis by the Risk Management department and rating changes are made as necessary. Interim reviews are performed if borrower circumstances warrant a more timely review.

The Corporation has established a uniform internal risk rating methodology for commercial loans utilizing risk grades from 1 through 7, with 1 being considered “excellent” and the rating of 7 being considered “doubtful.” A summary of the general definitions for the risk ratings follows:

Prime Quality: This category includes all obligors whose balance sheet, current position, capitalization, profitability and cash flow have been demonstrated to be consistently of such high quality that the potential for significant disruption in their financial performance is virtually nonexistent. Such borrowers have excellent management in place with depth, well defined and established product lines or services, and operate businesses generally isolated from the normal influences of the business cycle.

High Quality: Borrowers assigned this rating are considered above average with high quality and excellent credit standards based on leverage, liquidity and debt coverage ratios, as well as having excellent management in critical areas.

Satisfactory “Average” Quality: This category includes borrowers that have average leverage, liquidity and debt service ratios that comparefavorably with industry standards.

Low Pass: This risk rating includes borrowers that have below average leverage, liquidity and debt service coverage ratios and management thatmay not be as solid on a historical basis or may compare less favorably with industry standards but are still considered acceptable.

Watch/Special Mention (OAEM): A borrower assigned to this rating category exhibits potential weaknesses or early warning signals that deserve close monitoring by management. If left uncorrected, these potential weaknesses may result in the borrower being unable to meet its financial obligations at some future date.

Substandard: A substandard rating is assigned to a borrower whose credit is inadequately protected by the paying capacity of the borrower, or by the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. These credits are characterized by the distinct possibility that the Corporation will sustain some loss if deficiencies are not corrected.

Doubtful: Borrowers assigned to this rating category have all of the weaknesses inherent in a substandard rating with the added factor that the weaknesses are pronounced to the point where, on the basis of current facts, conditions and values, collection or liquidation in full is highly questionable or improbable. While the possibility of loss is extremely high, the existence of specific pending factors, which may work to the borrower’s advantage, warrants that the estimated loss be deferred until a more exact status can be determined.

The Corporation classifies consumer loans in the risk rating classifications of Pass, Special Mention, Substandard and Doubtful. These classifications generally conform to the risk rating methodology for commercial loans as follows: Pass - risk rating 1 through 4; Special Mention - risk rating 5; Substandard - risk rating 6; Doubtful - risk rating 7.

The following tables present the credit risk profile of the Corporation’s loan portfolio based on rating category and payment activity as of June 30, 2012:

Commercial Credit Exposure: Credit Risk Profile by Creditworthiness Category

Risk Rating:	Commercial		Agricultural		Agricultural Real Estate		Commercial Real Estate		Commercial Real Estate Development		Total
1-2	$	3,312	$	8,659	$	15,580	$	24,411	$	161	$	52,123
3		23,140		12,307		18,609		74,378		3,070		131,504
4		16,144		1,401		13,780		61,469		946		93,740
5		2,151		-		1,089		13,130		5,310		21,680
6		6,167		25		2,571		57,514		18,776		85,053
7		-		-		1,699		-		1,861		3,560
Total	$	50,914	$	22,392	$	53,328	$	230,902	$	30,124	$	387,660

Consumer Credit Exposure: Credit Risk Profile by Creditworthiness Category

	Residential
Risk Rating:	Real Estate		Consumer		Total
Pass	$	79,355	$	38,529	$	117,884
Special Mention		284		171		455
Substandard		11,979		2,468		14,447
Doubtful		175		28		203
Total	$	91,793	$	41,196	$	132,989

The following tables present the credit risk profile of the Corporation’s loan portfolio based on rating category and payment activity as of December 31, 2011:

Commercial Credit Exposure: Credit Risk Profile by Creditworthiness Category

Risk Rating:	Commercial		Agricultural		Agricultural Real Estate		Commercial Real Estate		Commercial Real Estate Development		Total
1-2	$	4,509	$	25,979	$	14,832	$	26,075	$	376	$	71,771
3		30,037		27,348		24,142		87,772		8,348		177,647
4		18,892		7,096		13,434		54,909		1,744		96,075
5		1,970		381		1,769		4,582		-		8,702
6		7,201		447		4,647		61,111		35,673		109,079
7		-		-		1,699		654		12,138		14,491
Total	$	62,609	$	61,251	$	60,523	$	235,103	$	58,279	$	477,765

Consumer Credit Exposure: Credit Risk Profile by Creditworthiness Category

	Residential
Risk Rating:	Real Estate		Consumer		Total
Pass	$	83,381	$	42,826	$	126,207
Special Mention		253		125		378
Substandard		13,358		3,113		16,471
Doubtful		180		20		200
Total	$	97,172	$	46,084	$	143,256

The following tables present the credit risk profile of the Corporation’s loan portfolio based on rating category and payment activity as of June 30, 2011:

Commercial Credit Exposure: Credit Risk Profile by Creditworthiness Category

Risk Rating:	Commercial		Agricultural		Agricultural Real Estate		Commercial Real Estate		Commercial Real Estate Development		Total
1-2	$	14,869	$	20,023	$	14,327	$	11,712	$	407	$	61,338
3		53,622		31,303		21,672		72,560		8,941		188,098
4		31,031		9,324		10,016		40,664		1,965		93,000
5		10,526		1,170		1,928		29,112		3,270		46,006
6		19,584		2,534		1,448		47,523		60,543		131,632
7		139		-0-		-0-		-0-		-0-		139
Total	$	129,771	$	64,354	$	49,391	$	201,571	$	75,126	$	520,213

Consumer Credit Exposure: Credit Risk Profile by Creditworthiness Category

	Residential
Risk Rating:	Real Estate		Consumer		Total
Pass	$	75,087	$	48,141	$	123,228
Special Mention		924		283		1,207
Substandard		10,450		2,377		12,827
Doubtful		212		0		212
Total	$	86,673	$	50,801	$	137,474

The accrual of interest on loans is discontinued at the time the loan is 90 days past due unless the credit is well-secured and in process of collection. Past due status is based on contractual terms of the loan. In all cases, loans are placed on non-accrual or charged-off at the earlier date if collection of principal and interest is considered doubtful.

All interest accrued but not collected for loans that are placed on non-accrual or charged-off are reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

The following table presents the Corporation’s loan portfolio aging analysis as of June 30, 2012:

	30-59 Days Past Due		60-89 Days Past Due		>90 Days Total		Past Due Past Due		Total Current		Total Loans		>90 Days & Accruing
Commercial	$	424	$	74	$	-	$	498	$	46,985	$	47,483	$	-
Agricultural		-		-		-		-		22,392		22,392		-
Agricultural Real Estate		-		-		-		-		49,783		49,783		-
Commercial Real Estate		460		-		-		460		198,687		199,147		-
Commercial Real Estate Development		-		-		-		-		11,869		11,869		-
Residential Real Estate		31		418		-		-449		84,807		85,256		-
Consumer		278		139		-		417		40,229		40,646		-
Non-Accrual		22		1,536		54,851		56,409		7,664		64,073		-
Total	$	1,215	$	2,167	$	54,851	$	58,233	$	462,416	$	520,649	$	-

The following table presents the Corporation’s loan portfolio aging analysis as of December 31, 2011:

	30-59 Days Past Due		60-89 Days Past Due		>90 Days Past Due		Total Past Due		Total Current		Total Loans		>90 Days & Accruing
Commercial	$	1,205	$	248	$	63	$	1,516	$	57,411	$	58,927	$	63
Agricultural		-		-		-		-		61,251		61,251		-
Agricultural Real Estate		80		18		-		98		54,895		54,993		-
Commercial Real Estate		3,631		1,702		1,588		6,921		195,302		202,223		1,588
Commercial Real Estate Development		-		114		-		114		14,656		14,770		-
Residential Real Estate		3,308		342		-		3,650		87,877		88,527		-
Consumer		540		349		-		889		44,194		45,083		-
Non-Accrual		4,375		7,414		62,579		74,368		20,879		95,247		-
Total	$	13,139	$	10,187	$	64,230	$	87,556	$	533,465	$	621,021	$	1,651

The following table presents the Corporation’s loan portfolio aging analysis as of June 30, 2011:

	30-59 Days Past Due		60-89 Days Past Due		>90 Days Past Due		Total Past Due		Total Current		Total Loans		>90 Days & Accruing
Commercial	$	790	$	1,052	$	274	$	2,116	$	117,808	$	119,924	$	274
Agricultural		656		-		-		656		61,876		62,532		-
Agricultural Real Estate		20		-		-		20		48,293		48,313		-
Commercial Real Estate		4,350		3,238		-		7,588		169,126		176,714		-
Commercial Real Estate Development		698		-		2,195		2,893		39,575		42,468		2,195
Residential Real Estate		-		1,763		-		1,763		77,819		79,582		-
Consumer		880		343		-		1,223		48,907		50,130		-
Non-Accrual		272		722		74,582		75,576		2,448		78,024		-
Total	$	7,666	$	7,118	$	77,051	$	91,835	$	565,852	$	657,687	$	2,469

A loan is considered impaired, in accordance with the impairment accounting guidance (ASC 310-10-35-16), when based on current information and events it is probable the Corporation will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include non-performing loans but also include loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection.

The following table presents impaired loans as of June 30, 2012:

							Six Months Ended						Three Months Ended
							Average				Interest		Average		Accrued		Interest
			Unpaid				Investment		Interest		Income		Investment		Interest		Income
	Recorded		Principal		Specific		in Impaired		Income		Recognized		in Impaired		Income		Recognized
	Balance		Balance		Allowance		Loans		Recognized		Cash Basis		Loans		Recognized		Cash Basis

With no related allowance recorded:
Commercial	$	2,933	$	-	$	3,323	$	46	$	61	$	3,209	$	3,317	$	17	$	17
Commercial Real Estate		25,140		-		26,502		230		238		38,660		25,823		141		136
Commercial & Agricultural
Real Estate Development		9,767		-		9,922		71		81		18,104		9,907		34		31
Residential Real Estate		4,013		-		4,228		43		46		5,254		4,163		23		17
Consumer		400		-		466		11		11		1,057		446		5		5

With an allowance recorded:
Commercial	$	1,479	$	1,139	$	1,589	$	15	$	22	$	1,510	$	1,578	$	8	$	5
Commercial Real Estate		11,996		1,229		13,167		16		33		16,981		12,157		15		15
Commercial & Agricultural
Real Estate Development		10,627		983		16,279		11		11		27,678		16,022		7		7
Residential Real Estate		5,533		1,491		5,697		102		92		6,121		5,540		34		23
Consumer		667		153		691		16		15		971		688		8		5

Total:
Commercial	$	61,942	$	3,351	$	70,782	$	389	$	446	$	106,142	$	68,796	$	222	$	211
Residential	$	9,546	$	1,491	$	9,925	$	145	$	138	$	11,375	$	9,703	$	57	$	40
Consumer	$	1,067	$	153	$	1,157	$	27	$	26	$	2,028	$	1,134	$	13	$	10

Interest income recognized on impaired loans includes interest accrued and collected on the outstanding balance of accrued impaired loans as well as interest cash collections on non-accruing impaired loans for which ultimate collectability is uncertain.

The following table presents impaired loans as of December 31, 2011:

							Average				Interest
			Unpaid				Investment		Interest		Income
	Recorded		Principal		Specific		in Impaired		Income		Recognized
	Balance		Balance		Allowance		Loans		Recognized		Cash Basis
With no related allowance recorded:
Commercial	$	1,300	$	1,631	$	-0-	$	5,593	$	74 $77
Commercial Real Estate		33,494		55,356		-0-		24,916		721		861
Commercial Real Estate Development		23,970		46,275		-0-		25,961		323		371
Residential Real Estate		7,305		9,773		-0-		5,993		173		205
Consumer		1,119		1,359		-0-		559		50		54
With an allowance recorded:
Commercial	$	3,566	$	3,566	$	2,632	$	2,737	$	148	$	165
Commercial Real Estate		8,666		8,666 2,566		13,398		424		478
Commercial Real Estate Development		21,974		21,974 8,215		20,241		1,335 1,420
Residential Real Estate		3,986		4,365 1,584		3,930 157		172
Consumer		561		561		219		665		23		24
Total:
Commercial	$	92,970	$	137,468	$	13,413	$	92,845	$	3,025	$	3,372
Residential	$	11,291	$	14,138	$	1,584	$	9,923	$	330	$	377
Consumer	$	1,680	$	1,920	$	219	$	1,224	$	73	$	78

The following table presents impaired loans as of June 30, 2011:

							Six Months Ended				Three Months Ended
	Recorded Balance		Unpaid Principal Balance		Specific Allowance		Average Investment in Impaired Loans		Interest Income Recognized		Average Investment in Impaired Loans		Interest Income Recognized
With no related allowance recorded:
Commercial	$	9,737	$	11,450	$	-0-	$	9,812	$	55	$	9,922	$	27
Commercial Real Estate		25,852		34,249		-0-		19,378		36	$	29,481	$	13
Commercial Real Estate Development		25,631		42,877		-0-		26,163		96	$	29,627	$	46
Residential Real Estate		6,374		7,588		-0-		5,527		15	$	6,846	$	4
Consumer		657		783		-0-		329		8	$	731	$	3

With an allowance recorded:
Commercial	$	3,562	$	3,930	$	1,879	$	2,735	$	8	$	3,691	$	2
Commercial Real Estate		7,145		7,351		1,169		12,638		181	$	7,159	$	85
Commercial Real Estate Development		14,714		15,294		4,722		16,611		151	$	14,799	$	73
Residential Real Estate		3,525		3,615		757		3,699		36	$	3,548	$	11
Consumer		409		409		298		589		6	$	412	$	3

Total:
Commercial	$	86,641	$	115,151	$	7,770	$	87,336	$	527	$	94,677	$	246
Residential	$	9,899	$	11,203	$	757	$	9,226	$	51	$	10,394	$	15
Consumer	$	1,066	$	1,192	$	298	$	917	$	14	$	1,143	$	6

Included in certain loan categories in the impaired loans are troubled debt restructurings, where economic concessions have been granted to borrowers who have experienced financial difficulties that were classified as impaired. These concessions typically result from our loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Troubled debt restructurings are considered impaired at the time of restructuring and typically are returned to accrual status after considering the borrower’s sustained repayment performance, as agreed, for a reasonable period of at least six months, or once the granted concessions have ended or are no longer applicable.

When a loan is modified into a troubled debt restructuring, the Corporation evaluated any possible impairment similar to other impaired loans based on the present value of expected future cash flows, discounted at the contractual interest rate of the original loan agreement, and uses the current fair value of the collateral, less selling costs for collateral dependent loans. If the Corporation determines that the value of the modified loan is less than recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allowance estimate or a charge-off to the allowance for loan losses. In periods subsequent to modification, the Corporation evaluates all troubled debt restructurings, including those that have payment defaults, for possible impairment through the allowance for loan losses.

The following tables present the recorded balance of troubled debt restructurings as of June 30, 2012 and December 31, 2011.

	June 30, 2012
	Total Troubled Debt		Troubled debt restructurings performing in accordance with modified terms				Troubled debt restructurings not performing in accordance
	Restructurings		Accruing		Nonaccrual		with modified terms

Commercial	$	1,185	$	1,118	$	48	$	19
Agricultural		-		-		-		-
Agricultural Real Estate		-		-		-		-
Commercial Real Estate		11,694		1,562		-		10,132
Commercial Real Estate Development		2,684		-		42		2,642
Residential Real Estate		4,707		2,448		258		2,001
Consumer		48		7		41		-

Total	$	20,318	$	5,135	$	389	$	14,794

	December 31, 2011
	Total Troubled Debt		Troubled debt restructurings performing in accordance with modified terms				Troubled debt restructurings not performing in accordance
	Restructurings		Accruing		Nonaccrual		with modified terms

Commercial	$	928	$	928	$	-0-	$	-0-
Agricultural		-0-		-0-		-0-		-0-
Agricultural Real Estate		-0-		-0-		-0-		-0-
Commercial Real Estate		11,588		506		-0-		11,082
Commercial Real Estate Development		2,711		-0-		-0-		2,711
Residential Real Estate		3,963		1,618		884		1,461
Consumer		188		145		43		-0-

Total		19,378		3,197		927		15,254

The following table presents loans modified as troubled debt restructurings during the six months ended June 30, 2012 and the year ended December 31, 2011:

	Period Ended June 30, 2012				Year Ended December 31, 2011
	Number of		Recorded		Number of		Recorded
	Modifications		Investment		Modifications		Investment
Commercial		3	$	19		1	$	928
Agricultural		-		-		0		0
Agricultural Real Estate		-		-		0		0
Commercial Real Estate		1		1,063		1		506
Commercial Real Estate Development		-		-		0		0
Residential Real Estate		5		1,058		13		2,463
Consumer		1		9		0		0

Total		10	$	2,149		15	$	3,897

During the six months ended June 30, 2012, the Corporation modified five residential real estate loans with a recorded investment of $1,058 prior to modification which was deemed a troubled debt restructuring. This modification, which was in conjunction with the Federal Home Loan Affordable Modification program (HAMP), involved a reduction in the contractual interest rate. This restructuring was considered to be collateral dependent, but the modifications resulted in the recording of no specific allowance based upon the fair value of the collateral.

In addition, the Corporation modified three commercial loans during the six months ended June 30, 2012 which had a recorded investment of $67 prior to modification and was deemed a troubled debt restructuring. The Corporation modified the loan payment terms to grant an interest only payment period. Based on the fair value of the collateral, a specific reserve was determined necessary for the entire amount of the restructured loan.

The Corporation modified one commercial real estate loan during the six months ended June 30, 2012 which had a recorded investment of $1,067 prior to modification and was deemed a troubled debt restructuring. The Corporation modified the loan payment terms to grant a concession by lengthening the amortization. Based on the fair value of the collateral, no specific reserve was determined necessary for this restructured loan.

During the six months ended June 30, 2012, three out of a total of forty-one troubled debt restructuring loans held by the Corporation were either charged down or charged off by a total of $27. These loans were primarily commercial real estate or commercial real estate development loans. Since these loans were collateral dependent, they were written down to the fair market value of the collateral minus estimated selling costs.

During the year ended December 31, 2011, the Corporation modified thirteen residential real estate loans with a recorded investment of $2,463 prior to modification which were deemed troubled debt restructurings. A total of twelve modifications totaling $2,234 were in conjunction with the Federal Home Affordable Modification program (HAMP). These modifications generally involved a reduction in the contractual interest rate or an adjusted loan amortization schedule. One of the modifications, with a recorded investment of $229 was completed outside of the HAMP program and resulted in a reduction of the contractual interest rate and extension of the loan’s maturity date. Of these residential troubled debt restructurings, eight were considered to be collateral dependent, and the modifications resulted in the recording of a specific allowance of $467, based upon the fair value of the collateral.

In addition, the Corporation modified one commercial loan during the year ended December 31, 2011 which had a recorded investment of $928 prior to modification and was deemed a troubled debt restructuring. The Corporation modified the loan payment terms to grant an interest only payment period. Based on the fair value of the collateral, no specific reserve was determined necessary for this loan.

The Corporation modified one commercial real estate loan during the year ended December 31, 2011 which had a recorded investment of $506 prior to modification and was deemed a troubled debt restructuring. The Corporation modified the loan payment terms to grant a concession by lengthening the amortization. Based on the fair value of the collateral, no specific reserve was determined necessary for this loan.

During the year ended December 31, 2011, seven out of a total of thirty-four troubled debt restructuring loans held by the Corporation were either charged down or charged off by a total of $2,774. These loans were primarily commercial real estate or commercial real estate development loans. Since these loans were collateral dependent, they were written down to the fair market value of the collateral minus estimated selling costs.

At June 30, 2011, the Corporation had $937 of commercial loans, $15,071 of commercial real estate loans, $5,293 of commercial real estate development loans, $3,461 of residential real estate loans and $188 of consumer loans that were modified in troubled debt restructurings and impaired. Of these amounts, the Corporation had troubled debt restructurings that were performing in accordance with their modified terms of $937 of commercial loans, $4,868 of commercial real estate loans, $5,293 of commercial real estate development loans, $3,186 of residential real estate loans and $188 of consumer loans at June 30, 2011.

The following table presents the Corporation’s non-accrual loans at June 30, 2012, December 31, 2011 and June 30, 2011. This table excludes accruing troubled debt restructurings.

	June 30, 2012		December 31, 2011		June 30, 2011
Commercial	$	3,431	$	3,682	$	9,847
Agricultural		-		-		1,822
Agricultural Real Estate		3,545		5,530		1,078
Commercial Real Estate		31,755		32,880		24,857
Commercial Real Estate Development		18,255		43,510		32,658
Residential Real Estate		6,537		8,644		7,091
Consumer		550		1,001		671
Total	$	64,073	$	95,247	$	78,024

NOTE 9 -- FAIR VALUE OF ASSETS AND LIABILITIES

ASC 820, Fair Value Measurements, defines the 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. ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

In accordance with ASC 820, the Corporation groups its financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1

Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.

Level 2

Valuations for assets and liabilities traded in less active dealer or broker markets. Valuations are obtained from third party pricing services for identical or comparable assets or liabilities which use observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets and liabilities.

Level 3

Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Following is a description of the valuation methodologies used for instruments measured at fair value on a recurring basis and recognized in the accompanying balance sheet.

Available-for-Sale Securities

The fair values of available-for-sale securities are determined by various valuation methodologies. Where quoted market prices are available in an active market, securities are classified within Level 1. The Corporation has no securities classified within Level 1. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flows. For those securities, the inputs used by the pricing service to determine fair values may include one, or a combination of, observable inputs such as benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference date market research publications. These securities are classified within Level 2 of the valuation hierarchy. Level 2 securities include obligations of U.S. government corporations and federal agency and U.S. Government sponsored enterprises (GSEs), obligations of states and political subdivisions, and GSE residential collateralized mortgage obligations. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy. The Corporation has no securities classified within Level 3.

The following table presents the Corporation’s assets that are measured at fair value on a recurring basis and the level within the ASC 820 hierarchy in which the fair value measurements fall as of June 30, 2012 and December 31, 2011 (in thousands):

June 30, 2012	Fair Value Measurements Using
(in thousands)	Fair Value		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
			(Level 1)		(Level 2)		(Level 3)

Available-for-sale securities
United States Government and federal agency and U.S. Government sponsored enterprises (GSEs)	$	66,173	$	-	$	66,173	$	-
State and Municipal		51,462		-		51,462		-
Collateralized mortgage obligations:
GSE Residential		95,046		-		95,046		-
Mutual funds		3,200		-		3,200		-
Total	$	215,881	$	-	$	215,881	$	-

December 31, 2011	Fair Value Measurements Using
			Quoted Prices in				Significant
(in thousands)			Active Markets for		Significant Other		Unobservable
	Fair Value		Identical Assets		Observable Inputs		Inputs
			(Level 1)		(Level 2)		(Level 3)
Available-for-sale securities
United States Government and federal agency and U.S. Government sponsored enterprises (GSEs)	$	78,022	$	-	$	78,022	$	-
State and Municipal		95,483		-		95,483		-
Collateral mortgage obligations:
GSE Residential		78,242		-		78,242		-
Total	$	251,747	$	-	$	251,747	$	-

Following is a description of the valuation methodologies used for assets measured at fair value on a non-recurring basis and recognized in the accompanying balance sheets, as well as the general classification of such assets pursuant to the valuation hierarchy.

Impaired Loans (Collateral Dependent) - Loans for which it is probable that the Corporation 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 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. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value.

Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method. Fair value adjustments on impaired loans were $22,815 for the six months ended June 30, 2012, $22,767 for the three months ended June 30, 2012, and $2,147 for the year ended December 31, 2011.

Mortgage Servicing Rights – As of June 30, 2012, the fair value used to determine the valuation allowance is based on an agreement entered into by the subsidiary bank dated June 30, 2012 to sell the Corporation’s mortgage servicing rights. As of December 31, 2011, the fair value used to determine the valuation allowance is estimated using discounted cash flow models. The valuation models incorporate assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. These variables change from quarter to quarter as market conditions and projected interest rates change, and may have an adverse impact on the value of the mortgage servicing rights and may result in a reduction to noninterest income. Due to the nature of the valuation inputs, mortgage servicing rights are classified within Level 3 of the hierarchy.

Other Real Estate Owned - Other real estate owned acquired through loan foreclosure is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. Estimated fair value of other real estate owned is based on appraisals or evaluations. 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. Appraisals are reviewed for accuracy and consistency. Appraisers are selected from the list of approved appraisers maintained by management. Fair value adjustments on other real estate owned were $1,045 for the six months ended June 30, 2012 and $795 for the three months ended June 30, 2012 and $4,199 for the year ended December 31, 2011.

The following table presents the quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements at June 30, 2012 (in thousands):

June 30, 2012

		Fair Value at June 30, 2012	Valuation Technique	Unobservable Inputs	Range (Weighted Average)
Impaired loans (collateral dependent)	$	16,511	Market comparable properties	Comparability adjustments (%)		(16.5%)
Mortgage servicing rights		2,146	Contracted sales price	None		not applicable
Other real estate owned		3,947	Market comparable properties	Marketability discount	5%	to	15%

The following table presents the fair value measurements of assets measured at fair value on a nonrecurring basis and the level within the ASC 820 fair value hierarchy in which fair value measurements fell at June 30, 2012 and December 31, 2011 (in thousands):

June 30, 2012

	Fair Value Measurements Using
	Fair Value		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
			(Level 1)		(Level 2)		(Level 3)
Impaired loans (collateral dependent)	$	16,511		-		-	$	16,511
Mortgage servicing rights		2,146		-		-		2,146
Other real estate owned		3,947		-		-		3,947

December 31, 2011

	Fair Value Measurements Using
	Fair Value		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
			(Level 1)		(Level 2)		(Level 3)
Impaired loans (collateral dependent)	$	32,903		-		-	$	32,903
Mortgage servicing rights		2,437		-		-		2,437
Other real estate owned		7,098		-		-		7,098

ASC 825, "Disclosures about Fair Value of Financial Instruments," requires all entities to disclose the estimated fair value of their financial instrument assets and liabilities. For the Corporation, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in ASC 825. Many of the Corporation's financial instruments, however, lack an available trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction. It is also the Corporation's general practice and intent to hold its financial instruments to maturity and to not engage in trading or sales activities except for loans held-for-sale and available-for-sale securities. Therefore, significant estimations and assumptions, as well as present value calculations, were used by the Corporation for the purposes of this disclosure.

Estimated fair values have been determined by the Corporation using the best available data and an estimation methodology suitable for each category of financial instruments. For those loans and deposits with floating interest rates, it is presumed that estimated fair values generally approximate the recorded book balances.

The following table presents estimated fair values of the Corporation’s financial instruments and the level within the fair value hierarchy in which the fair value measurements fall at June 30, 2012 and December 31, 2012 (in thousands):

June 30, 2012			Fair Value
			Measurements
			Using:
			Quoted Prices In Active Markets		Significant Other		Significant
			for Identical		Observable		Unobservable
	Carrying		Assets		Inputs		Inputs
	Amount		(Level 1)		(Level 2)		(Level 3)
Financial Assets:

Cash and due from banks	$	16,221	$	16,221	$		$
Interest-bearing deposits in financial institutions		125,008		125,008
Held to maturity investment securities		7,643				7,734
Loans, net, including loans held for sale		500,513						501,837
Accrued interest receivable		3,800				3,800


Financial Liabilities:

Non-interest bearing demand deposits	$	152,741	$		$	152,741	$
Interest-bearing deposits		724,430				727,594
Borrowings		75,743						75,743
Accrued interest payable		1,447				1,447


Unrecognized financial instruments (net of contract amount):

Commitments to originate loans	$	-	$	-	$	-	$	-
Lines of credit		-		-		-		-
Letters of credit		-		-		-		-

December 31, 2011
	Carrying Value		Fair Value

Financial Assets:
Cash and due from banks	$	16,307	$	16,307
Interest-bearing deposits in financial institutions		46,988		46,988
Investment securities		261,583		261,689
Loans, net, including loans held-for-sale		592,828		658,359
Accrued interest receivable		6,453		6,453


Financial Liabilities:
Non-interest-bearing demand deposits	$	171,939	$	171,939
Interest-bearing deposits		745,356		750,355
Borrowings		84,835		84,829
Accrued interest payable		877		877

Unrecognized financial instruments (net of contract amount):
Commitments to originate loans		-0-		-0-
Lines of credit		-0-		-0-
Letters of credit		-0-		-0-

Financial instruments actively traded in a secondary market have been valued using quoted available market prices. Cash and due from banks, interest-bearing time deposits in other banks, federal funds sold, loans held-for-sale and interest receivable are valued at book value, which approximates fair value.

Financial liability instruments with stated maturities have been valued using a present value discounted cash flow analysis with a discount rate approximating current market for similar liabilities. Interest payable is valued at book value, which approximates fair value.

Financial liability instruments with no stated maturities have an estimated fair value equal to both the amount payable on demand and the recorded book balance.

The net loan portfolio has been valued using a present value discounted cash flow. The discount rate used in these calculations is the current rate at which similar loans would be made to borrowers with similar credit ratings, same remaining maturities and assumed prepayment risk.

The fair value of commitments to originate loans is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair values of letters of credit and lines of credit are based on fees currently charged for similar agreements or on the estimated cost to terminate or otherwise settle the obligations with the counterparties at the reporting date.

Changes in assumptions or estimation methodologies may have a material effect on these estimated fair values.

The Corporation's remaining assets and liabilities, which are not considered financial instruments, have not been valued differently than has been customary with historical cost accounting. No disclosure of the relationship value of the Corporation's core deposit base is required by ASC 825.

Fair value estimates are based on existing balance sheet financial instruments, without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, the subsidiary bank has a large fiduciary services department that contributes net fee income annually. The fiduciary services department is not considered a financial instrument, and its value has not been incorporated into the fair value estimates. Other significant assets and liabilities that are not considered financial assets or liabilities include the mortgage banking operation, brokerage network, deferred taxes, premises and equipment, and goodwill. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

Management believes that reasonable comparability between financial institutions may not be likely, due to the wide range of permitted valuation techniques and numerous estimates which must be made, given the absence of active secondary markets for many of the financial instruments. This lack of uniform valuation methodologies also introduces a greater degree of subjectivity to these estimated fair values.

NOTE 10 -- INCOME TAXES

A reconciliation of income tax benefit at 34 percent of pre-tax income to the Corporation’s actual tax expense (benefit) for the three and six month periods ended June 30 is shown below:

(in thousands)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011

Computed "expected" tax benefit	$	(2,107	)	$	(1,870	)	$	(1,722	)	$	(1,310	)

Increase (decrease) in income taxes resulting from:
Tax-exempt income		(175	)		(300	)		(382	)		(610	)
State income tax, net of federal tax effect		(264	)		(692	)		(229	)		(627	)
Bank-owned life insurance income		(82	)		(77	)		(164	)		(155	)
Change in valuation allowance		2,577			0			2,469			0
Other, net		51			364			81			(39	)
Actual tax expense (benefit)	$	-		$	(2,575	)	$	53		$	(2,663	)

During the third quarter of 2011, management established a full valuation allowance of $27,722 against net deferred tax assets. Further additions to the valuation allowance have been made in subsequent quarters bringing the total deferred tax valuation allowance to $31,893 as of June 30, 2012. Under generally accepted accounting principles, 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 realizability of the deferred tax asset is based on management’s evaluation of both positive and negative evidence, the forecast of future income, prudent and feasible tax planning strategies and assessments of current and future economic and business conditions. Positive evidence includes the existence of taxes paid in available carry-back years as well as taxable income projections for future periods, while negative evidence includes the cumulative losses in the current year and prior two years and general business and economic trends. After evaluating all of the factors previously summarized and considering the weight of the positive evidence compared to the negative evidence, the Corporation has determined a full valuation adjustment was necessary as of June 30, 2012 and December 31, 2011.

NOTE 11 -- REGULATORY MATTERS

The Corporation and its subsidiary bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and its subsidiary bank must meet specific capital guidelines that involve quantitative measures of each entity’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Corporation’s and its subsidiary bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Furthermore, the Corporation and subsidiary bank’s regulators could require adjustments to regulatory capital not reflected in these financial statements.

Quantitative measures established by regulation to ensure capital adequacy require the Corporation and its subsidiary bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital to risk-weighted assets, and of Tier 1 capital to average adjusted assets. As of June 30, 2012 and December 31, 2011, the subsidiary bank and the Corporation were classified as significantly under-capitalized for all three ratios.

The most recent notifications, at June 30, 2012 from the federal banking agencies categorized the subsidiary bank as critically under-capitalized within the meaning of the prompt corrective action provision. To be categorized as well-capitalized, the Corporation and the subsidiary bank must maintain total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table that follows, at December 31, 2011.

The Corporation’s and the subsidiary bank’s actual capital amounts and ratios as of June 30, 2012 and December 31, 2011 are as follows:

	Actual					Minimum Capital Requirement					Minimum To Be Well- Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
As of June 30, 2012:

Total Capital (to risk-weighted assets):

Princeton National Bancorp, Inc.	$	(7,736)		(1.31)	%	$	47,270		8.00	%	$	70,830		12.00	%
Citizens First National Bank		25,496		4.33	%		47,215		8.00	%		70,823		12.00	%

Tier 1 Capital (to risk-weighted assets):
Princeton National Bancorp, Inc.	$	(7,736)		(1.31)	%	$	23,610		4.00	%		N/A		N/A
Citizens First National Bank		17,932		3.05	%		23,608		4.00	%		N/A		N/A

Tier 1 Capital (to average adjusted assets):
Princeton National Bancorp, Inc.	$	(7,736)		(0.80)	%	$	38,740		4.00	%	$	77,480		8.00	%
Citizens First National Bank		17,932		1.85	%		38,737		4.00	%		77,474		8.00	%

	Actual					Minimum Capital Requirement					Minimum To Be Well- Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
As of December 31, 2011:

Total Capital (to risk-weighted assets):
Princeton National Bancorp, Inc.	$	(3,418)		(0.50)	%	$	55,204		8.00	%	$	81,306		12.00	%
Citizens First National Bank		31,554		4.60	%		54,892		8.00	%		82,339		12.00	%

Tier 1 Capital (to risk-weighted assets):
Princeton National Bancorp, Inc.	$	(3,418)		(0.50)	%	$	27,102		4.00	%	$	N/A		N/A	%
Citizens First National Bank		22,707		3.31	%		27,446		4.00	%		N/A		N/A	%

Tier 1 Capital (to average adjusted assets):
Princeton National Bancorp, Inc.	$	(3,418)		(0.32)	%	$	42,365		4.00	%	$	84,729		8.00	%
Citizens First National Bank		22,707		2.14	%		42,354		4.00	%		84,718		8.00	%

On March 15, 2010 the subsidiary bank entered into a Written Agreement with the OCC. The Agreement sets forth the subsidiary bank’s commitments to: (i) review and take action as necessary regarding its allowance for loan and lease losses; (ii) improve the subsidiary bank’s asset quality through the development of workout plans for criticized assets and the assessment of credit risk; and (iii) revise the subsidiary bank’s credit risk rating management information system. The subsidiary bank has taken steps to address the issues raised in the Agreement and intends to fully comply with the requirements set forth in the Agreement.

Pursuant to the Agreement, the subsidiary bank’s Board of Director’s has reviewed on a monthly basis the adequacy of the subsidiary bank’s allowance for loan losses and established a program for the maintenance of an adequate allowance. The subsidiary bank also took immediate action to protect its interest in criticized assets and to adopt individual written workout plans with respect to such assets. A copy of the workout plans is provided to the OCC on a quarterly basis for any criticized asset equal to or exceeding $100,000. Under the Agreement, the board ensures that the subsidiary bank’s internal ratings of loan relationships are timely, accurate and consistent with the regulatory credit classification criteria established by the OCC.

The subsidiary bank’s risk management staff reports independently to the Directors’ Loan Committee. The Directors’ Loan Committee reports further to the subsidiary bank’s Board of Directors. Management furnishes its reports and additional documentation to these committees on a regular basis. The coverage of independent loan review processes, which are monitored by the risk management department, have been expanded significantly. The Directors’ Loan Committee has directed risk management to refine its loan review grading methodology to ensure that loans with a probability of payment default or well-defined weaknesses are graded substandard regardless of mitigating controls which might reduce the credit risk. The Directors’ Loan Committee monitors this process through bi-monthly meetings and reviews loan review reports to ensure compliance with the terms of the Agreement.

In the fourth quarter of 2010, the subsidiary bank filled a newly created role of Chief Credit Officer and established a credit administration division and a special assets group. The primary responsibility of the credit administration division is to oversee the development, maintenance, and monitoring of loan policies and procedures. Other responsibilities include credit analysis, credit risk management, loan servicing and administration and collections, as well as loan portfolio analysis and the allowance for loan losses. The functions of the special assets group include loss mitigation and workout of non-performing loans, liquidation of non-performing assets and other responsibilities to accelerate and maximize loan recoveries. As part of establishing the new credit administration division, the subsidiary bank’s Chief Credit Officer identified and engaged experienced personnel to fill key roles within credit administration in continuing to address the subsidiary bank’s commitments relative to the Agreement.

On September 20, 2011, the subsidiary bank entered into a Stipulation and Consent to the Issuance of a Consent Order (the “Consent Order”) with the OCC. Pursuant to the Consent Order, the subsidiary bank has agreed to take certain actions and operate in compliance with the Consent Order’s provisions during its term.

Under the terms of the Consent Order, the subsidiary bank is required to, among other things: (i) adopt and adhere to a three-year written strategic plan that establishes objectives for the subsidiary bank’s overall risk profile, earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital adequacy, reduction in non-performing assets and its product development; (ii) adopt and maintain a capital plan; (iii) by December 19, 2011, achieve and thereafter maintain a Tier 1 capital ratio of at least 8% and a total risk-based capital ratio of at least 12%; (iv) seek approval of the OCC prior to paying dividends on its capital stock; (v) develop a program to reduce the subsidiary bank’s credit risk; (vi) take certain actions related to credit and collateral exceptions; (vii) reaffirm the subsidiary bank’s liquidity risk management program; and (viii) appoint a compliance committee of the Board of Directors to help ensure the subsidiary bank’s compliance with the Consent Order. The subsidiary bank is also required to submit certain regular reports with respect to the foregoing requirements.

On October 27, 2011, the Corporation entered into a Written Agreement with the Federal Reserve Bank. Pursuant to the Written Agreement, the Corporation has agreed to take certain actions and operate in compliance with the Written Agreement’s provisions during its term.

Under the terms of the Written Agreement, the Corporation is required to, among other things: (i) serve as a source of strength to the subsidiary bank, including taking steps to ensure that the subsidiary bank complies with the Consent Order it entered into with the OCC on September 20, 2011, and any other supervisory action taken by the subsidiary bank’s federal regulator; (ii) refrain from declaring or paying any dividend, or taking dividends or other payments representing a reduction in the subsidiary bank’s capital, each without the prior written consent of the FRB and the Director of the Division of Banking Supervision and Regulation (the “Director”) of the Board of Governors of the Federal Reserve System; (iii) refrain from making any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior approval of the FRB and the Director; (iv) refrain from incurring, increasing, or guaranteeing any debt, and from purchasing or redeeming any shares of its capital stock, each without the prior approval of the FRB; (v) provide the FRB with a written plan to maintain sufficient capital at the Corporation on a consolidated basis; (vi) provide the FRB with a projection of the Corporation’s planned sources and uses of cash; (vii) comply with certain regulatory notice provisions pertaining to the appointment of any new director or senior executive officer, or the changing of responsibilities of any senior executive officer; and (viii) comply with certain regulatory restrictions on indemnification and severance payments. The Corporation is also required to submit certain reports to the FRB with respect to the foregoing requirements.

The Consent Order replaced the previously disclosed formal written agreement entered into by the subsidiary bank with the OCC on March 15, 2010. The formal written agreement had set forth the subsidiary bank’s commitment to; (i) review and take action as necessary regarding its allowance for loan losses; (ii) improve the subsidiary bank’s asset quality through the development of workout plans for criticized assets and the assessment of credit risk; and (iii) revise the subsidiary bank’s credit risk rating management information system.

On December 19, 2011, the subsidiary bank submitted to the OCC a three year strategic plan and capital plan designed to strengthen the Corporation and its subsidiary bank’s operations and capital position going forward. The plans reflected the current challenges with respect to the capital and difficulties in projecting the impact of economic weakness in the Corporation’s markets on its loan portfolio, as well as strategies to maintain the financial strength of the Corporation and its subsidiary bank. A significant part of the plans was the initiative by the Corporation to sell branch locations of the subsidiary bank in order to generate profits to improve capital ratios of the subsidiary bank.

On March 29, 2012, the subsidiary bank’s Board of Directors received a Prompt Corrective Action (“PCA”) Notice under 12 U.S.C. 1831o and 12 C.F.R. Part 6 due to its amended Call Report filed with the OCC on March 22, 2012 reflecting capital ratios in the Significantly Undercapitalized PCA capital category. This Notice places the Bank under certain mandatory PCA restrictions regarding the payment of capital distributions and management fees, as well as restrictions on asset growth, on certain expansion activities, including acquisitions, new branches, and new lines of business, and on payment of bonuses and compensation to senior executive officers. These mandatory requirements also include a requirement that the Bank submit an acceptable Capital Restoration Plan (“CRP”) to the OCC, addressing the steps the Bank will take to become adequately capitalized, the levels of capital to be attained during each quarter of each year of the CRP, the types and level of activities in which the Bank will engage; and how management will comply with the restrictions against asset growth, and acquisition, branching and new lines of business.

On April 18, 2012, the Corporation received written notice (the “Listing Notice”) from the Listing Qualifications Staff (the “Staff”) of the NASDAQ stock market that the Corporation was no longer in compliance with the minimum stockholders’ equity requirement for continued listing on the NASDAQ Global Market. NASDAQ Global Market Listing Rule 5450(b)(1)(A) requires registrants to maintain a minimum of $10,000,000 in stockholders’ equity. As disclosed in the Corporation’s fiscal year 2011 annual report on Form 10-K, filed on April 12, 2012, the Corporation’s stockholders’ equity as of December 31, 2011 did not meet this requirement. Subsequent requirements set in March and June 2012 were also not met.

The Listing Notice does not result in the immediate delisting of the Corporation’s common stock from the NASDAQ Global Market. Rather, in accordance with the NASDAQ Listing Rules, the Corporation has 45 calendar days from the date of the Listing Notice to submit to the Staff a plan to regain compliance with this continued listing requirement.

On June 18, 2012, the Corporation notified the NASDAQ Global Market that it intended to voluntarily delist its common stock from the NASDAQ Global Market. The Corporation’s stock became available for trade on the OTCQB Marketplace effective June 29, 2012.

On May 7, 2012, the subsidiary bank submitted to the OCC the CRP required under the PCA Notice received in March 2012 reflecting the strategies to achieve compliance with the requirements of the notice, including plans regarding the sale of branches and the sale of stock to improve capital ratios of the subsidiary bank. The initial CRP was not accepted by the OCC and management is currently in the process of drafting and submitting a revised CRP.

On August 22, 2012, Citizens First National Bank (the “Bank”) , the wholly-owned subsidiary of Princeton National Bancorp, Inc. (the “Company”), received a notification from the Office of the Comptroller of the Currency (“OCC”) confirming that the Bank became “critically undercapitalized” within the meaning of the Prompt Corrective Action (“PCA”) provisions of the Federal Deposit Insurance Act and the regulations of the OCC as of August 20, 2012, the date the Bank filed its amended Report of Condition and Income Report for the quarter ended June 30, 2012 (“Call Report”). Based on the information in the Call Report, the Bank reported that its tangible equity to total assets (Tangible Capital) ratio as of the end of the quarter was 1.92%. The Bank’s capital category is determined solely for the purposes of applying PCA and the capital category may not constitute an accurate representation of the Bank’s overall financial condition or prospects.

As a result of it being “critically undercapitalized” for PCA purposes, the Bank remains obligated to submit a capital restoration plan acceptable to the OCC, which plan must be guaranteed by the Company. In addition to other restrictions and prohibitions applicable to depository institutions that are “critically undercapitalized,” the Bank is prohibited, without the prior written approval of the Federal Deposit Insurance Corporation (the “FDIC”), from (1) entering into any material transaction other than in the usual course of business, including any investment, expansion, acquisition, sale of assets, or other similar action with respect to which the Bank is required to provide notice to the OCC; (2) extending any credit for any highly leveraged transactions as defined in 12 C.F.R. § 325.2(i); (3) amending the Bank’s charter or bylaws, except to the extent necessary to carry out any other requirement of law, regulation, or order; (4) making any material change in accounting methods; (5) engaging in any covered transaction as defined in Section 23A(b) of the Federal Reserve Act (12 U.S.C. § 371c(b)); (6) paying excessive compensation or bonuses; and (7) paying interest on new or renewed liabilities at a rate that would increase the Bank’s weighted average cost of funds to a level significantly exceeding the prevailing rates of interest on insured deposits in the Bank’s normal market areas. The Bank also remains subject to regulatory restrictions prohibiting the acceptance, renewal or rolling over of brokered deposits.

The PCA framework generally requires that depository institutions that are “critically undercapitalized” be placed into conservatorship or receivership within 90 days of the date on which it was determined that the institution was “critically undercapitalized,” unless the depository institution can raise sufficient capital, merge with another financial institution or the OCC and the FDIC determine and document that “other action” would better achieve the purposes of the PCA capital requirements. The Company and the Bank are diligently working to evaluate and pursue strategic alternatives. There can be no assurance that the Company or the Bank will be successful in obtaining outside additional capital or merging with or being acquired by another company within any regulatory imposed time frame.

As a member of the FDIC, the deposits at the Bank continue to be insured by the FDIC up to the legal maximum insurance limit – currently $250,000 per depositor, per deposit category. The Bank’s staff can help depositors with any questions about the mechanics of FDIC deposit insurance.

NOTE 12 -- IMPACT OF NEW ACCOUNTING STANDARDS

In December 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-11 “Balance Sheet (Topic 210) - Disclosures about Offsetting Assets and Liabilities.” ASU 2011-11 requires an entity to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. ASU 2011-11 is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. Retrospective disclosure is required for all comparative periods presented. The Company is assessing the impact of ASU 2011-11 on its disclosures.

In June 2011, the FASB issued ASU No. 2011-05 “Comprehensive Income (Topic 220) - Presentation of Comprehensive Income.” ASU 2011-05 requires that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. In December 2011, FASB issued ASU No. 2011-12 which defers the effective date of the requirement in ASU 2011-05 to present items that are reclassified from accumulated other comprehensive income to net income alongside their respective components of net income and other comprehensive income. ASU 2011-05 was effective retrospectively for fiscal years, and interim periods within those years, beginning after December 15, 2011. The effect of applying this standard is reflected in the Consolidated Statements of Comprehensive Income and Consolidated Statements of Stockholders’ Equity.

In May 2011, the FASB issued ASU No. 2011-04 “Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” ASU 2011-04 changed the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. Consequently, the amendments in this update result in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs (International Financial Reporting Standards). ASU 2011-04 was effective prospectively during interim and annual periods beginning on or after December 15, 2011. Early application by public entities was not permitted. The effect of applying this standard is reflected in Note 11 — Fair Value Measurements.

Schedule 7

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

For the six month periods ended June 30, 2012 and 2011

The following discussion and analysis provides information about Princeton National Bancorp, Inc.'s (“PNBC” or the “Corporation”) financial condition and results of operations for the six month periods ended June 30, 2012 and 2011. This discussion and analysis should be read in conjunction with the Corporation’s condensed Consolidated Financial Statements and Notes thereto included in this report. This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), such as discussions of the Corporation’s pricing and fee trends, credit quality and outlook, liquidity, new business results, expansion plans, anticipated expenses and planned schedules. The Corporation intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Corporation, are identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions. Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties including: the effect of the disruption in financial markets and the United States government programs introduced to restore stability and liquidity, changes in interest rates, general economic conditions and the state of the United States economy, legislative/regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Corporation’s market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements. Further information concerning the Corporation and its business, including a discussion of these and additional factors that could materially affect the Corporation’s financial results, is included in the Corporation’s 2011 Annual Report on Form 10-K under the heading “Item 1. Business.”

CRITICAL ACCOUNTING POLICIES AND USE OF SIGNIFICANT ESTIMATES

The Corporation has established various accounting policies that govern the application of U.S. generally accepted accounting principles in the preparation of the Corporation’s financial statements. The significant accounting policies of the Corporation are described in the footnotes to the condensed Consolidated Financial Statements. Certain accounting policies involve significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and assumptions, which could have a material impact on the carrying values of assets and liabilities and the results of operations of the Corporation.

Allowance for Loan Losses

The Corporation believes the allowance for loan losses is the critical accounting policy that requires the most significant judgments and assumptions used in the preparation of its condensed Consolidated Financial Statements. We determine probable incurred losses inherent in our loan portfolio and establish an allowance for those losses by considering factors including historical loss rates, expected cash flows and estimated collateral values. In assessing these factors, we use organizational history and experience with credit decisions and related outcomes. The allowance for loan losses represents our best estimate of losses inherent in the existing loan portfolio. The allowance for loan losses is increased by the provision for loan losses charged to expense and reduced by loans charged off, net of recoveries. We evaluate our allowance for loan losses quarterly. If our underlying assumptions later prove to be inaccurate based on subsequent loss evaluations, the allowance for loan losses is adjusted.

We estimate the appropriate level of allowance for loan losses by separately evaluating impaired and non-impaired loans. A specific allowance is assigned to an impaired loan when expected cash flows or collateral do not justify the carrying amount of the loan. The methodology used to assign an allowance to a non-impaired loan is more subjective. Generally, the allowance assigned to non-impaired loans is determined by applying historical loss rates to existing loans with similar risk characteristics, adjusted for qualitative factors including the volume and severity of identified classified loans, changes in economic conditions, changes in credit policies or underwriting standards, and changes in the level of credit risk associated with specific industries and markets. We also utilize loan migration analysis to further analyze risk of loss in the loan portfolio based on previous loan risk rating, current loan risk rating and charge-off history associated with each individual loan category.

The Corporation is also using migration analysis to analyze the risk in the substandard loan categories. The migration analysis tracks all classified loans and the resulting charge-offs that have resulted from these classified loans. In certain loan sectors, the qualitative adjustment factors have been increased due to the risks reflected in recent migration analysis. This is primarily in loan categories, such as commercial real estate, where the Corporation has experienced recent elevated charge off history.

Because the economic and business climate in any given industry or market, and its impact on any given borrower, can change rapidly, the risk profile of the loan portfolio is continually assessed and adjusted when appropriate. Notwithstanding these procedures, there still exists the possibility that our assessment could prove to be significantly incorrect and that an immediate adjustment to the allowance for loan losses would be required.

Other Real Estate Owned

Other real estate owned acquired through loan foreclosure is initially recorded at fair value less estimated selling costs when acquired, establishing a new cost basis. The adjustment at the time of foreclosure is recorded through the allowance for loan losses. Due to the subjective nature of establishing the fair value when the asset is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate. If it is determined that fair value declines subsequent to foreclosure, a valuation allowance is recorded through non-interest expense. Operating costs associated with the assets after acquisition are also recorded as non-interest expense. Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and posted to other non-interest expense.

Deferred Income Tax Assets/Liabilities

Net deferred income tax assets arise from differences in the dates that items of income and expense enter into reported income and taxable income. Deferred tax assets and liabilities are established for these items as they arise. Deferred tax assets are reviewed quarterly to determine if they are realizable based on the historical level of taxable income, estimates of future taxable income and the reversals of deferred tax liabilities. In most cases, the realization of the deferred tax asset is based on future profitability. If the Corporation experiences net operating losses for tax purposes, the realization of deferred tax assets would be evaluated for a potential valuation reserve.

Additionally, the Corporation reviews its uncertain tax positions annually under ASC 740-10, Accounting for Uncertainty in Income Taxes. An uncertain tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount actually recognized is the largest amount of tax benefit that is greater than 50% likely to be recognized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. A significant amount of judgment is applied to determine both whether the tax position meets the “more likely than not” test as well as to determine the largest amount of tax benefit that is greater than 50% likely to be recognized. Differences between the position taken by management and that of taxing authorities could result in a reduction of a tax benefit or increase to tax liability, which could adversely affect future income tax expense.

Impairment of Intangible Assets

Core deposit and customer relationships, which are intangible assets with a finite life, are recorded on our balance sheets. These intangible assets were capitalized as a result of past acquisitions and are being amortized over their estimated useful lives of up to 15 years. Core deposit intangible assets with finite lives will be tested for impairment when changes in events or circumstances indicate that the carrying amount may not be recoverable. Core deposit intangible assets were tested for impairment during 2011, and no impairment was recognized.

Mortgaging Service Rights (“MSRs”)

MSR fair values are very sensitive to movements in interest rates as expected future net servicing income depends on the projected outstanding principal balances of the underlying loans, which can be greatly reduced by prepayments. Prepayments usually increase when mortgage interest rates decline and decrease when mortgage interest rates rise. For discussion regarding the impairment of MSRs, see Note 4 – “Originated Mortgage Servicing Rights” in the Notes to condensed Consolidated Financial Statements.

Fair Value Measurements

The fair value of a financial instrument is defined as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Corporation estimates the fair value of a financial instrument using a variety of valuation methods. Where financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value. When the financial instruments are not actively traded, other observable market inputs, such as quoted prices of securities with similar characteristics, may be used, if available, to determine fair value. When observable market prices do not exist, the Corporation estimates fair value. The Corporation’s valuation methods consider factors such as liquidity and concentration concerns. Other factors such as model assumptions, market dislocations and unexpected correlations can affect estimates of fair value. Imprecision in estimating these factors can impact the amount of revenue or loss recorded.

ASC 820 defines the 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. ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

ASC 820, “Fair Value Measurements,” establishes a framework for measuring the fair value of financial instrument that considers the attributes specific to particular assets or liabilities and establishes a three-level hierarchy for determining fair value based on the transparency of inputs to each valuation as of the fair value measurement date. The three levels are defined as follows:

Level 1 - quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2- inputs include quoted prices for similar assets and liabilities in active markets, quoted prices of identical or similar assets or liabilities in markets that are not active, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3 - inputs that are unobservable and significant to the fair value measurement.

At the end of each quarter, the Corporation assesses the valuation hierarchy for each asset or liability measured. From time to time, assets or liabilities may be transferred within hierarchy levels due to changes in availability of observable market inputs to measure fair value at the measurement date. Transfers into or out of hierarchy levels are based upon the fair value at the beginning of the reporting period. A more detailed description of the fair values measured at each level of the fair value hierarchy can be found in Note 9- “Fair Value of Assets and Liabilities” in the Notes to condensed Consolidated Financial Statements.

RECENT DEVELOPMENTS

Regulatory Matters

In connection with regular examinations of the Corporation by the Federal Reserve Bank of Chicago (“FRB”), and the Office of the Comptroller of the Currency (“OCC”), various actions were taken by the regulatory agencies, none of which resulted in the imposition of fines or penalties.

A Consent Order (“Order”) is a formal action by the OCC requiring a bank to take corrective measures to address deficiencies identified by the OCC. The subsidiary bank can continue to serve its customers in all areas including making loans, establishing lines of credit, accepting deposits and processing banking transactions. All customer deposits remain fully insured to the maximum limits set by the FDIC.

A Memorandum of Understanding (a “Memorandum”) agreement is characterized by regulatory authorities as an informal action that is neither published nor made publicly available by the agencies and is used when circumstances warrant a milder form of action than a formal supervisory action, such as an Order.

A Written Agreement (an “Agreement”) is a formal enforcement action by the FRB, similar in nature to a Memorandum, but is legally binding and will be published and made public.

On August 21, 2012, the subsidiary bank was notified that it is critically undercapitalized for PCA purposes, effective August 20, 2012, as a result of the financial results reported in the Bank’s June 30, 2012 Call Report. As a result of the Bank being classified as critically undercapitalized for purposes of PCA, the OCC is required, within 90 days of August 20, 2012, to appoint a receiver or conservator for the Bank, or to take such other action that it determines, with the concurrence of the FDIC, would better achieve the purposes of PCA. Based on current circumstances, it is unlikely that the regulators would pursue a course of action other than conservatorship or receivership. If the Bank is placed into conservatorship or receivership, PNBC would suffer a complete loss of the value of our ownership interest in the Bank, and we subsequently may be exposed to significant claims by the FDIC and the OCC.

Capital Resources

Other than the issuance of common stock, the Corporation’s primary source of capital is net income retained by the Corporation. During the years ended December 31, 2011 and 2010, the Corporation incurred net losses of $54,350 and $16,979 respectively, and paid no common dividends. During the year ended December 31, 2009, the Corporation had a net loss of $21,126 and paid dividends to common stockholders of $2,301. Stockholders equity decreased by $9,451 to ($4,516) as of June 30, 2012 due to a net loss of $5,118 and a decrease in other comprehensive income of $4,394 compared to December 31, 2011. Total stockholders’ equity decreased $51,908 to $4,935 from $56,861 from December 31, 2010 to December 31, 2011.

In recent regulatory guidance, the Board of Governors of the Federal Reserve System has emphasized that voting common stockholders’ equity generally should be the dominant element within Tier 1 capital for bank holding companies and that it is the most desirable element of capital from the supervisory standpoint. The Board of Governors has reiterated that bank holding companies should place primary reliance on common equity and has cautioned bank holding companies against over-reliance on non-common-equity capital elements.

The Federal Reserve Board uses capital adequacy guidelines in its examination and regulation of bank holding companies and their subsidiary banks. Risk-based capital ratios are established by allocating assets and certain off-balance sheet commitments into four risk-weighted categories. These balances are then multiplied by the factor appropriate for that risk-weighted category. The guidelines require bank holding companies and their subsidiary banks to maintain a total capital to total risk-weighted assets ratio of not less than 8.0%, of which at least one half must be Tier 1 capital, and a Tier 1 leverage ratio of not less than 4.0%.

Federal regulations require all financial institutions to evaluate capital adequacy by the risk-based capital method, which makes capital requirements more sensitive to the levels of risk inherent in different assets. At June 30, 2012, the Corporation’s total risk-based capital ratio was -1.31%, the Tier 1 risk-based capital ratio was -1.31%, and its Tier 1 leverage ratio was -0.80%. At June 30, 2012, the subsidiary bank’s total risk-based capital ratio was 4.33%, the Tier 1 risk-based capital ratio was 3.05% and its Tier 1 leverage ratio was 1.85%. As of December 31, 2011, the Corporation’s total risk-based capital ratio was -0.50%, Tier 1 risk-based capital ratio was -0.50% and its Tier 1 leverage ratio was -0.32%. As of December 31, 2011, the subsidiary bank’s total risk-based capital ratio was 4.60%, Tier 1 risk-based capital ratio was 3.31% and its Tier 1 leverage ratio was 2.14%. These capital ratios fell below the adequately capitalized levels primarily due to the extent of operating losses incurred at the subsidiary bank in 2009, 2010, and 2011. The risk-based regulatory capital ratios are further reduced by the limitation on trust preferred securities includible in Tier 2 capital, based on the decreased level of Tier 1 capital.

Without prior approval, the subsidiary bank is restricted as to the amount of dividends that may be declared to the balance of the retained earnings account adjusted for defined bad debts. In addition, the FDIC has authority to prohibit or to limit the payment of dividends by a bank if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the banking organization. The Corporation and its subsidiary bank are prohibited from paying any dividends without regulatory consent, pursuant to regulatory enforcement actions taken at the subsidiary bank. For further discussion, see the “Regulatory Matters” section of this filing.

The Corporation has generated net losses in each of the last three full years, with $54,350 in 2011, $16,979 in 2010 and $21,126 in 2009. The 2011 loss was partially the result of a 100% valuation allowance established against the Corporation’s net deferred tax assets of $27,722. The 2009 loss was largely due to the 100% write-off of the subsidiary bank’s goodwill of $24,521. The subsidiary bank continued to generate losses in 2010 and 2011 from significant increases in non-performing assets, impaired loans and loan loss provisions, resulting in the subsidiary bank’s primary regulator imposing a Consent Order. Additions to the required level of provision for loan losses resulted in the generation of a net loss of $5,118 for the six months ended June 30, 2012. For further discussion of regulatory enforcement actions, see the “Regulatory Matters” section of this filing.

Due to the net losses incurred by the Corporation in the last three full years, stockholders equity has been reduced to a level that leaves the Corporation with very little capacity to absorb further losses.

In 2010, the Corporation and subsidiary bank’s Board of Directors initiated a process to identify and evaluate a broad range of strategic alternatives to strengthen the Corporation’s capital base and enhance shareholder value. These strategic alternatives include asset sales, consolidation of operations, the closing or sale of branches, capital enhancement and other recapitalization transactions. The subsidiary bank retained outside financial and legal advisors to assist with its evaluation and oversight.

In December 2011, as part of the Capital Plan submitted to the OCC in response to the Consent Order, several capital enhancement alternatives were evaluated, including a public offering of common shares, a shareholder rights offering, the sale of branch locations, and other asset sales. In 2012, the Board and management continue to evaluate these potential alternatives with advisors, independent parties and the OCC, which under the Consent Order must provide prior approval before the execution of any capital enhancement transaction.

Other Developments

On January 24, 2011, the Corporation notified the U.S. Treasury that it will defer regularly scheduled payments on the Corporation’s 25,083 shares in Series B Preferred Stock. As of June 30, 2012 and 2011, “dividends in arrears” on the preferred stock, which must be paid prior to the payment of dividends on common shares, totaled approximately $1,881,000 and $627,000, respectively.

RESULTS OF OPERATIONS

Net loss available to common stockholders was ($6,446,000) for the second quarter of 2012 compared to ($2,932,000) for the second quarter of 2011. Basic and diluted loss per common share available to common stockholders for the second quarter of 2012 was ($1.92) compared to basic and diluted loss per share of ($0.88) for the second quarter of 2011. This represents a decrease of $3,514,000 or $1.04 per basic and diluted common share. The annualized return on average assets and return on average equity were (2.64%) and (440.10%), respectively, for the second quarter of 2012, compared to (1.08%) and (20.32%) for the second quarter of 2011.

Net loss available to common stockholders was ($5,760,000) for the first six months of 2012 compared to ($1,205,000) for the first six months of 2011. Basic and diluted loss per common share available to common stockholders for the first six months of 2012 was ($1.72) compared to basic and diluted loss per share of ($0.36) for the first six months of 2011. This represents a decrease of $4,555,000 or $1.36 per basic and diluted common share. Higher net loss is attributable primarily to a decrease in net interest income, increased non-interest expenses including loan collection expenses and FDIC assessments, and continued significant provisions for loan losses. The annualized return on average assets and return on average equity were (1.17%) and (203.23%), respectively, for the second quarter of 2012, compared with (.22%) and (4.21%) for the first six months of 2011.

Net interest income before the provision for loan losses was $7,059,000 for the second quarter of 2012, compared to $8,756,000 for the second quarter of 2011 (a decrease of $1,692,000 or 19.4%). The net yield on interest-earning assets (on a fully taxable equivalent basis) decreased by 0.72% to 3.40% for the second quarter 2012 from 4.12% in the second quarter of 2011.

Net interest income before the provision for loan losses was $14,779,000 for the first six months of 2012, compared to $18,113,000 for the first six months 2011 (a decrease of $3,334,000 or 18.4%) due to continued yield compression experienced in the historically low interest rate environment. The net yield on interest-earning assets (on a fully taxable equivalent basis) decreased by 0.80% to 3.47% for the first six months 2012 from 4.27% in the first six months of 2011. This decrease in the net yield on average interest-earning assets was driven by yield compression experienced in both the loan and investment portfolios, offset in part by a reduction in the cost of interest-bearing liabilities, primarily time deposits, which decreased from 0.34% for the second quarter of 2011 to 0.90% for the second quarter of 2012.

The Corporation’s provision for loan loss expense recorded each quarter is determined by management’s evaluation of the risk characteristics of the loan portfolio. Net charge-offs decreased during the second quarter of 2012 to $17,294,000, compared to net charge-offs of $18,828,000 for the second quarter of 2011. The Corporation recorded a loan loss provision of $10,025,000 in the second quarter of 2012 compared to a provision of $8,050,000 in the second quarter of 2011.

Net charge-offs decreased during the first six months of 2012 to $18,041,000, compared to net charge-offs of $20,522,000 for the first six months 2011. The Corporation recorded a loan loss provision of $10,100,000 in the first six months of 2012 compared to a provision of $9,925,000 in the first six months of 2011. The allowance for loan losses is discussed more fully in the “Allowance for Loan Losses” section of this filing.

Non-interest income totaled $8,349,000 for the second quarter of 2012, compared to $4,027,000 in the second quarter of 2011, an increase of $4,322,000 or 107.4%. This increase was due largely to an increase in the realization of gains on securities sold of $3,500,000 in the second quarter of 2012 compared to 2011. The Corporation’s subsidiary bank’s Employee Health Benefit Plan is partially self insured up to certain stop losses in place with insurance companies. In addition to the funded status of the component of the plan covering retired employees, for which a separate benefit obligation exists, the Corporation’s bank subsidiary has established a funding reserve for medical costs and claims related to active employees. Contributions in excess of actual costs and claims are held in a trust agency account. There are no restrictions on any funds set aside for this purpose. No asset or obligation related to this component of the plan is recorded on the Corporation or subsidiary bank’s books. During the quarter, the bank subsidiary changed the funding methodology and no longer contributes to the funding reserve using a premium equivalent expense as if the plan were not partially self insured. Instead, the reserve is maintained based on the actual cost and experience. This change resulted in the recovery of $908,241 in pre- funded health insurance benefits. Annualized non-interest income as a percentage of total average assets increased to 3.46% for the second quarter of 2012, from 1.49% for the same period in 2011.

Non-interest income totaled $11,492,000 for the first six months of 2012, compared to $7,627,000 in the first six months of 2011, an increase of $3,865,000 or 50.7%. This increase was due largely to an increase in the realization of gains on securities sold of $2,970,000 in the second quarter of 2012 compared to 2011. Annualized non-interest income as a percentage of total average assets increased to 2.33% for the first six months of 2012, from 1.41% for the same period in 2011.

Total non-interest expense for the second quarter of 2012 was $11,508,000, an increase of $1,275,000 (or 12.5%) from $10,233,000 in the second quarter of 2011. The largest differences between these periods for 2012 and 2011 were an increase in loan collections costs and deposit insurance assessments of $894,000 and $609,000 (increases of 240.0% and 136.2%, respectively). These increases were partially offset by decreases in net other real estate expenses of $151,000 and decreases in salaries and employee benefits of $156,000 (decreases of 10.5% and 3.4%, respectively) in the second quarter 2012 compared to 2011. Annualized non-interest expense as a percentage of total average assets increased to 4.76% for the second quarter of 2012 compared to 3.78% for the same period in 2011.

Total non-interest expense for the first six months of 2012 was $21,236,000, an increase of $1,568,000 (or 7.97%) from $19,668,000 in the first six months of 2011. The largest differences between these periods for 2012 and 2011 was an increase in loan collections costs and deposit insurance assessments of $1,641,000 and $885,000 (an increase of 307.3% and 81.4%, respectively) due to increased costs incurred in the aggressive collection of problem loans and higher risk-assessed FDIC insurance premiums. These increases were partially offset by net gains realized on the sale of other real estate owned properties totaling $974,000. Other real estate expenses, net resulted in expense of $935,000 in the first half of 2012, a decrease of $1,080,000 (53.6%) compared to the net expense of $2,015,000 in the first half of 2011. Annualized non-interest expense as a percentage of total average assets increased to 4.30% for the first six months of 2012, compared to 3.64% for the same period in 2011.

INCOME TAXES

The Corporation recorded income tax expense of $53,000 for the six months ended June 30, 2012, as compared to an income tax benefit of $2,663,000 for the six months ended June 30, 2011. The effective tax rate was 1.05% for the six-month period ended June 30, 2012 and (69.1%) for the six-month period ended June 30, 2011.

During the third quarter of 2011, management established a full valuation allowance against existing net deferred tax assets. Under generally accepted accounting principles, 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 realizability of the deferred tax asset is based on management’s evaluation of both positive and negative evidence, the forecasts of future income, prudent and feasible tax planning strategy and assessments of current and future economic and business conditions. Positive evidence includes the existence of taxes paid in available carry-back years as well as taxable income projections for future periods, while negative evidence includes the cumulative losses in the current year and prior two years and general business and economic trends. After evaluating all of the factors previously summarized and considering the weight of the positive evidence compared to the negative evidence, the Corporation has determined a full valuation adjustment was necessary as of June 30, 2012 and December 31, 2011.

For more information on the Corporation’s income taxes see Note 10 – “Income Taxes” in the Notes to condensed Consolidated Financial Statements.

FDIC

On September 29, 2009, the Board of Directors of the FDIC adopted a Notice of Proposed Rulemaking (NPR) that would require insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The FDIC estimated that the total prepaid assessments collected would be approximately $45 billion. The FDIC Board also voted to adopt a uniform three-basis point increase in assessment rates effective on January 1, 2011, and extend the restoration period from seven to eight years.

Under GAAP accounting rules, unlike special assessments, prepaid assessments do not immediately affect bank earnings. Each institution recorded the entire amount of its assessment related to future periods as a prepaid expense (an asset) as of December 31, 2009, the date the payment was made. The Corporation paid an assessment of $6,763,000 for the fourth quarter of 2009 and for all of 2010, 2011 and 2012.

Beginning January 1, 2010, and each quarter thereafter, each institution would record an expense (charge to earnings) for its regular quarterly assessment and an offsetting credit to the prepaid assessment until the asset is exhausted. At June 30, 2012, the Corporation had a remaining prepaid assessment of $273,000. This amount is included in Other Assets in the Condensed Consolidated Balance Sheets. The Corporation recorded $1,754,000 of federal insurance assessment expense for the second quarter of 2012 and $902,000 for the second quarter of 2011.

ANALYSIS OF FINANCIAL CONDITION

Total assets at June 30, 2012 decreased to $954,150,000 from $1,014,316,000 at December 31, 2011 (a decrease of $60.2 million or 5.9%). There was an increase of $77,934,000 in cash and cash equivalents to $141,229,000 as of June 30, 2012 from $63,295,000 as of December 31, 2011. Total loan balances decreased by $92.4 million, or 15.7%, during the six month period to $498.2 million due to seasonal pay downs in the agricultural portfolio and continued general decline in the overall demand for new low-risk credit. Investment balances totaled $223,524,000 at June 30, 2012, compared to $261,583,000 at December 31, 2011 (a decrease of $38.1 million, or 14.6%). Total deposits decreased to $877,171,000 at June 30, 2012 from $917,295,000 at December 31, 2011 (a decrease of $40.1 million or 4.4%). Comparing categories of deposits at June 30, 2012 to December 31, 2011, time deposits increased $4.8 million (or 1.6%), while interest-bearing demand deposits decreased $28.6 million (or 8.1%), savings deposits increased $2.9 million (or 3.4%) and demand deposits decreased $19.2 million (or 11.2%). Borrowings, consisting of customer repurchase agreements and Federal Home Loan Bank (“FHLB”) advances, decreased from $84,835,000 at December 31, 2011 to $75,743,000 at June 30, 2012 (a decrease of $9.1 million or 10.7%). This decrease was due to a decrease in outstanding customer repurchase agreements and repayment of FHLB advances.

CAPITAL PURCHASE PROGRAM

On January 23, 2009, the Corporation received $25,083,000 of equity capital by issuing to the United States Department of Treasury 25,083 shares of the Corporation’s 5.00% Series B Non-voting Cumulative Preferred Stock, par value $0.01 per share with a liquidation preference of $1,000 per share and a ten-year warrant to purchase up to 155,025 shares of the Corporation’s common stock, par value $5.00 per share, at an exercise price of $24.27 per share. The proceeds received were allocated to the preferred stock and additional paid-in capital based on their relative fair values. The resulting discount on the preferred stock is amortized against retained earnings and is reflected in the Corporation’s consolidated statement of income as “Accretion of preferred stock discount”, resulting in additional dilution to the Corporation’s earnings per share. The warrants are exercisable, in whole or in part, over a term of 10 years. The warrants were included in the Corporation’s diluted average common shares outstanding (subject to anti-dilution). Both the preferred securities and warrants were accounted for as additions to the Corporation’s regulatory Tier 1 and total capital.

On January 24, 2011, the Corporation notified the U.S. Treasury that it will defer regularly scheduled payments on the Corporation’s 25,083 shares in Series B Preferred Stock. As of June 30, 2012, “dividends in arrears” on the preferred stock, which must be paid prior to the payment of dividends on common shares, total approximately $1,881,000.

LOANS

The Corporation’s loan portfolio largely reflects the profile of the communities in which it operates. The Corporation essentially offers four types of loans: commercial, agricultural, real estate and consumer installment. The Corporation has no foreign loans. The following table summarizes the Corporation’s loan portfolio:

	June 30, 2012						December 31, 2011						June 30, 2011
	Amount			% of Total			Amount			% of Total			Amount			% of Total
Commercial	$	50,914			9.8	%	$	62,609			10.1	%	$	129,771			19.7	%

Agricultural		22,392			4.3	%		61,251			9.9	%		64,354			9.8	%

Agricultural real estate		53,328			10.3	%		60,523			9.7	%		49,391			7.5	%
Commercial real estate		230,902			44.3	%		235,103			37.9	%		201,571			30.6	%
Commercial real estate development		30,124			5.8	%		58,279			9.4	%		75,126			11.4	%
Residential real estate		91,793			17.6	%		97,172			15.6	%		86,673			13.2	%
Total Real Estate		406,147			78.0	%		451,077			72.6	%		412,761			62.8	%

Consumer		41,196			7.9	%		46,084			7.4	%		50,801			7.7	%
Total loans	$	520,649			100.0	%	$	621,021			100.0	%	$	657,687			100.0	%

Total assets	$	954,150					$	1,014,316					$	1,069,761
Loans to total assets		54.6	%					61.2	%					61.5	%

Total loans decreased $100,372 (or 16.1%) in the first six months of 2012. There were no acquisitions in the second quarter of 2012 or in 2011. The decrease in 2012 reflects capital management objectives consistent with 2011, as well as the continued negative effects of the current economic environment in which business and consumer borrowers have reduced demand and capacity for new indebtedness. This reduced demand and borrower financial deterioration continue to result in a higher percentage level of loans charged off and transferred to other real estate owned.

Commercial loans decreased $11,695 (or 18.7%) in the first six months of 2012. The decrease is due to reduced borrower demand; borrower financial deterioration leading to higher levels of loan charge offs and transfers to other real estate owned and management’s general position toward avoiding inappropriate credit risk in new loan origination.

Loans to agricultural operations decreased $38,859 (or 63.4%) in the first six months of 2012. Short-term agricultural loans are seasonal in nature with paydown from grain sales occurring near the beginning and end of each year. Strong agricultural production in support of the bio-fuels industry (primarily ethanol) and worldwide food demand have dramatically influenced corn prices since the latter part of 2006. Rising corn prices have influenced soybean prices as the two commodities generally compete for planted acreage. Corn and soybeans remain the two primary crops of the Corporation’s market area. Also selling prices remain historically strong in 2011 and into 2012, resulting in another year of high profitability for most of the Corporation’s agricultural customers. The balance sheet of local agriculture remains strong, both in terms of equity and liquidity. The result of these market forces have resulted in a larger seasonal paydown of agricultural balances then in prior years. The highly experienced agricultural staff continues to effectively manage agricultural portfolio risk and seek opportunities to regain this portfolio position in 2012. Agricultural loans as a percentage of total loans were 4.3% at June 30, 2012, compared to 9.9% at year-end 2011.

Total real estate loans decreased $44,930 (or 10.0%) in the first six months of 2012. Residential real estate loans with fixed rates of more than 5 years are generally sold into the secondary market. With home mortgage rates in 2011 and the second quarter of 2012 continuing at their lowest level in over 50 years, many borrowers continue to refinance adjustable rate loans into fixed rate loans that were sold. Total home mortgage closings were $34,507 and $18,252 in the first six months of 2012 and 2011, respectively.

Consumer installment loans decreased $4,888 (or 10.6%) in the first six months of 2012. Home equity lending, which continues to reflect reduced consumer demand, comprises over two thirds of the installment portfolio.

Although the risk of non-payment for any reason exists with respect to all loans, certain other more specific risks are associated with each type of loan. The primary risks associated with commercial loans are quality of the borrower’s management and the impact of national economic factors. Development and construction loans have primary risks associated with demand for housing and other construction projects. As these businesses are capital intensive, when demand for product weakens, revenues are reduced while fixed costs such as debt service remain. With respect to agricultural loans, the primary risks are weather and, like commercial loans, the quality of the borrower’s management. Risks associated with real estate loans include concentrations of loans in a loan type, such as commercial or agricultural, and fluctuating land values. Non-owner occupied commercial real estate loans have risks related to occupancy and lease rates during economic downturns. Installment loans also have risks associated with concentrations of loans in a single type of loan. Installment loans additionally carry the risk of a borrower’s unemployment as a result of deteriorating economic conditions. With the exception of agricultural lending, the current economic environment has increased the risk level in the subsidiary bank’s loan portfolio.

The Corporation’s strategy with respect to addressing and managing these types of risks, whether loan demand is weak or strong, is for the subsidiary bank to follow its loan policies and sound underwriting practices, which include: (i) granting loans on a sound and collectible basis, (ii) investing funds profitably for the benefit of the stockholders and the protection of depositors, (iii) serving the legitimate needs of the community and the subsidiary bank’s general market area while obtaining a balance between maximum yield and minimum risk, (iv) ensuring that primary and secondary sources of repayment are adequate in relation to the amount of the loan, (v) administering loan policies through a Directors’ Loan Committee, an Executive Loan Committee and Officer approvals, (vi) developing and maintaining adequate diversification of the loan portfolio as a whole and of the loans within each loan category and (vii) ensuring that each loan is properly documented and, if appropriate, secured or guaranteed by government agencies, and that insurance coverage is adequate, especially with respect to certain agricultural loans because of the risk of poor weather. In the present difficult economic environment, bank officers and staff actively work with borrowers to achieve the best resolutions possible.

NON-PERFORMING LOANS AND OTHER REAL ESTATE OWNED

Non-performing loans consist of non-accrual loans, loans past due 90 days on which interest is still accruing and loans modified in troubled debt restructurings (restructured loans). Non-performing loans amounted to 13.3% of total loans at June 30, 2012 compared to 16.26% at December 31, 2011. The decrease reflects improvement in the Corporation’s loan portfolio during 2012. The primary components of the non-accrual total remain in two industries. One is the commercial real estate development industry, primarily in the Corporation’s northern and eastern market areas. Non-performing commercial real estate development loans comprise approximately 27.6% of the Corporation’s total non-performing loans as of June 30, 2012. Due to dramatic declines in residential real estate sales activity, certain builders and developers have encountered difficulty in servicing their debt, eventually leading to non-performing status. The other primary component of non-performing loans is commercial real estate loans, which comprise approximately 41.6% of the non-performing total as of June 30, 2012. These are comprised of owner-occupied facilities and leased facilities and are located throughout the Corporation’s market area. The balance of non-performing loans is comprised primarily of residential real estate and home equity credits. The Corporation has been proactive in obtaining updated appraisals for non-performing loans secured by real estate. The continued downward pressure on real estate values, particularly development properties, has prompted charge-offs and the recording of specific reserves for potential loss on loans secured by real estate. Though additional reserve levels are expected to be required due to the potential for future devaluation of these troubled loan sectors, management believes this situation peaked in 2011, and the level of additional reserves will begin to diminish.

Restructured loans at June 30, 2012 were $20,318 compared to $19,378 at December 31, 2011. These are loans to borrowers that are experiencing varying levels of financial stress but are expected to recover. To assist the borrowers, the Corporation has provided some concession in loan terms, most commonly extending the loan amortization or adjusting the interest rate. In the present economic environment, the vast majority of non-performing loans are secured by real estate. At the time a loan is restructured, the Corporation considers the repayment history of the loan and the value of the collateral. If the principal or interest is due and has remained unpaid for 90 days of more and the loan is not well-secured, the loan is placed on nonaccrual status. If the principal and interest payments are current and the loan is well-secured, the restructured loan continues to accrue interest. Once a loan is placed on nonaccrual status, the borrower is required to make current principal and interest payments based on the modified terms for a period of at least 6 months before returning the loan to accrual status.

As of June 30, 2012 and December 31, 2011, $5,135 and $3,197, respectively, in restructured loans were in accrual status. When the loan is restructured, the Loan Officer is required to document the basis for the restructure, obtain current and complete credit and cash flow information and identify a specific repayment plan that would retire the debt. This information is provided to the Credit Analysis department which prepares a thorough credit presentation. The credit presentation includes the modified terms of the loan, a collateral analysis and a cash flow analysis based on the modified terms of the loan. The credit presentation is presented to the Directors’ Loan Committee for approval.

Problem credits are closely monitored by the lending staff, credit administration division and special assets group, which was newly formed in 2010. In addition an independent loan review staff provides further assistance in identifying problem loan situations. Loans over 90 days past due are normally either charged off or placed on a non-accrual status. Problem credits have a life cycle where they either improve or they move through a workout/liquidation process. The workout process often includes reclassification to non-accrual status, unless the loan is well secured and in the process of collection. Collateral securing non-accrual real estate loans that are not resolved by borrowers becomes other real estate owned via foreclosure or receipt of a deed in lieu of foreclosure. The Corporation actively markets other real estate owned properties for sale.

The Corporation formed a special assets group in January 2011 to focus on the management of the other real estate owned workout process. Total other real estate owned as of June 30, 2012 and December 31, 2011 was $21,141 and $21,848, respectively.

The following table provides information on the Corporation’s non-performing loans and other real estate owned as of the periods indicated:

	June 30, 2012			December 31, 2011			June 30, 2011
Non-accrual	$	49,099		$	79,943		$	69,550
90 days past due and accruing		-			1,651			2,469
Restructured		20,318			19,378			24,950
Total non-performing loans	$	69,417		$	100,972		$	96,969
Other real estate owned		21,141			21,848			18,308
Total non-performing assets	$	91,455		$	122,820		$	115,277
Non-performing loans to total loans (net of unearned interest)		13.33	%		16.26	%		14.74	%
Non-performing assets to total assets		9.58	%		12.11	%		10.78	%

Of the $69,417 in impaired loans at June 30, 2012, the Corporation relied on third party appraisals for $64,757 of the impaired loans. Approximately, $66,626 or 96.0% of the impaired loans had current third party appraisals which were relied upon. These appraisals were completed within 12 months of June 30, 2012. The appraisals for the remaining $774 in impaired loans in which third party appraisals were obtained had not been updated as the fair value in the last appraisal received and the current estimated value were in significant excess of the outstanding debt. The average loan to fair value for the $774 was approximately 66.8%.

The following table provides a loan-to-value ratio distribution for the $774 in impaired loans with appraisals over twelve months old as of June 30, 2012:

Loan-to-Value	Amount
0 - 50%	$	388
50 - 60%	$	58
60 - 70%	$	-
70 - 80%	$	87
80 - 90%	$	241
90% +	$	-

Once a loan is deemed an impaired loan, the loan officer completes a Problem Asset Workout Summary, which includes a detailed review of the collateral. If the estimated current collateral value is in significant excess of the outstanding debt, a new appraisal is not ordered. If the collateral value is not in significant excess of the outstanding debt or the appraisal is over twelve months old, the loan officer will determine if a new appraisal should be ordered based on their knowledge of the current market in the collateral’s area. If the Corporation determines that full collection of the principal of the debt owed is not likely, a new appraisal is ordered. If the estimated fair value represented in the new appraisal is less than the outstanding debt, a charge-off is recorded equal to the difference between the discounted collateral value and the outstanding debt.

The determination of a specific allowance or charge-off is reviewed by the Corporation on a monthly basis. During the six months ended June 30, 2012, the Corporation recorded partial charge-offs totaling $13,075 on the impaired loans with an outstanding balance of $11,017. The charge-offs were considered warranted as the loans were considered collateral dependent and the discounted collateral value was not sufficient to cover the outstanding debt.

The Corporation has established reporting lines independent of loan production areas for staff that administer the Corporation’s real estate collateral valuation program – including the ordering, reviewing, and acceptance of appraisals. The Corporation requires appraisals on real estate if the loan is over $250,000 or if the collateral is commercial real estate at the time of origination of the loan. If the appraisal is not within one year of the reporting period, the loan officer may provide an additional discount on the collateral based on the loan officer’s review of the collateral and its current condition, the Corporation’s knowledge of the current economic environment in the collateral’s market and the Corporation’s past experience with real estate in the area. The date of the appraisal is also considered in conjunction with the economic environment and the decline in the real estate market since the appraisal was obtained. This additional discount is usually 10% to 20%. If the loan is below $250,000 and is not commercial real estate, an evaluation of the collateral will be completed by an independent qualified party. Underlying collateral consisting of vehicles, equipment or other assets is valued using information provided by the borrower. The loan officer must confirm the existence of the assets and provide adequate discounts on the value of the collateral when determining its adequacy to cover the loan.

Problem Asset Workout Summaries are reviewed by the Corporation’s credit administration division and utilized in the preparation of the allowance for loan losses calculation. Summaries include a collateral analysis detailing a description of the collateral, the date of the appraisal and the discounts on the collateral. If the discounted collateral is sufficient to cover the outstanding loan balance, no specific valuation allowance is placed on the loan.

ALLOWANCE FOR POSSIBLE LOAN LOSSES

The allowance shown in the following table represents the allowance available to absorb losses within the entire portfolio:

	June 30, 2012			December 31, 2011			June 30, 2011

Amount of loans outstanding at end of period (net of unearned interest)	$	520,649		$	621,021		$	657,687
Average amount of loans outstanding for the period (net of unearned interest)	$	567,217		$	584,928		$	691,101
Allowance for loan losses at beginning of year	$	30,413		$	29,726		$	29,726
Charge-offs:
Agricultural		-			2,258			38
Commercial		1,544			44,411			18,498
Real estate-mortgage		17,535			3,541			1,439
Installment		667			1,667			682

Total charge-offs		19,746			51,877			20,657
Recoveries:
Agricultural		-			15			-0-
Commercial		120			501			45
Real estate-mortgage		1,491			10			7
Installment		94			235			83

Total recoveries		1,705			761			135

Net loans charged off		18,041			51,116			20,522
Provision for loan losses		10,100			51,803			9,925

Allowance for loan losses at end of period	$	22,472		$	30,413		$	19,129

Net loans charged off to average loans (annualized)		6.36	%		8.74	%		5.94	%
Allowance for loan losses non-performing loans		32.37	%		30.12	%		19.73	%
Allowance for loan losses to total loans at of period (net of unearned interest)		4.32	%		4.90	%		2.91	%

The allowance for loan losses is considered by management to be a critical accounting policy. The allowance for loan losses is increased by provisions charged to operating expense and decreased by charge-offs, net of recoveries. The allowance is based on factors that include the overall composition of the loan portfolio, types of loans, past loss experience, loan delinquencies, potential substandard and doubtful loans, and such other factors that, in management’s best judgment, deserve evaluation in estimating possible loan losses. The adequacy of the allowance for possible loan losses is monitored monthly during the ongoing, systematic review of the loan portfolio by the allowance review committee of the subsidiary bank. The results of these reviews are reported to the Board of Directors of the subsidiary bank on a monthly basis. Monitoring and addressing problem loan situations are the responsibility of the subsidiary bank’s staff, management and its Board of Directors.

More specifically, the Corporation calculates the appropriate level of the allowance for loan losses on a monthly basis using base charge-offs for each loan type, substandard loans and potential losses with respect to specific loans. In addition to management’s assessment of the portfolio, the Corporation and the subsidiary bank are examined periodically by regulatory agencies. Although the regulatory agencies do not determine whether the subsidiary bank’s allowance for loan losses is adequate, such agencies do review the procedures and policies followed by management of the subsidiary bank in establishing the allowance.

Given the current state of the economy, management has assessed the impact of the recession on each category of loans and adjusted historical loss factors for more recent economic trends. Management utilizes a twelve quarter history as one component in assessing the probability of inherent future losses, while including additional weighting of the most recent historical data. Given the decline in economic conditions over the past year, management has also increased its allocation to various loan categories for economic factors. Some of the economic factors include the potential for reduced cash flow for commercial operating loans from reduction in sales or increased operating costs, decreased occupancy rates for commercial buildings, reduced levels of home sales for commercial and land developments, reduced values in real estate or other collateral, the decline in and uncertainty regarding grain prices and increased operating costs for farmers, and increased levels of unemployment and bankruptcy impacting consumers’ ability to pay. Each of these economic uncertainties was taken into consideration in developing the appropriate level of reserve.

Crop insurance and the overall relationship between production is pricing is expected to compensate the Company’s Ag customers for any weather related losses they may have otherwise experienced as a result of the summer drought (experienced in the Midwest and throughout the country) and it’s affect on crop production.

The Corporation’s allowance for loan losses has two components. The second component is based upon individual review of nonperforming, substandard or other loans identified as a risk for loss and deemed impaired. This includes the Corporation’s nonperforming loans, which consist of nonaccrual loans, loans past due over 90 days and troubled debt restructurings, loans designated as impaired as defined by accounting and regulatory guidance and loans evaluated for potential loss on an individual basis.

The second component is based upon expected, but unidentified, losses inherent in the Corporation’s loan portfolio. The second component is determined utilizing the Corporation’s most recent twelve quarter net charge-off history which is then adjusted for qualitative and quantitative factors. These reserve percentages are reviewed on a quarterly basis by an Allowance Review Committee which is comprised of members of management, including lending, credit administration, accounting and risk management. The qualitative and quantitative factors considered include economic conditions, changes in underwriting practices, changes in the value of collateral, changes in the portfolio volume, staff experience, past due and nonaccrual loans, loan review oversight, concentrations of loans and competition.

During 2011, in evaluating the adequacy of the allowance for loan losses, the Corporation implemented loan migration analysis to further analyze the risk in the loan portfolio based on previous loan risk rating, current loan risk rating and charge off history associated with each individual loan pool. The loans with risk rating 1 through 4 (“pass loan pools”) that have experienced high historical losses during the past six years of economic downturn have been adjusted with negative qualitative adjustments to reflect the estimation of future losses within these pools based on the most recent migration analysis. The loss migration analysis of these pass loan pools reflected less than a 1% charge off rate compared to a significantly higher charge off rate for loans with risk rating of 5 and 6 (“substandard loan pools”). These qualitative adjustments to the pass loan pool component of the allowance for loan losses analysis reflect the results of this migration analysis, as well as the seasoned nature of the loans comprising the pass loan pool that have been evaluated by an independent loan review process with over 80% loan review penetration.

During the second quarter of 2012, an independent risk model validation was performed relative to the Corporation’s computations and determinations of the adequacy of the allowance for loan and lease losses account. The Corporation’s conclusions regarding the adequacy were also evaluated and tested for reasonableness.

The allowance for loan losses of $22,472 and $30,413, respectively, was 4.32% and 4.90% of total loans as of June 30, 2012 and December 31, 2011. The Corporation’s net charge-offs as a percentage of average loans was 6.36% and 8.74% for the six months ended June 30, 2012 and year ended December 31, 2011, respectively. The Corporation’s net charge-offs experienced and the level of the required allowance for loan losses have declined in the first six months of 2012 from the high levels experienced in 2010 and 2011 due to the Corporation’s aggressive efforts to identify and recognize the impact on the troubled loan portfolio of the deterioration in the economic environment, especially relative to commercial real estate and commercial real estate development loans in its northern and eastern markets in Grundy, Kane and DuPage counties.

During the first six months of 2012, $19,746 in loan charge-offs were recorded due to the receipt of updated appraisals reflecting the current deterioration in the collateral value of commercial real estate and commercial real estate development properties that has arisen due to the impacts on the real estate and construction industries of the lingering effects of the economic downturn. The Corporation also recorded $1,705 in recoveries of prior loan charge-offs in the first six months of 2012 as a result of ongoing aggressive collection efforts. This net charge-off level resulted in the recording of $10,100 in provision for loan losses in the first six months of 2012. The reduction in loans in the six months ending June 30, 2012 as well as continued improvement in the Corporation’s loan portfolio combined to result in the ratio of the allowance for loan losses to loans net of unearned interest as of June 30, 2012 decreasing to 4.32% from 4.90% as of December 31, 2011. The reduction in CRE loans and CRE development loans in combination with a reduction of specific reserves required due to borrower paydowns and charge-offs, offset by increases in general reserves due to continued uncertainty in some segments of the loan portfolio and the economy as a whole resulted in a slight increase of $175,000 in provisions for loan losses in the six months ended June 30, 2012 compared to 2011.

During 2011, $51,877 in loans were charged-off compared to $23,166 in 2010. $44,411 of these 2011 charge-offs were commercial loans, primarily $23,513 of commercial real estate loans and $14,543 of commercial real estate development loans. This was primarily due to the impact of the economic downturn and the resulting weak economic recovery which resulted in ongoing negative impact on the housing and commercial real estate industries. Specifically, the sluggish economic recovery in the real estate industry negatively impacted real estate valuations, which combined with the high number and dollar amount of loans in the subsidiary bank’s portfolio increased the level of charge-offs incurred.

The allowance for loan losses as a percentage of non-performing loans increased to 32.4% as of June 30, 2012 from 30.1% as of December 31, 2011. The allowance for loan losses calculation takes into consideration continuing economic declines and resulting increases in non-performing loans in the quantitative and qualitative factors used to adjust the reserve percentages on loans not specifically reserved for in the calculation.

There was $6,892 in specific loan loss reserves for the non-performing loans as of June 30, 2012, compared to $15,216 as of December 31, 2011. Although non-performing loans remain elevated, the balance is comprised of loans that management believes will not result in significant additional losses not reserved in the allowance for loan losses as of June 30, 2012. Management considers the allowance for loan losses adequate to meet probable losses as of June 30, 2012.

LIQUIDITY

Liquidity is measured by a financial institution’s ability to raise funds through customer deposits, borrowed funds, capital or the sale of assets, including other real estate owned. Additional sources of liquidity, including cash flow from both the repayment of loans and the securitization of assets, are also considered in determining whether liquidity is satisfactory. Liquid funds are used to maintain reserve requirements, fund loans, purchase treasury shares and meet deposit withdrawals and operational requirements. Liquidity is obtained through growth of core funds (defined as core deposits, 50% of non-public entity certificates of deposit over $100 and repurchase agreements issued to commercial customers), liquid assets and accessibility to the money and capital markets. The Corporation and the subsidiary bank have access to short-term funds through the Federal Home Loan Bank of Chicago and the Federal Reserve Bank of Chicago. The Federal Home Loan Bank of Chicago can also provide longer-term borrowings to help meet liquidity requirements.

As of June 30, 2012, though the subsidiary bank maintains sufficient liquidity in the form of cash and cash equivalents, the Corporation’s ability to generate additional liquidity is stressed as a result of the lack of a borrowing line of credit with another financial institution and the inability of the subsidiary bank to pay dividends to the Corporation due to restrictions imposed by the regulatory enforcement order at the subsidiary bank. In response, the Corporation initiated a process to identify and evaluate a broad range of strategic alternatives to strengthen the company’s capital base and enhance shareholder value, and retained outside financial and legal advisors to assist with its evaluation and oversight. For further discussion, see the “Capital Resources” section of this filing.

The subsidiary bank has adequate liquidity available. The most liquid assets are cash and due from banks, interest-bearing deposits with financial institutions and cash held at the Federal Reserve Bank of Chicago. The balance of these assets, which represent the Corporation’s cash and cash equivalents, are dependent on the Corporation’s operating, investing, lending and financing activities during any given period.

The following table summarizes the Corporation’s average cash and cash equivalents for the six months ending June 30, 2012 and the years ending December 31, 2011 and 2010.

	June 30			December 31
	2012			2011			2010
Cash and due from banks	$	8,169		$	18,362		$	14,769
Interest-bearing deposits with financial institutions		78,952			54,987			55,352
Total	$	87,121		$	73,349		$	70,121

Percent of average total assets		8.79	%		6.79	%		6.06	%

The following table summarizes the Corporation’s cash and cash equivalents as of June 30, 2012 and December 31, 2011 and 2010.

	June 30			December 31
	2012			2011			2010
Cash and due from banks	$	16,221		$	16,307		$	12,992
Interest-bearing deposits with financial institutions		125,008			46,988			30,888
Total	$	141,229		$	63,295		$	43,880

Percent of average total assets		14.25	%		6.20	%		4.00	%

As indicated in the table above, average cash and cash equivalents increased 18.9% to $87,121 as of June 30, 2012 from $73,349 as of December 31, 2011, which increased 4.6% from $70,121 as of December 31, 2010. As a percent of average total assets, average cash and cash equivalents increased to 8.79% as of June 30, 2012 from 6.79% as of December 31, 2011, which had increased from 6.06% as of December 31, 2010. The increase in average cash and cash equivalents during the periods up to June 30, 2012 was attributable to increased liquidity maintained by the Corporation as a cushion for liquidity reserves.

In the six months ended June 30, 2012, the Corporation experienced an increase in cash and cash equivalents of $77,934 or 123.1%, to $141,229 from $63,295 as of December 31, 2011. This increase was due primarily to a net decrease in loans of $85,771. Investing activities provided $122,851, including the $68,493 in net loan redemption and $14,473 in proceeds from the sales of other real estate owned. Financing activities required $49,195 from a $40,124 decrease in deposits and a $9,092 decrease in short term borrowings, primarily customer repurchase agreement accounts and the repayment of FHLB advances. Cash and cash equivalents of $141,229 at June 30, 2012, along with available unpledged securities, are deemed adequate to meet short-term liquidity needs.

In 2011, the Corporation experienced an increase in cash and cash equivalents of $19,415 or 44.2%, to $63,295 from $43,880 in 2010. This increase was due primarily to a net decrease in loans of $23,562. Investing activities provided $31,868, including $23,562 in net loan redemption and $5,009 in proceeds from the sales of other real estate owned. Financing activities utilized $32,346 from a $45,666 reduction in deposits; offset by a $17,276 increase in short term borrowings, primarily customer repurchase agreement accounts. Cash and cash equivalents of $63,295 at December 31, 2011, along with available unpledged securities are deemed adequate to meet short-term liquidity needs.

The ratio of temporary investments and other short-term available funds (those investments maturing within one year, plus twelve months’ projected payments on mortgage-backed securities and collateralized mortgage obligations, and cash and due from banks’ balances) to volatile liabilities (50% of non-public entity certificates of deposit over $100, repurchase agreements issued to public entities, short-term borrowings from banks, and deposits of public entities) was 126.64% at June 30, 2012 and 67.7% at December 31, 2011. Core deposits (demand deposits, interest-bearing checking accounts, savings deposits and certificates of deposit less than $100) were 83.9% of total deposits at June 30, 2012 and 87.8% at December 31, 2011. Money market accounts of approximately $191,285 and $221,130 at June 30, 2012 and December 31, 201, respectively, are classified by the Corporation as core deposits.

The subsidiary bank’s core deposit base is stable. While a majority of time deposits in amounts of $100,000 or more will mature within 12 months, management expects that a significant portion of these deposits will be renewed. Historically, large time deposits have been stable and management is confident it can offer interest rates at the time of renewal that are competitive with other financial institutions. If a significant portion of the certificates of deposit were not renewed, it would have an adverse effect on liquidity. However, the Corporation has other available funding sources, including excess liquidity reserves, unpledged investment securities and Federal Home Loan Bank advance borrowing capability to mitigate this risk.

On January 24, 2011, the Corporation notified the U.S. Treasury that it will defer regularly scheduled dividend payments on the Corporation’s 25,083 in Series B Preferred Shares, and the Corporation provided notice to Bank of America, N.A., as successor Trustee by merger, of the Corporation’s $25,000 in junior subordinated debt securities due 2035 (the Corporation Capital Trust I) that the Corporation is exercising its right to defer interest payments for a period of twenty (20) consecutive quarterly interest payment periods beginning with the next interest payment period of March 15, 2011, unless the Corporation subsequently gives notice that it has elected to shorten such deferral period. By taking these actions, the Corporation expects to save approximately $1,776 in annual cash payments, based on current rates.

The long-term liquidity needs of the Corporation will be driven by the changing needs of its customers and the ability to offset strategies of its competitors. The Corporation’s existing liquidity and equity base, coupled with common stock available for issuance, a low level of debt, unpledged investment securities and available borrowing sources provide multiple options for funding future liquidity needs, including contingency funding in the event of periods of unexpected reduction of liquidity.

FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

The Corporation generates agribusiness, commercial, mortgage and consumer loans to customers located primarily in North Central Illinois. The Corporation’s loans are generally secured by specific items of collateral including real property, consumer assets and business assets. Although the Corporation has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent upon economic conditions in the agricultural industry.

In the normal course of business to meet the financing needs of its customers, the subsidiary bank is party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the subsidiary bank has in particular classes of financial instruments.

The subsidiary bank's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The subsidiary bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. At June 30, 2012, commitments to extend credit and standby letters of credit were approximately $71.3 million and $1.6 million, respectively.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The subsidiary bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary, by the subsidiary bank upon extension of credit is based on management's credit evaluation of the counterparty. Collateral held varies, but may include real estate, accounts receivable, inventory, property, plant and equipment, and income-producing properties.

Standby letters of credit are conditional commitments issued by the subsidiary bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. The subsidiary bank secures the standby letters of credit with the same collateral used to secure the loan. The maximum amount of credit that would be extended under standby letters of credit is equal to the off-balance sheet contract amount. The standby letters of credit have terms that expire in one year or less.

LAND HELD FOR SALE

The Corporation owns separate lots in Elburn and Aurora, Illinois that have been removed from the land balance and are now shown on the Corporation’s balance sheet as land held-for-sale, at the lower of cost or market. The land in Elburn, approximately 2 acres, was purchased in 2003 in anticipation of the construction of a branch facility and has a cost basis of $740,000 at June 30, 2012. The land in Aurora, consisting of two lots remaining from the original purchase of fourteen acres in 2004 which was used to construct a branch facility, has a cost basis of $1,344,000. In addition, the Corporation sold former land held for sale in Somonauk, Illinois with cost basis of $80,000 for a realized gain of $75,000 during the second quarter of 2012.

LEGAL PROCEEDINGS

There are various claims pending against the Corporation's subsidiary bank, arising in the normal course of business. Management believes, based upon consultation with counsel, that liabilities arising from these proceedings, if any, will not be material to the Corporation’s financial position or results of operation.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As a smaller reporting company under the SEC’s scaled reporting requirements, the Corporation is not required to include the information required by this item. Accordingly, the information is omitted from this 10-Q filing.

EFFECTS OF INFLATION

The condensed Consolidated Financial Statements and related condensed consolidated financial data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America and practices within the banking industry which require the measurement of financial condition and operating results in terms of historical dollars, without considering the changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution's performance than the effects of general levels of inflation.

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

The following table sets forth (in thousands) details of average balances, interest income and expense, and resulting annualized yields/costs for the Corporation for the periods indicated, reported on a fully taxable equivalent basis, using a tax rate of 34%.


	Six Months Ended, June 30, 2012							Six Months Ended, June 30, 2011
	Average				Yield/			Average				Yield/
	Balance		Interest		Cost			Balance		Interest		Cost
Average Interest-Earning Assets

Interest-bearing deposits	$	78,952	$	95		0.24	%	$	47,180	$	56		0.24	%
Taxable investment securities		221,725		2,892		2.63	%		162,888		3,107		3.85	%
Tax-exempt investment securities		53,409		1,558		5.88	%		84,713		2,517		5.99	%
Net loans		539,361		13,183		4.93	%		604,960		17,119		5.71	%

Total interest-earning assets		893,447		17,728		4.00	%		899,741		22,799		5.11	%

Average non-interest earning assets		97,321							190,943

Total average assets	$	990,768						$	1,090,684


Average Interest-Bearing Liabilities

Interest-bearing demand deposits	$	345,585	$	545		0.32	%	$	382,769	$	1,176		0.62	%
Savings deposits		88,297		24		0.05	%		81,035		29		0.07	%
Time deposits		301,081		1,346		0.90	%		351,130		2,167		1.24	%
Interest-bearing demand notes issued to the U.S.
Treasury		-		-		0.00	%		1,075		-		0.00	%
Federal funds purchased and customer repurchase
agreements		54,203		171		0.64	%		37,506		120		0.65	%
Advances from Federal Home Loan Bank		4,093		8		0.39	%		6,746		32		0.96	%
Trust preferred securities		25,000		262		2.11	%		25,000		232		1.87	%

Total interest-bearing liabilities		818,259		2,356		0.58	%		885,261		3,756		0.86	%

Net yield on average interest-earning assets			$	15,372		3.47	%			$	19,043		4.27	%

Average non-interest-bearing liabilities		166,698							147,665

Average stockholders' equity		5,811							57,758

Total average liabilities and stockholders' equity	$	990,768						$	1,090,684

The following table reconciles tax-equivalent net interest income (as shown above) to net interest income as reported on the Condensed Consolidated Statements of Income.

	For the Six Months Ended
	June 30,
	2012		2011
Net interest income as stated	$	17,135	$	18,113
Tax equivalent adjustment-investments		530		856
Tax equivalent adjustment-loans		63		74

Tax equivalent net interest income	$	17,728	$	19,043

Schedule 8

Controls and Procedures

(a)

Disclosure controls and procedures. Management evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2012. The Corporation’s disclosure controls and procedures are the controls, along with other procedures that are designed to ensure that it will record, process, summarize and report in a timely manner the information it must disclose in reports that it files with or submits to the SEC. Thomas D. Ogaard, President and Chief Executive Officer, along with other senior management reviewed and participated in this evaluation. Based on this evaluation, management concluded that, as of the date of the evaluation, disclosure controls were effective.

(b)	Internal controls. Aside from the changes implemented by management as noted below, there have been no significant changes in our internal accounting controls or in other factors during the quarter ended June 30, 2012.

As discussed in Exhibit 99.1 contained in the Corporation’s December 31, 2011 10-K filed on April 12, 2012, BKD, LLP, the Corporation’s external public accounting firm, identified a control deficiency that was determined to be a material weakness during the audit of the Corporation’s financial statements as of December 31, 2011. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. The material weaknesses noted was not having sufficient documentation to support the qualitative factors related to the allowance for loan loss calculation and inadequate controls related to the timely communication of in-process appraisals requiring additional specific reserve as of December 31, 2011. Management considers the material weakness related to the inadequate controls related to the timely communication of in process appraisals to be remediated as of June 30, 2012. However, management does not consider the material weakness related to not having sufficient documentation to support the qualitative factors related to the allowance for loan losses as remediated as of June 30, 2012. Management continues to be developing information to support its qualitative factors for changes in appraisals related to changes in collateral market values. However, management continues to take remediation actions to address this internal control matter and is still working on the remediation to cure by September 30, 2012. A more complete discussion of management’s actions are detailed below.

Management has evaluated the procedures for supporting the qualitative factors related to the allowance for loan loss calculation and timely communication of in-process appraisals. The following processes have been implemented to specifically mitigate the control weakness identified:

To ensure proper financial reporting, the Corporation utilizes a migration analysis to support the qualitative factor adjustments. A review of the June 30, 2012 allowance for loan losses calculation was performed including a thorough review of the migration analysis, qualitative factors, and all appraisals on impaired loans received subsequent to June 30, 2012. Management determined the appropriate allowance for loan losses amount necessary based on generally accepted accounting principles which resulted in the balance of the allowance for loan losses as of June 30, 2012. Management has not specifically correlated its qualitative factors for the changes in appraisals due to changes in market conditions. Management continues to obtain subsequent appraisal information to support its qualitative factors and will enhance its documentation by September 30, 2012.

The evaluation of the allowance for loan losses continues to be subject to enhanced consideration of the loan migration analysis, thereby providing a more objective level of information in support of the qualitative factors used in calculating the allowance for loan losses. The Allowance Review Committee, meets on a quarterly basis, or more often if deemed necessary, to determine the adequacy of the allowance for loan losses calculation. As of June 30, 2012, the Allowance Review Committee included as members the Chief Executive Officer, Chief Credit Officer, EVP & Senior Commercial Banking Manager, SVP Retail Banking and VP & Credit Risk Analytics.

The credit administration department implemented a more robust tracking system of the entire appraisal services process as part of the Corporation’s “real estate, asset valuation standards, and procedures” that includes standards and procedures surrounding the timing of such. The appraisal services tracking system identifies the date appraisals were ordered within credit administration’s the loan services group through tracking the appraisal technical review process within the credit analysis group. Each group maintains an independent tracking system on these two key components so that the deliverables associated with the Bank’s real estate, asset valuation standards and procedures are met, along with ensuring the accurate and timely reporting of valuations as they impact its financial reporting. Management has also enhanced and documented the timing requirement of both the appraisal ordering and their review process to ensure the information is received timely for accurate reporting related to the quarterly financial statement preparation process.

Management identified a significant internal control weakness related to inadequate accounting department staffing during the quarter ended June 30, 2012. Elevated levels of employee turnover left the department without the expertise necessary to perform the all of the job functions assigned to them during the quarter. This change in the internal controls presents a reasonable possibility that the Company’s controls may fail to prevent, or detect and correct a misstatement of an account balance or disclosure.

This internal control weakness was mitigated by the following management initiatives:

Having the Company’s former Chief Operating Officer assumed the responsibilities of the Chief Financial Officer during substantially the entire quarter.

Having the internal audit perform an audit of the accounting functions with the primary objective of evaluating the process and significant control points for effectiveness, adequacy and efficiency of operations. Deficiencies identified as a result of the audit have been assessed by management and remediation measures are being taken.

Contracting with independent contractors with experience in financial accounting and reporting in June to prepare regulatory and SEC reports.

Management continues to focus on staff development and supervision through the use of independent contractors as the Company continues its search for a permanent accounting management team.

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