Edgar Filing: HORIZON BANCORP /IN/

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Form 10-Q

HORIZON BANCORP

FORM 10-Q

United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2014

Commission file number 0-10792

HORIZON BANCORP

(Exact name of registrant as specified in its charter)

Indiana

35-1562417

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)


515 Franklin Square, Michigan City, Indiana		46360
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (219) 879-0211

Former name, former address and former fiscal year, if changed since last report: N/A

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 x 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 x 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):

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 9,210,786 shares of Common Stock, no par value, at November 7, 2014.

HORIZON BANCORP

FORM 10-Q

INDEX


PART I. FINANCIAL INFORMATION		3

Item 1.	Financial Statements (Unaudited)	3

	Condensed Consolidated Balance Sheets	3

	Condensed Consolidated Statements of Income	4

	Condensed Consolidated Statements of Comprehensive Income (Loss)	5

	Condensed Consolidated Statement of Stockholders’ Equity	6

	Condensed Consolidated Statements of Cash Flows	7

	Notes to Condensed Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	37

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	53

Item 4.	Controls and Procedures	53

PART II. OTHER INFORMATION		54

Item 1.	Legal Proceedings	54

Item 1A.	Risk Factors	54

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	54

Item 3.	Defaults Upon Senior Securities	54

Item 4.	Mine Safety Disclosures	54

Item 5.	Other Information	54

Item 6.	Exhibits	55

Signatures		56

Index To Exhibits		57

PART 1 — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

HORIZON BANCORP AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(Dollar Amounts in Thousands)


	September 30 2014		December 31 2013
	(Unaudited)
Assets
Cash and due from banks	$	37,318	$	31,721
Investment securities, available for sale		323,492		508,591
Investment securities, held to maturity (fair value of $175,838 and $9,910)		172,449		9,910
Loans held for sale		4,167		3,281
Loans, net of allowance for loan losses of $16,160 and $15,992		1,326,861		1,052,836
Premises and equipment, net		50,945		46,194
Federal Reserve and Federal Home Loan Bank stock		16,912		14,184
Goodwill		28,034		19,748
Other intangible assets		4,193		3,288
Interest receivable		8,411		7,501
Cash value life insurance		39,120		36,190
Other assets		25,143		24,832

Total assets	$	2,037,045	$	1,758,276

Liabilities
Deposits
Non-interest bearing	$	278,527	$	231,096
Interest bearing		1,171,136		1,060,424

Total deposits		1,449,663		1,291,520
Borrowings		350,113		256,296
Subordinated debentures		32,603		32,486
Interest payable		477		506
Other liabilities		14,409		12,948

Total liabilities		1,847,265		1,593,756

Commitments and contingent liabilities
Stockholders’ Equity
Preferred stock, Authorized, 1,000,000 shares Series B shares $.01 par value, $1,000 liquidation value Issued 12,500 shares		12,500		12,500
Common stock, no par value Authorized, 22,500,000 shares Issued, 9,280,041 and 8,706,971 shares Outstanding, 9,210,786 and 8,630,966 shares		—		—
Additional paid-in capital		45,729		32,496
Retained earnings		130,864		121,253
Accumulated other comprehensive income (loss)		687		(1,729	)

Total stockholders’ equity		189,780		164,520

Total liabilities and stockholders’ equity	$	2,037,045	$	1,758,276

See notes to condensed consolidated financial statements

HORIZON BANCORP AND SUBSIDIARIES

Condensed Consolidated Statements of Income

(Dollar Amounts in Thousands, Except Per Share Data)


	Three Months Ended September 30						Nine Months Ended September 30
	2014			2013			2014			2013
	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)
Interest Income
Loans receivable	$	16,403		$	14,843		$	45,988		$	48,189
Investment securities
Taxable		2,339			2,084			7,124			6,153
Tax exempt		1,109			1,114			3,328			3,105

Total interest income		19,851			18,041			56,440			57,447

Interest Expense
Deposits		1,352			1,395			3,984			4,320
Borrowed funds		1,593			1,465			4,493			4,369
Subordinated debentures		506			512			1,503			1,504

Total interest expense		3,451			3,372			9,980			10,193

Net Interest Income		16,400			14,669			46,460			47,254
Provision for loan losses		1,741			104			2,080			2,917

Net Interest Income after Provision for Loan Losses		14,659			14,565			44,380			44,337

Non-interest Income
Service charges on deposit accounts		1,076			1,083			3,037			2,984
Wire transfer fees		151			169			408			562
Interchange fees		1,223			1,123			3,436			3,049
Fiduciary activities		1,131			953			3,378			3,140
Gain on sale of investment securities (includes $988 for the three and nine months ended September 30, 2014 and $6 for the three months ended and $374 for the nine months ended September 30, 2013, related to accumulated other comprehensive earnings reclassifications)		988			6			988			374
Gain on sale of mortgage loans		2,153			1,667			6,101			7,580
Mortgage servicing income net of impairment		116			348			556			813
Increase in cash value of bank owned life insurance		296			278			781			787
Other income		256			283			854			930

Total non-interest income		7,390			5,910			19,539			20,219

Non-interest Expense
Salaries and employee benefits		8,215			7,694			23,991			22,919
Net occupancy expenses		1,404			1,172			4,188			3,778
Data processing		907			766			2,714			2,184
Professional fees		358			357			1,385			1,310
Outside services and consultants		595			436			2,554			1,634
Loan expense		1,202			1,040			3,489			3,556
FDIC insurance expense		313			270			854			821
Other losses		(35	)		55			98			146
Other expense		2,394			2,271			7,002			6,487

Total non-interest expense		15,353			14,061			46,275			42,835

Income Before Income Tax		6,696			6,414			17,644			21,721
Income tax expense (includes $346 for the three and nine months ended September 30, 2014 and $2 for the three months ended and $131 for the nine months ended September 30, 2013 related to income tax expense from reclassification items)		1,738			1,629			4,491			5,960

Net Income		4,958			4,785			13,153			15,761
Preferred stock dividend and discount accretion		(40	)		(66	)		(102	)		(308	)

Net Income Available to Common Shareholders	$	4,918		$	4,719		$	13,051		$	15,453

Basic Earnings Per Share	$	0.53		$	0.55		$	1.45		$	1.79
Diluted Earnings Per Share		0.51			0.52			1.39			1.72

See notes to condensed consolidated financial statements

HORIZON BANCORP AND SUBSIDIARIES

Condensed Consolidated Statements of Comprehensive Income

(Dollar Amounts in Thousands)


	Three Months Ended September 30						Nine Months Ended September 30
	2014			2013			2014			2013
	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)

Net Income	$	4,958		$	4,785		$	13,153		$	15,761

Other Comprehensive Income
Change in fair value of derivative instruments:
Change in fair value of derivative instruments for the period		373			38			(169	)		2,058
Income tax effect		(131	)		(13	)		59			(720	)

Changes from derivative instruments		242			25			(110	)		1,338

Change in securities available-for-sale:
Unrealized appreciation (depreciation) for the period on available-for-sale securities		(6,039	)		(959	)		723			(15,566	)
Unrealized appreciation for the period on held-to-maturity ₍₁₎		2,283			—			2,175			—
Reclassification adjustment for securities gains realized in income		988			6			988			374
Income tax effect		969			334			(1,360	)		5,318

Unrealized gains (losses) on available-for-sale securities		(1,799	)		(619	)		2,526			(9,874	)

Other Comprehensive Income (Loss), Net of Tax		(1,557	)		(594	)		2,416			(8,536	)

Comprehensive Income	$	3,401		$	4,191		$	15,569		$	7,225

₍₁₎ -

The amortization of the unrealized holding gains in accumulated other comprehensive income at the date of the transfer partially offsets the accretion of the difference between the par value and the fair value of the investment securities at the date of the transfer.

See notes to condensed consolidated financial statements

HORIZON BANCORP AND SUBSIDIARIES

Condensed Consolidated Statement of Stockholders’ Equity

(Unaudited)

(Dollar Amounts in Thousands, Except Per Share Data)


	Preferred Stock		Additional Paid-in Capital		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total
Balances, January 1, 2014	$	12,500	$	32,496	$	121,253		$	(1,729	)	$	164,520
Net income						13,153						13,153
Other comprehensive income, net of tax									2,416			2,416

Amortization of unearned compensation				271								271
Exercise of stock options				128								128
Stock option expense				145								145
Stock issued from acquisition				12,689								12,689
Cash dividends on preferred stock (1.00%)						(102	)					(102	)
Cash dividends on common stock ($.37 per share)						(3,440	)					(3,440	)

Balances, September 30, 2014	$	12,500	$	45,729	$	130,864		$	687		$	189,780

See notes to condensed consolidated financial statements

HORIZON BANCORP AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(Dollar Amounts in Thousands)


	Nine Months Ended September 30
	2014			2013
	(Unaudited)			(Unaudited)
Operating Activities
Net income	$	13,153		$	15,761
Items not requiring (providing) cash
Provision for loan losses		2,080			2,917
Depreciation and amortization		2,806			2,522
Share based compensation		145			31
Mortgage servicing rights recovery		(28	)		(208	)
Premium amortization on securities available for sale, net		1,733			2,221
Gain on sale of investment securities		(988	)		(374	)
Gain on sale of mortgage loans		(6,101	)		(7,580	)
Proceeds from sales of loans		169,858			306,505
Loans originated for sale		(164,643	)		(289,775	)
Change in cash value of life insurance		(745	)		(753	)
Gain on sale of other real estate owned		(176	)		(270	)
Net change in
Interest receivable		(563	)		210
Interest payable		(50	)		(72	)
Other assets		2,251			8,493
Other liabilities		327			326

Net cash provided by operating activities		19,059			39,954

Investing Activities
Purchases of securities available for sale		(77,164	)		(152,275	)
Proceeds from sales, maturities, calls, and principal repayments of securities available for sale		99,805			103,893
Purchase of securities held to maturity		(4,839	)		(9,910	)
Proceeds from maturities of securities held to maturity		7,900			—
Purchase of Federal Reserve Bank stock		(592	)		(851	)
Net change in loans		(154,677	)		101,796
Proceeds on the sale of OREO and repossessed assets		2,378			2,138
Purchases of premises and equipment		(4,086	)		(3,033	)
Acquisition of SCB		7,894			—
Purchase of Mortgage Company		(735	)		—

Net cash provided by (used in) by investing activities		(124,116	)		41,758

Financing Activities
Net change in
Deposits		37,124			34,167
Borrowings		76,944			(103,142	)
Proceeds from issuance of stock		128			34
Dividends paid on common shares		(3,440	)		(2,698	)
Dividends paid on preferred shares		(102	)		(308	)

Net cash provided by (used in) financing activities		110,654			(71,947	)

Net Change in Cash and Cash Equivalents		5,597			9,765
Cash and Cash Equivalents, Beginning of Period		31,721			30,735

Cash and Cash Equivalents, End of Period	$	37,318		$	40,500

Additional Supplemental Information
Interest paid	$	10,009		$	10,265
Income taxes paid		1,600			3,100
Transfer of loans to other real estate owned		3,078			2,528
Transfer of available-for-sale securities to held-to-maturity		167,047			—
The Company purchased all of the capital stock of Summit for $18,896. In conjunction with the acquisition, liabilities were assumed as follows:
Fair value of assets acquired		158,585			—
Cash paid to retire Summit debt		6,207			—
Cash paid for the capital stock		1,029			—
Liabilities assumed		138,660			—

See notes to condensed consolidated financial statements

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Note 1 - Accounting Policies

The accompanying unaudited condensed consolidated financial statements include the accounts of Horizon Bancorp (“Horizon” or the “Company”) and its wholly-owned subsidiaries, including Horizon Bank, N.A. (“Bank”). All inter-company balances and transactions have been eliminated. The results of operations for the periods ended September 30, 2014 are not necessarily indicative of the operating results for the full year of 2014. The accompanying unaudited condensed consolidated financial statements reflect all adjustments that are, in the opinion of Horizon’s management, necessary to fairly present the financial position, results of operations and cash flows of Horizon for the periods presented. Those adjustments consist only of normal recurring adjustments.

Certain information and note disclosures normally included in Horizon’s annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in Horizon’s Annual Report on Form 10-K for 2013 filed with the Securities and Exchange Commission on February 28, 2014. The condensed consolidated balance sheet of Horizon as of December 31, 2013 has been derived from the audited balance sheet as of that date.

Basic earnings per share is computed by dividing net income available to common shareholders (net income less dividend requirements for preferred stock and accretion of preferred stock discount) by the weighted-average number of common shares outstanding. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The following table shows computation of basic and diluted earnings per share.


	Three Months Ended September 30				Nine Months Ended September 30
	2014		2013		2014		2013
	(Unaudited)		(Unaudited)		(Unaudited)		(Unaudited)
Basic earnings per share
Net income	$	4,958	$	4,785	$	13,153	$	15,761
Less: Preferred stock dividends and accretion of discount		40		66		102		308

Net income available to common shareholders	$	4,918	$	4,719	$	13,051	$	15,453

Weighted average common shares outstanding		9,208,707		8,618,969		9,009,663		8,617,972

Basic earnings per share	$	0.53	$	0.55	$	1.45	$	1.79


Diluted earnings per share
Net income available to common shareholders	$	4,918	$	4,719	$	13,051	$	15,453

Weighted average common shares outstanding		9,208,707		8,618,969		9,009,663		8,617,972
Effect of dilutive securities:
Warrants		309,790		314,353		308,647		299,704
Restricted stock		36,387		40,833		37,127		39,883
Stock options		33,448		45,056		33,922		41,069

Weighted average shares outstanding		9,588,332		9,019,211		9,389,359		8,998,628

Diluted earnings per share	$	0.51	$	0.52	$	1.39	$	1.72

At September 30, 2014 and 2013, there were 46,766 and no shares, respectively, which were not included in the computation of diluted earnings per share because they were non-dilutive.

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Horizon has share-based employee compensation plans, which are described in the notes to the financial statements included in the December 31, 2013 Annual Report on Form 10-K.

Reclassifications

Certain reclassifications have been made to the 2013 condensed consolidated financial statements to be comparable to 2014. These reclassifications had no effect on net income.

Note 2 – Acquisition

On April 3, 2014 Horizon closed its acquisition of SCB Bancorp, Inc. (“Summit”) and Horizon Bank N.A.’s acquisition of Summit Community Bank, through mergers effective as of that date. Under the final terms of the acquisition, the exchange ratio was 0.4904 shares of Horizon’s common stock and $5.15 in cash for each share of Summit common stock outstanding. Summit shares outstanding at the closing were 1,164,442, and the shares of Horizon common stock issued to Summit shareholders totaled 570,820. Horizon’s stock price was $22.23 per share at the close of business on April 3, 2014. Based upon these numbers, the total value of the consideration for the acquisition was $18.9 million (not including the retirement of Summit debt). For the nine months ended September 30, 2014, the Company had approximately $1.3 million in costs related to the acquisition. These expenses are classified in the other expense section of the income statement and primarily located in the salaries and employee benefits, professional services and other expense line items. As a result of the acquisition, the Company will have an opportunity to increase its deposit base and reduce transaction costs. The Company also expects to reduce cost through economies of scale.

Under the purchase method of accounting, the total estimated purchase price is allocated to Summit’s net tangible and intangible assets based on their current estimated fair values on the date of the acquisition. Based on management’s preliminary valuation of the fair value of tangible and intangible assets acquired and liabilities assumed, which are based on estimates and assumptions that are subject to change, the preliminary purchase price for the Summit acquisition is allocated as follows:


ASSETS
Cash and due from banks	$	15,161

Commercial		70,441
Residential mortgage		43,448
Consumer		10,192

Total loans		124,081

Premises and equipment, net		2,548
FRB and FHLB stock		2,136
Goodwill		8,286
Core deposit intangible		822
Interest receivable		347
Cash value life insurance		2,185
Other assets		3,019

Total assets purchased	$	158,585


Common shares issued	$	12,689
Cash paid		6,207
Retirement of Holding Company Debt		1,029

Total estimated purchase price	$	19,925


LIABILITIES
Deposits
Non-interest bearing	$	27,274
NOW accounts		16,332
Savings and money market		35,045
Certificates of deposits		42,368

Total deposits		121,019

Borrowings		16,990
Interest payable		52
Other liabilities		599

Total liabilities assumed	$	138,660

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Of the total estimated purchase price of $19.9 million, $822,000 has been allocated to core deposit intangible. Additionally, $8.3 million has been allocated to goodwill and $4.4 million of the purchase price is deductible and was assigned to the business assets. The core deposit intangible will be amortized over seven years on a straight line basis.

The Company acquired loans in the acquisition and the transferred loans had evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected.

Loans purchased with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered to be credit impaired. Evidence of credit quality deterioration as of the purchase date may include information such as past-due and non-accrual status, borrower credit scores and recent loan-to-value percentages. Purchased credit-impaired loans are accounted for under the accounting guidance for loans and debt securities acquired with deteriorated credit quality (ASC 310-30) and initially measured at fair value, which includes estimated future credit losses expected to be incurred over the life of the loan. Accordingly, an allowance for credit losses related to these loans is not carried over and recorded at the acquisition date. Management estimated the cash flows expected to be collected at acquisition using our internal risk models, which incorporate the estimate of current key assumptions, such as default rates, severity and prepayment speeds.

The Company acquired the $130.5 million loan portfolio at a fair value discount of $6.4 million. The performing portion of the portfolio, $106.2 million, had an estimated fair value of $104.6 million. The excess of expected cash flows above the fair value of the performing portion of loans will be accreted to interest income over the remaining lives of the loans in accordance with ASC 310-20.

Final estimates of certain loans, those for which specific credit-related deterioration, since origination, are recorded at fair value, reflecting the present value of the amounts expected to be collected. Income recognition of these loans is based on reasonable expectation about the timing and amount of cash flows to be collected.

The following table details the acquired loans that are accounted for in accordance with ASC 310-30 as of April 3, 2014.


Contractually required principal and interest at acquisition	$	14,460
Contractual cash flows not expected to be collected (nonaccretable differences)		3,146

Expected cash flows at acquisition		11,314
Interest component of expected cash flows (accretable discount)		1,688

Fair value of acquired loans accounted for under ASC 310-30	$	9,626

Pro-forma statements were not presented due to the materiality of the transaction.

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Note 3 – Securities

The fair value of securities is as follows:


September 30, 2014	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
Available for sale
U.S. Treasury and federal agencies	$	27,093	$	67	$	(335	)	$	26,825
State and municipal		47,006		1,641		(52	)		48,595
Federal agency collateralized mortgage obligations		123,916		970		(1,758	)		123,128
Federal agency mortgage-backed pools		122,393		2,678		(962	)		124,109
Private labeled mortgage-backed pools		763		23		—			786
Corporate notes		32		17		—			49

Total available for sale investment securities	$	321,203	$	5,396	$	(3,107	)	$	323,492


Held to maturity
U.S. Treasury and federal agencies	$	9,783	$	49	$	(4	)	$	9,828
State and municipal		135,839		2,958		(22	)		138,775
Federal agency collateralized mortgage obligations		4,193		9		—			4,202
Federal agency mortgage-backed pools		22,634		399		—			23,033

Total held to maturity investment securities	$	172,449	$	3,415	$	(26	)	$	175,838


December 31, 2013	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
Available for sale
U.S. Treasury and federal agencies	$	43,808	$	133	$	(807	)	$	43,134
State and municipal		176,670		4,405		(3,177	)		177,898
Federal agency collateralized mortgage obligations		116,047		1,242		(2,583	)		114,706
Federal agency mortgage-backed pools		170,006		3,172		(2,284	)		170,894
Private labeled mortgage-backed pools		1,188		38		—			1,226
Corporate notes		708		25		—			733

Total available for sale investment securities	$	508,427	$	9,015	$	(8,851	)	$	508,591

Held to maturity, State and Municipal	$	9,910	$	—	$	—		$	9,910

Based on evaluation of available evidence, including recent changes in market interest rates, credit rating information, and information obtained from regulatory filings, management believes the declines in fair value for these securities are temporary. While these securities are held in the available for sale portfolio and held-to-maturity, Horizon intends, and has the ability, to hold them until the earlier of a recovery in fair value or maturity.

Should the impairment of any of these securities become other than temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income in the period the other-than-temporary impairment is identified. At September 30, 2014, no individual investment security had an unrealized loss that was determined to be other-than-temporary.

The unrealized losses on the Company’s investments in securities of state and municipal governmental agencies, U.S. Treasury and federal agencies, federal agency collateralized mortgage obligations, and federal agency mortgage-backed pools were caused by interest rate volatility and not a decline in credit quality. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. The Company expects to recover the amortized cost basis over the term of the securities. Because the Company does not intend to sell the investments and it is not likely that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be at maturity, the Company did not consider those investments to be other-than-temporarily impaired at September 30, 2014.

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

The Company elected to transfer 319 available-for-sale (“AFS”) securities with an aggregate fair value of $167.1 million to a classification of held-to-maturity (“HTM”) on April 1, 2014. In accordance with FASB ASC 320-10-55-24, the transfer from AFS to HTM must be recorded at the fair value of the AFS securities at the time of transfer. The net unrealized holding gain of $1.3 million, net of tax, at the date of transfer was retained in accumulated other comprehensive income (loss), with the associated pre-tax amount retained in the carrying value of the HTM securities. Such amounts will be amortized to comprehensive income over the remaining life of the securities. The fair value of the transferred AFS securities became the book value of the HTM securities at April 1, 2014, with no unrealized gain or loss at this date. Future reporting periods, with potential changes in market value for these securities, would likely record an unrealized gain or loss for disclosure purposes.

The amortized cost and fair value of securities available for sale and held to maturity at September 30, 2014 and December 31, 2013, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.


	September 30, 2014				December 31, 2013
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Available for sale
Within one year	$	4,623	$	4,670	$	3,643	$	3,663
One to five years		45,741		46,156		49,198		49,627
Five to ten years		17,166		17,888		106,225		107,424
After ten years		6,601		6,755		62,120		61,051

		74,131		75,469		221,186		221,765
Federal agency collateralized mortgage obligations		123,916		123,128		116,047		114,706
Federal agency mortgage-backed pools		122,393		124,109		170,006		170,894
Private labeled mortgage-backed pools		763		786		1,188		1,226

Total available for sale investment securities	$	321,203	$	323,492	$	508,427	$	508,591


Held to maturity
Within one year	$	5,951	$	6,136	$	9,910	$	9,910
One to five years		381		382		—		—
Five to ten years		93,628		95,216		—		—
After ten years		45,662		46,869		—		—

		145,622		148,603		9,910		9,910
Federal agency collateralized mortgage obligations		4,193		4,202		—		—
Federal agency mortgage-backed pools		22,634		23,033		—		—

Total held to maturity investment securities	$	172,449	$	175,838	$	9,910	$	9,910

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

The following table shows the gross unrealized losses and the fair value of the Company’s investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.


	Less than 12 Months					12 Months or More					Total
September 30, 2014	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses

U.S. Treasury and federal agencies	$	3,956	$	(4	)	$	23,648	$	(335	)	$	27,604	$	(339	)
State and municipal		6,200		(35	)		2,674		(39	)		8,874		(74	)
Federal agency collateralized mortgage obligations		37,987		(318	)		40,882		(1,440	)		78,869		(1,758	)
Federal agency mortgage-backed pools		7,945		(26	)		33,870		(936	)		41,815		(962	)

Total temporarily impaired securities	$	56,088	$	(383	)	$	101,074	$	(2,750	)	$	157,162	$	(3,133	)


	Less than 12 Months					12 Months or More					Total
December 31, 2013	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses

U.S. Treasury and federal agencies	$	32,099	$	(807	)	$	—	$	—		$	32,099	$	(807	)
State and municipal		57,078		(2,993	)		3,206		(184	)		60,284		(3,177	)
Federal agency collateralized mortgage obligations		64,445		(2,121	)		8,601		(462	)		73,046		(2,583	)
Federal agency mortgage-backed pools		87,919		(2,284	)		—		—			87,919		(2,284	)

Total temporarily impaired securities	$	241,541	$	(8,205	)	$	11,807	$	(646	)	$	253,348	$	(8,851	)


	Three Months Ended September 30					Nine Months Ended September 30
	2014			2013		2014			2013
Sales of securities available for sale (Unaudited)
Proceeds	$	45,228		$	648	$	45,228		$	23,853
Gross gains		1,001			6		1,001			382
Gross losses		(13	)		—		(13	)		(8	)

Note 4 – Loans


	September 30 2014			December 31 2013
Commercial
Working capital and equipment	$	292,265		$	241,569
Real estate, including agriculture		354,132			245,313
Tax exempt		8,899			2,898
Other		22,053			15,409

Total		677,349			505,189

Real estate
1–4 family		247,196			181,393
Other		4,543			4,565

Total		251,739			185,958

Consumer
Auto		150,795			139,915
Recreation		5,676			4,839
Real estate/home improvement		35,240			30,729
Home equity		108,608			96,924
Unsecured		3,910			3,825
Other		4,571			3,293

Total		308,800			279,525

Mortgage warehouse		105,133			98,156

Total loans		1,343,021			1,068,828
Allowance for loan losses		(16,160	)		(15,992	)

Loans, net	$	1,326,861		$	1,052,836

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Commercial

Commercial loans are primarily based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected, and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves larger loan principal amounts and the repayment of these loans is generally dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s commercial real estate portfolio are diverse in terms of property type, and are monitored for concentrations of credit. The Company monitors and evaluates commercial real estate loans based on collateral, cash flow and risk grade criteria. As a general rule, the Company avoids financing single purpose projects unless other underwriting factors are present to help mitigate risk. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans.

Real Estate and Consumer

With respect to residential loans that are secured by 1-4 family residences and are generally owner occupied, the Company generally establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded. Home equity loans are typically secured by a subordinate interest in 1-4 family residences, and consumer loans are secured by consumer assets such as automobiles or recreational vehicles. Some consumer loans are unsecured such as small installment loans and certain lines of credit. Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas such as unemployment levels. Repayment can also be impacted by changes in property values on residential properties. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

Mortgage Warehousing

Horizon’s mortgage warehouse lending has specific mortgage companies as customers of Horizon Bank. Individual mortgage loans originated by these mortgage companies are funded as a secured borrowing with a pledge of collateral under Horizon’s agreement with the mortgage company. Each individual mortgage is assigned to Horizon until the loan is sold to the secondary market by the mortgage company. In addition, Horizon takes possession of each original note and forwards such note to the end investor once the mortgage company has sold the loan. At the time a loan is transferred to the secondary market, the mortgage company repurchases the loan under its option within the agreement. Due to the repurchase feature contained in the agreement, the transaction does not qualify as a sale and therefore is accounted for as a secured borrowing with a pledge of collateral pursuant to the agreement with the mortgage company. When the individual loan is sold to the end investor by the mortgage company, the proceeds from the sale of the loan are received by Horizon and used to pay off the loan balance with Horizon along with any accrued interest and any related fees. The remaining balance from the sale is forwarded to the mortgage company. These individual loans typically are sold by the mortgage company within 30 days and are seldom held more than 90 days. Interest income is accrued during this period and collected at the time each loan is sold. Fee income for each loan sold is collected when the loan is sold, and no costs are deferred due to the term between each loan funding and related payoff, which is typically less than 30 days.

Based on the agreements with each mortgage company, at any time a mortgage company can repurchase from Horizon their outstanding loan balance on an individual mortgage and regain possession of the original note. Horizon also has the option to request that the mortgage company repurchase an individual mortgage.

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Should this occur, Horizon would return the original note and reassign the assignment of the mortgage to the mortgage company. Also, in the event that the end investor would not be able to honor the purchase commitment and the mortgage company would not be able to repurchase its loan on an individual mortgage, Horizon would be able to exercise its rights under the agreement.

The following table shows the recorded investment of individual loan categories.


September 30, 2014	Loan Balance			Interest Due		Deferred Fees / (Costs)			Recorded Investment
Owner occupied real estate	$	233,069		$	390	$	678		$	234,137
Non owner occupied real estate		298,408			352		545			299,305
Residential spec homes		1,289			2		—			1,291
Development & spec land loans		12,574			20		37			12,631
Commercial and industrial		130,682			842		67			131,591

Total commercial		676,022			1,606		1,327			678,955

Residential mortgage		239,989			1,048		628			241,665
Residential construction		11,122			20		—			11,142
Mortgage warehouse		105,133			480		—			105,613

Total real estate		356,244			1,548		628			358,420

Direct installment		36,720			111		(380	)		36,451
Direct installment purchased		236			—		—			236
Indirect installment		139,138			298		—			139,436
Home equity		133,190			565		(104	)		133,651

Total consumer		309,284			974		(484	)		309,774

Total loans		1,341,550			4,128		1,471			1,347,149
Allowance for loan losses		(16,160	)		—		—			(16,160	)

Net loans	$	1,325,390		$	4,128	$	1,471		$	1,330,989


December 31, 2013	Loan Balance			Interest Due		Deferred Fees / (Costs)			Recorded Investment
Owner occupied real estate	$	156,262		$	257	$	207		$	156,726
Non owner occupied real estate		224,713			105		299			225,117
Residential spec homes		400			—		—			400
Development & spec land loans		21,289			62		42			21,393
Commercial and industrial		101,920			737		57			102,714

Total commercial		504,584			1,161		605			506,350

Residential mortgage		176,068			578		382			177,028
Residential construction		9,508			14		—			9,522
Mortgage warehouse		98,156			480		—			98,636

Total real estate		283,732			1,072		382			285,186

Direct installment		29,983			104		(281	)		29,806
Direct installment purchased		294			—		—			294
Indirect installment		131,384			320		—			131,704
Home equity		117,958			529		187			118,674

Total consumer		279,619			953		(94	)		280,478

Total loans		1,067,935			3,186		893			1,072,014
Allowance for loan losses		(15,992	)		—		—			(15,992	)

Net loans	$	1,051,943		$	3,186	$	893		$	1,056,022

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Note 5 – Accounting for Certain Loans Acquired in a Transfer

The Company acquired loans in acquisitions and the transferred loans had evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected.

The carrying amounts of those loans included in the balance sheet amounts of loans receivable are as follows:


	September 30 2014 Heartland		September 30 2014 Summit		September 30 2014 Total
Commercial		18,527		67,646	$	86,173
Real estate		10,055		24,747		34,802
Consumer		8,287		9,106		17,393

Outstanding balance	$	36,869	$	101,499	$	138,368

Carrying amount, net of allowance of $205					$	138,163


	December 31 2013 Heartland		December 31 2013 Summit		December 31 2013 Total
Commercial	$	37,048	$	—	$	37,048
Real estate		11,761		—		11,761
Consumer		11,485		—		11,485

Outstanding balance	$	60,294	$	—	$	60,294

Carrying amount, net of allowance of $389					$	59,905

Accretable yield, or income expected to be collected for the nine months ended September 30, is as follows:


	Nine Months Ended September 30, 2014
	Heartland			Summit			Total
Balance at January 1	$	3,185		$	—		$	3,185
Additions		—			1,688			1,688
Accretion		(425	)		(222	)		(647	)
Reclassification from nonaccreatable difference		—			—			—
Disposals		(210	)		(46	)		(256	)

Balance at September 30	$	2,550		$	1,420		$	3,970


	Nine Months Ended September 30, 2013
	Heartland			Summit		Total
Balance at January 1	$	6,111		$	—	$	6,111
Additions		—			—		—
Accretion		(1,016	)		—		(1,016	)
Reclassification from nonaccreatable difference		—			—		—
Disposals		(1,629	)		—		(1,629	)

Balance at September 30	$	3,466		$	—	$	3,466

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

During the three and nine months ended September 30, 2014, the Company increased the allowance for loan losses by a charge to the income statement of $0 and $253,000, respectively, and for the three and nine months ended September 30, 2013, $100,000 and $1.5 million, respectively. $134,000 of allowances for loan losses were reversed for the three and nine months ended September 30, 2014 and $0 of allowance for loan losses were reversed for the three and nine months ended September 30, 2013.

Note 6 – Allowance for Loan Losses

The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the prior one to five years. Management believes the five-year historical loss experience methodology is appropriate in the current economic environment, as it captures loss rates that are comparable to the current period being analyzed. The actual allowance for loan loss activity is provided below.


	Three Months Ended						Nine Months Ended
	September 30						September 30
	2014			2013			2014			2013
	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)
Balance at beginning of the period	$	15,660		$	19,565		$	15,992		$	18,270
Loans charged-off:
Commercial
Owner occupied real estate		—			6			—			138
Non owner occupied real estate		—			45			22			191
Residential development		—			—			—			—
Development & Spec Land Loans		—			—			173			—
Commercial and industrial		1,093			774			1,220			913

Total commercial		1,093			825			1,415			1,242
Real estate
Residential mortgage		31			416			225			559
Residential construction		—			—			—			—
Mortgage warehouse		—			—			—			—

Total real estate		31			416			225			559
Consumer
Direct Installment		74			88			151			195
Direct Installment Purchased		—			—			—			—
Indirect Installment		306			271			874			624
Home Equity		37			201			468			639

Total consumer		417			560			1,493			1,458

Total loans charged-off		1,541			1,801			3,133			3,259

Recoveries of loans previously charged-off:
Commercial
Owner occupied real estate		4			14			10			46
Non owner occupied real estate		10			1			85			3
Residential development		—			—			—			—
Development & Spec Land Loans		55			—			55			—
Commercial and industrial		18			111			435			147

Total commercial		87			126			585			196
Real estate
Residential mortgage		12			5			19			8
Residential construction		—			—			—			—
Mortgage warehouse		—			—			—			—

Total real estate		12			5			19			8
Consumer
Direct Installment		10			54			49			448
Direct Installment Purchased		—			—			—			—
Indirect Installment		165			202			431			372
Home Equity		26			—			137			32

Total consumer		201			256			617			852

Total loan recoveries		300			387			1,221			1,056

Net loans charged-off (recovered)		1,241			1,414			1,912			2,203

Provision charged to operating expense
Commercial		1,563			(940	)		1,682			802
Real estate		697			675			(290	)		986
Consumer		(519	)		994			688			1,025

Total provision charged to operating expense		1,741			729			2,080			2,813

Balance at the end of the period	$	16,160		$	18,880		$	16,160		$	18,880

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Certain loans are individually evaluated for impairment, and the Company’s general practice is to proactively charge down impaired loans to the fair value of the underlying collateral.

Consistent with regulatory guidance, charge-offs on all loan segments are taken when specific loans, or portions thereof, are considered uncollectible. The Company’s policy is to promptly charge these loans off in the period the uncollectible loss is reasonably determined.

For all loan portfolio segments except 1-4 family residential properties and consumer, the Company promptly charges-off loans, or portions thereof, when available information confirms that specific loans are uncollectible based on information that includes, but is not limited to, (1) the deteriorating financial condition of the borrower, (2) declining collateral values, and/or (3) legal action, including bankruptcy, that impairs the borrower’s ability to adequately meet its obligations. For impaired loans that are considered to be solely collateral dependent, a partial charge-off is recorded when a loss has been confirmed by an updated appraisal or other appropriate valuation of the collateral.

The Company charges-off 1-4 family residential and consumer loans, or portions thereof, when the Company reasonably determines the amount of the loss. The Company adheres to timeframes established by applicable regulatory guidance which provides for the charge-down or specific allocation of 1-4 family first and junior lien mortgages to the net realizable value less costs to sell when the value is known but no later than when a loan is 180 days past due. Pursuant to such guidelines, the Company also charges-off unsecured open-end loans when the loan is 90 days past due, and charges down to the net realizable value other secured loans when they are 90 days past due. Loans at these respective delinquency thresholds for which the Company can clearly document that the loan is both well-secured and in the process of collection, such that collection in full will occur regardless of delinquency status, are not charged off.

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment analysis:


September 30, 2014	Commercial		Real Estate		Mortgage Warehousing		Consumer		Total
Allowance For Loan Losses
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	1,175	$	—	$	—	$	—	$	1,175
Collectively evaluated for impairment		5,846		3,304		1,300		4,041		14,491
Loans acquired with deteriorated credit quality		494		—		—		—		494

Total ending allowance balance	$	7,515	$	3,304	$	1,300	$	4,041	$	16,160


Loans:
Individually evaluated for impairment	$	8,497	$	—	$	—	$	—	$	8,497
Collectively evaluated for impairment		669,867		252,807		105,613		309,774		1,338,061
Loans acquired with deteriorated credit quality		591		—		—		—		591

Total ending loans balance	$	678,955	$	252,807	$	105,613	$	309,774	$	1,347,149


December 31, 2013	Commercial		Real Estate		Mortgage Warehousing		Consumer		Total
Allowance For Loan Losses
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	1,312	$	—	$	—	$	—	$	1,312
Collectively evaluated for impairment		4,963		3,462		1,638		4,228		14,291
Loans acquired with deteriorated credit quality		389		—		—		—		389

Total ending allowance balance	$	6,664	$	3,462	$	1,638	$	4,228	$	15,992


Loans:
Individually evaluated for impairment	$	7,448	$	—	$	—	$	—	$	7,448
Collectively evaluated for impairment		489,547		186,526		98,636		279,448		1,054,157
Loans acquired with deteriorated credit quality		9,355		24		—		1,030		10,409

Total ending loans balance	$	506,350	$	186,550	$	98,636	$	280,478	$	1,072,014

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Note 7 – Non-performing Loans and Impaired Loans

The following table presents the non-accrual, loans past due over 90 days still on accrual, and troubled debt restructured (“TDRs”) by class of loans:


September 30, 2014	Non-accrual		Loans Past Due Over 90 Days Still Accruing		Non- Performing TDRs		Performing TDRs		Total Non- Performing Loans
Commercial
Owner occupied real estate	$	2,715	$	—	$	—	$	781	$	3,496
Non owner occupied real estate		2,591		—		—		1,563		4,154
Residential development		—		—		—		—		—
Development & Spec Land Loans		—		—		—		—		—
Commercial and industrial		547		—		—		1,125		1,672

Total commercial		5,853		—		—		3,469		9,322

Real estate
Residential mortgage		2,471		—		—		—		2,471
Residential construction		—		—		—		—		—
Mortgage warehouse		—		—		—		—		—

Total real estate		2,471		—		—		—		2,471

Consumer
Direct Installment		259		3		—		—		262
Direct Installment Purchased		—		—		—		—		—
Indirect Installment		539		59		—		—		598
Home Equity		1,706		—		—		—		1,706

Total Consumer		2,504		62		—		—		2,566

Total	$	10,828	$	62	$	—	$	3,469	$	14,359


December 31, 2013	Non-accrual		Loans Past Due Over 90 Days Still Accruing		Non- Performing TDRs		Performing TDRs		Total Non- Performing Loans
Commercial
Owner occupied real estate	$	293	$	—	$	222	$	778	$	1,293
Non owner occupied real estate		2,289		45		1,117		518		3,969
Residential development		—		—		—		—		—
Development & Spec Land Loans		182		—		—		—		182
Commercial and industrial		1,250		—		777		—		2,027

Total commercial		4,014		45		2,116		1,296		7,471

Real estate
Residential mortgage		2,459		2		719		2,686		5,866
Residential construction		—		—		280		—		280
Mortgage warehouse		—		—		—		—		—

Total real estate		2,459		2		999		2,686		6,146

Consumer
Direct Installment		202		—		—		—		202
Direct Installment Purchased		—		—		—		—		—
Indirect Installment		531		2		—		—		533
Home Equity		2,542		—		311		1,072		3,925

Total Consumer		3,275		2		311		1,072		4,660

Total	$	9,748	$	49	$	3,426	$	5,054	$	18,277

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Included in the $10.8 million of non-accrual loans and the $3.1 million of non-performing TDRs at September 30, 2014 were $1.3 million and $362,000, respectively, of loans acquired for which accretable yield was recognized.

From time to time, the Bank obtains information that may lead management to believe that the collection of payments may be doubtful on a particular loan. In recognition of this, it is management’s policy to convert the loan from an “earning asset” to a non-accruing loan. The entire balance of a loan is considered delinquent if the minimum payment contractually required to be made is not received by the specified due date. Further, it is management’s policy to place a loan on a non-accrual status when the payment is delinquent in excess of 90 days or the loan has had the accrual of interest discontinued by management. The officer responsible for the loan and the Chief Credit Officer or the senior collection officer must review all loans placed on non-accrual status. Subsequent payments on non-accrual loans are recorded as a reduction of principal, and interest income is recorded only after principal recovery is reasonably assured. Non-accrual loans are returned to accrual status when, in the opinion of management, the financial position of the borrower indicates there is no longer any reasonable doubt as to the timely collection of interest or principal in accordance with the loan terms. The Company requires a period of satisfactory performance of not less than nine months before returning a non-accrual loan to accrual status.

A loan becomes impaired when, based on current information, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. When a loan is classified as impaired, the degree of impairment must be recognized by estimating future cash flows from the debtor. The present value of these cash flows is computed at a discount rate based on the interest rate contained in the loan agreement. However, if a particular loan has a determinable market value for its collateral, the creditor may use that value. Also, if the loan is secured and considered collateral dependent, the creditor may use the fair value of the collateral. Interest income on loans individually classified as impaired is recognized on a cash basis after all past due and current principal payments have been made.

Smaller-balance, homogeneous loans are evaluated for impairment in total. Such loans include residential first mortgage loans secured by 1 – 4 family residences, residential construction loans, automobile, home equity, second mortgage loans and mortgage warehouse loans. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. When analysis of borrower operating results and financial condition indicate that underlying cash flows of a borrower’s business are not adequate to meet its debt service requirements, the loan is evaluated for impairment. Often this is associated with a delay or shortfall in payments of 30 days or more. Loans are generally moved to non-accrual status when they are 90 days or more past due. These loans are often considered impaired. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

Loans for which it is probable that the Company will not collect all principal and interest due according to contractual terms, including TDRs, are measured for impairment. Allowable methods for determining the amount of impairment include estimating fair value using the fair value of the collateral for collateral-dependent loans.

The Company’s TDRs are considered impaired loans and included in the allowance methodology using the guidance for impaired loans. At September 30, 2014, the type of concessions the Company has made on restructured loans has been temporary rate reductions and/or reductions in monthly payments and there have been no restructured loans with modified recorded balances. Any modification to a loan that is a concession and is not in the normal course of lending is considered a restructured loan. A restructured loan is returned to accruing status after six consecutive payments but is still reported as TDR unless the loan bears interest at a market rate. As of September 30, 2014, the Company had $8.9 million in TDRs and $5.8 million were performing according to the restructured terms and no TDRs were returned to accrual status during the first nine months of 2014. There was $1.5 million of specific reserves allocated to TDRs at September 30, 2014 based on the discounted cash flows.

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Loans transferred and classified as troubled debt restructuring during the three and nine months ended September 30, 2014 and 2013, segregated by class, are shown in the table below.


	Three Months Ending				Three Months Ending				Nine Months Ending				Nine Months Ending
	September 30, 2014				September 30, 2013				September 30, 2014				September 30, 2013
	Number of Defaults		Unpaid Principal Balance		Number of Defaults		Unpaid Principal Balance		Number of Defaults		Unpaid Principal Balance		Number of Defaults		Unpaid Principal Balance
Commercial
Owner occupied real estate		—	$	—		—	$	—		—	$	—		—	$	—
Non owner occupied real estate		—		—		—		—		—		—		—		—
Residential development		—		—		—		—		—		—		—		—
Development & Spec Land Loans		—		—		—		—		—		—		—		—
Commercial and industrial		—		—		—		—		2		362		—		—

Total commercial		—		—		—		—		2		362		—		—

Real estate
Residential mortgage		1		98		2		368		2		322		5		758
Residential construction		—		—		—		—		—		—		—		—
Mortgage warehouse		—		—		—		—		—		—		—		—

Total real estate		1		98		2		368		2		322		5		758

Consumer
Direct Installment		—		—		—		—		—		—		—		—
Direct Installment Purchased		—		—		—		—		—		—		—		—
Indirect Installment		—		—		—		—		—		—		—		—
Home Equity		1		163		1		997		3		358		1		997

Total Consumer		1		163		1		997		3		358		1		997
		—		—						—		—

Total		2	$	261		3	$	1,365		7	$	1,042		6	$	1,755

Troubled debt restructured loans which had payment defaults during the three and nine months ended September 30, 2014 and 2013, segregated by class, are shown in the table below. Default occurs when a loan is 90 days or more past due or has been transferred to non-accrual.


	Three Months Ending				Three Months Ending				Nine Months Ending				Nine Months Ending
	September 30, 2014				September 30, 2013				September 30, 2014				September 30, 2013
	Number of Defaults		Unpaid Principal Balance		Number of Defaults		Unpaid Principal Balance		Number of Defaults		Unpaid Principal Balance		Number of Defaults		Unpaid Principal Balance
Commercial
Owner occupied real estate		—	$	—		—	$	—		—	$	—		—	$	—
Non owner occupied real estate		—		—		—		—		—		—		—		—
Residential development		—		—		—		—		—		—		—		—
Development & Spec Land Loans		—		—		—		—		—		—		—		—
Commercial and industrial		—		—		—		—		2		362		—		—

Total commercial		—		—		—		—		2		362		—		—

Real estate
Residential mortgage		1		98		—		—		2		246		3		239
Residential construction		—		—		—		—		—		—		—		—
Mortgage warehouse		—		—		—		—		—		—		—		—

Total real estate		1		98		—		—		2		246		3		239

Consumer
Direct Installment		—		—		—		—		—		—		—		—
Direct Installment Purchased		—		—		—		—		—		—		—		—
Indirect Installment		—		—		—		—		—		—		—		—
Home Equity		1		163		1		997		3		358		1		997

Total Consumer		1		163		1		997		3		358		1		997
		—		—						—		—

Total		2	$	261		1	$	997		7	$	966		4	$	1,236

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

The following table presents commercial loans individually evaluated for impairment by class of loan:


							Three Months Ending				Nine Months Ending
September 30, 2014	Unpaid Principal Balance		Recorded Investment		Allowance For Loan Loss Allocated		Average Balance in Impaired Loans		Cash/Accrual Interest Income Recognized		Average Balance in Impaired Loans		Cash/Accrual Interest Income Recognized
With no recorded allowance
Commercial
Owner occupied real estate	$	2,851	$	2,854	$	—	$	2,126	$	85	$	1,525	$	129
Non owner occupied real estate		3,232		3,235		—		3,257		43		3,274		141
Residential development		—		—		—		—		—		—		—
Development & Spec Land Loans		—		—		—		—		—		—		—
Commercial and industrial		281		281		—		367		—		433		—

Total commercial		6,364		6,370		—		5,750		128		5,232		270

With an allowance recorded
Commercial
Owner occupied real estate		403		403		13		406		—		274		6
Non owner occupied real estate		333		333		150		335		—		343		—
Residential development		—		—		—		—		—		—		—
Development & Spec Land Loans		—		—		—		—		—		—		—
Commercial and industrial		1,391		1,391		1,012		1,560		—		1,567		2

Total commercial		2,127		2,127		1,175		2,301		—		2,184		8

Total	$	8,491	$	8,497	$	1,175	$	8,051	$	128	$	7,416	$	278


							Three Months Ending					Nine Months Ending
September 30, 2013	Unpaid Principal Balance		Recorded Investment		Allowance For Loan Loss Allocated		Average Balance in Impaired Loans			Cash/Accrual Interest Income Recognized		Average Balance in Impaired Loans		Cash/Accrual Interest Income Recognized
With no recorded allowance
Commercial
Owner occupied real estate	$	1,329	$	1,331	$	—	$	1,959		$	16	$	2,685	$	43
Non owner occupied real estate		3,167		3,170		—		3,814			8		3,298		21
Residential development		—		—		—		—			—		—		—
Development & Spec Land Loans		21		21		—		24			—		25		—
Commercial and industrial		546		561		—		1,297			—		1,311		—

Total commercial		5,063		5,083		—		7,094			24		7,319		64

With an allowance recorded
Commercial
Owner occupied real estate		—		—		—		(1	)		—		—		—
Non owner occupied real estate		487		487		302		491			—		502		—
Residential development		—		—		—		—			—		—		—
Development & Spec Land Loans		149		149		48		173			—		165		—
Commercial and industrial		2,188		2,200		966		2,379			—		1,808		23

Total commercial		2,824		2,836		1,316		3,042			—		2,475		23

Total	$	7,887	$	7,919	$	1,316	$	10,136		$	24	$	9,794	$	87

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

The following table presents the payment status by class of loan:


September 30, 2014	30 - 59 Days Past Due			60 - 89 Days Past Due			Greater than 90 Days Past Due			Total Past Due			Loans Not Past Due			Total
Commercial
Owner occupied real estate	$	338		$	—		$	—		$	338		$	232,731		$	233,069
Non owner occupied real estate		—			—			—			—			298,408			298,408
Residential development		—			—			—			—			1,289			1,289
Development & Spec Land Loans		—			—			—			—			12,574			12,574
Commercial and industrial		134			—			—			134			130,548			130,682

Total commercial		472			—			—			472			675,550			676,022

Real estate
Residential mortgage		491			183			—			674			239,315			239,989
Residential construction		—			—			—			—			11,122			11,122
Mortgage warehouse		—			—			—			—			105,133			105,133

Total real estate		491			183			—			674			355,570			356,244

Consumer
Direct Installment		139			32			3			174			36,546			36,720
Direct Installment Purchased		—			—			—			—			236			236
Indirect Installment		986			273			59			1,318			137,820			139,138
Home Equity		665			69			—			734			132,456			133,190

Total consumer		1,790			374			62			2,226			307,058			309,284

Total	$	2,753		$	557		$	62		$	3,372		$	1,338,178		$	1,341,550

Percentage of total loans		0.21	%		0.04	%		0.00	%		0.25	%		99.75	%


December 31, 2013	30 - 59 Days Past Due			60 - 89 Days Past Due			Greater than 90 Days Past Due			Total Past Due			Loans Not Past Due			Total
Commercial
Owner occupied real estate	$	341		$	—		$	—		$	341		$	155,921		$	156,262
Non owner occupied real estate		424			—			45			469			224,244			224,713
Residential development		—			—			—			—			400			400
Development & Spec Land Loans		—			—			—			—			21,289			21,289
Commercial and industrial		—			—			—			—			101,920			101,920

Total commercial		765			—			45			810			503,774			504,584

Real estate
Residential mortgage		445			87			2			534			175,534			176,068
Residential construction		—			—			—			—			9,508			9,508
Mortgage warehouse		—			—			—			—			98,156			98,156

Total real estate		445			87			2			534			283,198			283,732

Consumer
Direct Installment		120			24			—			144			29,839			29,983
Direct Installment Purchased		—			—			—			—			294			294
Indirect Installment		1,011			175			2			1,188			130,196			131,384
Home Equity		767			58			—			825			117,133			117,958

Total consumer		1,898			257			2			2,157			277,462			279,619

Total	$	3,108		$	344		$	49		$	3,501		$	1,064,434		$	1,067,935

Percentage of total loans		0.29	%		0.03	%		0.00	%		0.33	%		99.67	%

The entire balance of a loan is considered delinquent if the minimum payment contractually required to be made is not received by the specified due date.

Horizon Bank’s processes for determining credit quality differ slightly depending on whether a new loan or a renewed loan is being underwritten, or whether an existing loan is being re-evaluated for credit quality. The latter usually occurs upon receipt of current financial information or other pertinent data that would trigger a change in the loan grade.

•

For new and renewed commercial loans, the Bank’s Credit Department, which acts independently of the loan officer, assigns the credit quality grade to the loan. Loan grades for loans with an aggregate credit exposure that exceeds the authorities in the respective markets (ranging from $1,000,000 to $2,500,000) are validated by the Loan Committee, which is chaired by the Chief Credit Officer (CCO).

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

•

Commercial loan officers are responsible for reviewing their loan portfolios and report any adverse material change to the CCO or Loan Committee. When circumstances warrant a change in the credit quality grade, loan officers are required to notify the CCO and the Credit Department of the change in the loan grade. Downgrades are accepted immediately by the CCO however, lenders must present their factual information to either the Loan Committee or the CCO when recommending an upgrade.

•

The CCO, or his designee, meets weekly with loan officers to discuss the status of past-due loans and classified loans. These meetings are also designed to give the loan officers an opportunity to identify an existing loan that should be downgraded to a classified grade.

•

Monthly, senior management meets with the Watch Committee, which reviews all of the past due, classified, and impaired loans and the relative trends of these assets. This committee also reviews the actions taken by management regarding foreclosure mitigation, loan extensions, troubled debt restructures, other real estate owned and personal property repossessions. The information reviewed in this meeting acts as a precursor for developing management’s analysis of the adequacy of the Allowance for Loan and Lease Losses.

For residential real estate and consumer loans, Horizon uses a grading system based on delinquency. Loans that are 90 days or more past due, on non-accrual, or are classified as a TDR are graded “Substandard.” After being 90 days delinquent a loan is charged off unless it is well secured and in the process of collection. If the latter case exists, the loan is placed on non-accrual. Occasionally a mortgage loan may be graded as “Special Mention.” When this situation arises, it is because the characteristics of the loan and the borrower fit the definition of a Risk Grade 5 described below, which is normally used for grading commercial loans. Loans not graded Substandard are considered Pass.

Horizon Bank employs a nine-grade rating system to determine the credit quality of commercial loans. The first five grades represent acceptable quality, and the last four grades mirror the criticized and classified grades used by the bank regulatory agencies (special mention, substandard, doubtful, and loss). The loan grade definitions are detailed below.

Risk Grade 1: Excellent (Pass)

Loans secured by liquid collateral, such as certificates of deposit, reputable bank letters of credit, or other cash equivalents; loans that are guaranteed or otherwise backed by the full faith and credit of the United States government or an agency thereof, such as the Small Business Administration; or loans to any publicly held company with a current long-term debt rating of A or better.

Risk Grade 2: Good (Pass)

Loans to businesses that have strong financial statements containing an unqualified opinion from a CPA firm and at least three consecutive years of profits; loans supported by unaudited financial statements containing strong balance sheets, five consecutive years of profits, a five-year satisfactory relationship with the Bank, and key balance sheet and income statement trends that are either stable or positive; loans secured by publicly traded marketable securities where there is no impediment to liquidation; loans to individuals backed by liquid personal assets and unblemished credit history; or loans to publicly held companies with current long-term debt ratings of Baa or better.

Risk Grade 3: Satisfactory (Pass)

Loans supported by financial statements (audited or unaudited) that indicate average or slightly below average risk and having some deficiency or vulnerability to changing economic conditions; loans with some weakness but offsetting features of other support are readily available; loans that are meeting the terms of repayment, but which may be susceptible to deterioration if adverse factors are encountered.

Loans may be graded Satisfactory when there is no recent information on which to base a current risk evaluation and the following conditions apply:

•

At inception, the loan was properly underwritten, did not possess an unwarranted level of credit risk, and the loan met the above criteria for a risk grade of Excellent, Good, or Satisfactory;

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

•

At inception, the loan was secured with collateral possessing a loan value adequate to protect the Bank from loss.

•

The loan has exhibited two or more years of satisfactory repayment with a reasonable reduction of the principal balance.

•

During the period that the loan has been outstanding, there has been no evidence of any credit weakness. Some examples of weakness include slow payment, lack of cooperation by the borrower, breach of loan covenants, or the borrower is in an industry known to be experiencing problems. If any of these credit weaknesses is observed, a lower risk grade may be warranted.

Risk Grade 4 Satisfactory/Monitored:

Loans in this category are considered to be of acceptable credit quality, but contain greater credit risk than Satisfactory loans. Borrower displays acceptable liquidity, leverage, and earnings performance within the Bank’s minimum underwriting guidelines. The level of risk is acceptable but conditioned on the proper level of loan officer supervision. Loans that normally fall into this grade include acquisition, construction and development loans and income producing properties that have not reached stabilization.

Risk Grade 4W Management Watch:

Loans in this category are considered to be of acceptable quality, but with above normal risk. Borrower displays potential indicators of weakness in the primary source of repayment resulting in a higher reliance on secondary sources of repayment. Balance sheet may exhibit weak liquidity and/or high leverage. There is inconsistent earnings performance without the ability to sustain adverse economic conditions. Borrower may be operating in a declining industry or the property type, as for a commercial real estate loan, may be high risk or in decline. These loans require an increased level of loan officer supervision and monitoring to assure that any deterioration is addressed in a timely fashion.

Risk Grade 5: Special Mention

Loans which possess some credit deficiency or potential weakness which deserves close attention. Such loans pose an unwarranted financial risk that, if not corrected, could weaken the loan by adversely impacting the future repayment ability of the borrower. The key distinctions of a Special Mention classification are that (1) it is indicative of an unwarranted level of risk and (2) weaknesses are considered “potential,” not “defined,” impairments to the primary source of repayment. These loans may be to borrowers with adverse trends in financial performance, collateral value and/or marketability, or balance sheet strength.

Risk Grade 6: Substandard

One or more of the following characteristics may be exhibited in loans classified Substandard:

•

Loans which possess a defined credit weakness. The likelihood that a loan will be paid from the primary source of repayment is uncertain. Financial deterioration is under way and very close attention is warranted to ensure that the loan is collected without loss.

•

Loans are inadequately protected by the current net worth and paying capacity of the obligor.

•

The primary source of repayment is gone, and the Bank is forced to rely on a secondary source of repayment, such as collateral liquidation or guarantees.

•

Loans have a distinct possibility that the Bank will sustain some loss if deficiencies are not corrected.

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

•

Unusual courses of action are needed to maintain a high probability of repayment.

•

The borrower is not generating enough cash flow to repay loan principal; however, it continues to make interest payments.

•

The lender is forced into a subordinated or unsecured position due to flaws in documentation.

•

Loans have been restructured so that payment schedules, terms, and collateral represent concessions to the borrower when compared to the normal loan terms.

•

The lender is seriously contemplating foreclosure or legal action due to the apparent deterioration in the loan.

•

There is a significant deterioration in market conditions to which the borrower is highly vulnerable.

Risk Grade 7: Doubtful

One or more of the following characteristics may be present in loans classified Doubtful:

•

Loans have all of the weaknesses of those classified as Substandard. However, based on existing conditions, these weaknesses make full collection of principal highly improbable.

•

The primary source of repayment is gone, and there is considerable doubt as to the quality of the secondary source of repayment.

•

The possibility of loss is high but because of certain important pending factors which may strengthen the loan, loss classification is deferred until the exact status of repayment is known.

Risk Grade 8: Loss

Loans are considered uncollectible and of such little value that continuing to carry them as assets is not feasible. Loans will be classified Loss when it is neither practical nor desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future.

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

The following table presents loans by credit grades.


September 30, 2014	Pass			Special Mention			Substandard			Doubtful			Total
Commercial
Owner occupied real estate	$	221,514		$	4,753		$	6,802		$	—		$	233,069
Non owner occupied real estate		278,452			6,668			13,288			—			298,408
Residential development		1,030			259			—			—			1,289
Development & Spec Land Loans		11,379			82			1,113			—			12,574
Commercial and industrial		125,423			1,906			3,353			—			130,682

Total commercial		637,798			13,668			24,556			—			676,022

Real estate
Residential mortgage		237,518			—			2,471			—			239,989
Residential construction		11,122			—			—			—			11,122
Mortgage warehouse		105,133			—			—			—			105,133

Total real estate		353,773			—			2,471			—			356,244

Consumer
Direct Installment		36,458			—			262			—			36,720
Direct Installment Purchased		236			—			—			—			236
Indirect Installment		138,540			—			598			—			139,138
Home Equity		131,484			—			1,706			—			133,190

Total Consumer		306,718			—			2,566			—			309,284

Total	$	1,298,289		$	13,668		$	29,593		$	—		$	1,341,550

Percentage of total loans		96.78	%		1.02	%		2.21	%		0.00	%

December 31, 2013	Pass			Special Mention			Substandard			Doubtful			Total
Commercial
Owner occupied real estate	$	146,085		$	2,231		$	7,946		$	—		$	156,262
Non owner occupied real estate		208,625			5,047			11,041			—			224,713
Residential development		400			—			—			—			400
Development & Spec Land Loans		19,858			91			1,340			—			21,289
Commercial and industrial		91,852			6,492			3,576			—			101,920

Total commercial		466,820			13,861			23,903			—			504,584

Real estate
Residential mortgage		170,202			—			5,866			—			176,068
Residential construction		9,228			—			280			—			9,508
Mortgage warehouse		98,156			—			—			—			98,156

Total real estate		277,586			—			6,146			—			283,732

Consumer
Direct Installment		29,781			—			202			—			29,983
Direct Installment Purchased		294			—			—			—			294
Indirect Installment		130,851			—			533			—			131,384
Home Equity		114,033			—			3,925			—			117,958

Total Consumer		274,959			—			4,660			—			279,619

Total	$	1,019,365		$	13,861		$	34,709		$	—		$	1,067,935

Percentage of total loans		95.45	%		1.30	%		3.25	%		0.00	%

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Note 8 – Derivative Financial Instruments

Cash Flow Hedges

As a strategy to maintain acceptable levels of exposure to the risk of changes in future cash flow due to interest rate fluctuations, the Company entered into interest rate swap agreements for a portion of its floating rate debt. The agreements provide for the Company to receive interest from the counterparty at three month LIBOR and to pay interest to the counterparty at a weighted average fixed rate of 6.14% on a notional amount of $30.5 million at September 30, 2014 and December 31, 2013. Under the agreements, the Company pays or receives the net interest amount monthly, with the monthly settlements included in interest expense.

Management has designated the interest rate swap agreement as a cash flow hedging instrument. For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivative representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings. At September 30, 2014 the Company’s cash flow hedge was effective and is not expected to have a significant impact on the Company’s net income over the next 12 months.

Fair Value Hedges

Fair value hedges are intended to reduce the interest rate risk associated with the underlying hedged item. The Company enters into fixed rate loan agreements as part of its lending policy. To mitigate the risk of changes in fair value based on fluctuations in interest rates, the Company has entered into interest rate swap agreements on individual loans, converting the fixed rate loans to a variable rate. For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in current earnings. At September 30, 2014, the Company’s fair value hedges were effective and are not expected to have a significant impact on the Company’s net income over the next 12 months.

The change in fair value of both the hedge instruments and the underlying loan agreements are recorded as gains or losses in interest income. The fair value hedges are considered to be highly effective and any hedge ineffectiveness was deemed not material. The notional amounts of the loan agreements being hedged were $102.4 million at September 30, 2014 and $95.3 million at December 31, 2013.

Other Derivative Instruments

The Company enters into non-hedging derivatives in the form of mortgage loan forward sale commitments with investors and commitments to originate mortgage loans as part of its mortgage banking business. At September 30, 2014, the Company’s fair value of these derivatives were recorded and over the next 12 months are not expected to have a significant impact on the Company’s net income.

The change in fair value of both the forward sale commitments and commitments to originate mortgage loans were recorded and the net gains or losses included in the Company’s gain on sale of loans.

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

The following tables summarize the fair value of derivative financial instruments utilized by Horizon:


	Asset Derivative			Liability Derivatives
	September 30, 2014			September 30, 2014
Derivatives designated as hedging instruments (Unaudited)	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Interest rate contracts	Loans	$	—	Other liabilities	$	372
Interest rate contracts	Other Assets		372	Other liabilities		2,996

Total derivatives designated as hedging instruments			372			3,368


Derivatives not designated as hedging instruments
Mortgage loan contracts	Other assets		469	Other liabilities		22

Total derivatives not designated as hedging instruments			469			22

Total derivatives		$	841		$	3,390


	Asset Derivative				Liability Derivatives
	December 31, 2013				December 31, 2013
Derivatives designated as hedging instruments (Unaudited)	Balance Sheet Location	Fair Value			Balance Sheet Location	Fair Value
Interest rate contracts	Loans	$	7		Other liabilities	$	(53	)
Interest rate contracts	Other Assets		(60	)	Other liabilities		2,826

Total derivatives designated as hedging instruments			(53	)			2,773


Derivatives not designated as hedging instruments
Mortgage loan contracts	Other assets		212		Other liabilities		22

Total derivatives not designated as hedging instruments			212				22

Total derivatives		$	159			$	2,795

The effect of the derivative instruments on the condensed consolidated statement of income for the three and nine month periods ending is as follows:


	Comprehensive Income on Derivative (Effective Portion)				Comprehensive Income on Derivative (Effective Portion)
	Three Months Ended September 30				Nine Months Ended September 30
Derivative in cash flow hedging relationship	2014 (Unaudited)		2013 (Unaudited)		2014 (Unaudited)			2013 (Unaudited)
Interest rate contracts	$	240	$	25	$	(110	)	$	1,338

FASB Accounting Standards Codification (“ASC”) Topic 820-10-20 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Topic 820-10-55 establishes a fair value hierarchy that emphasizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value.

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)


		Amount of Gain (Loss) Recognized on Derivative						Amount of Gain (Loss) Recognized on Derivative
		Three Months Ended September 30						Nine Months Ended September 30
Derivative in fair value hedging relationship	Location of gain (loss) recognized on derivative	2014 (Unaudited)			2013 (Unaudited)			2014 (Unaudited)			2013 (Unaudited)
Interest rate contracts	Interest income - loans	$	(326	)	$	211		$	425		$	(1,635	)
Interest rate contracts	Interest income - loans		326			(211	)		(425	)		1,635

Total		$	—		$	—		$	—		$	—


		Amount of Gain (Loss) Recognized on Derivative						Amount of Gain (Loss) Recognized on Derivative
		Three Months Ended September 30						Nine Months Ended September 30
Derivative not designated as hedging relationship	Location of gain (loss) recognized on derivative	2014 (Unaudited)			2013 (Unaudited)			2014 (Unaudited)			2013 (Unaudited)
Mortgage contracts	Other income - gain on sale of loans	$	(22	)	$	169		$	(1	)	$	(239	)

Note 9 – Disclosures about Fair Value of Assets and Liabilities

The Fair Value Measurements topic of the FASB ASC defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. There are three levels of inputs that may be used to measure fair value:


Level 1		Quoted prices in active markets for identical assets or liabilities

Level 2		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 or 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 condensed consolidated financial statements, as well as the general classification of such instruments pursuant to the valuation hierarchy. There have been no significant changes in the valuation techniques during the period ended September 30, 2014. For assets classified within Level 3 of the fair value hierarchy, the process used to develop the reported fair value is described below.

Available for sale securities

When quoted market prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. 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. Level 2 securities include U.S. Treasury and federal agency securities, state and municipal securities, federal agency mortgage obligations and mortgage-backed pools, private-label mortgage-backed pools and corporate notes. Level 2 securities are valued by a third party pricing service commonly used in the banking industry utilizing observable inputs. Observable inputs include dealer quotes, market spreads, cash flow analysis, the U.S. Treasury yield curve, trade execution data, market consensus prepayment spreads and available credit information and the bond’s terms and conditions. The pricing provider utilizes evaluated pricing models that vary based on asset class. These models incorporate available market information including quoted prices of securities with similar characteristics and, because many fixed-income securities do not trade on a daily basis, apply available information through processes such as benchmark curves, benchmarking of like securities, sector grouping, and matrix pricing. In addition, model processes, such as an option adjusted spread model, is used to develop prepayment and interest rate scenarios for securities with prepayment features.

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Hedged loans

Certain fixed rate loans have been converted to variable rate loans by entering into interest rate swap agreements. The fair value of those fixed rate loans is based on discounting the estimated cash flows using interest rates determined by the respective interest rate swap agreement. Loans are classified within Level 2 of the valuation hierarchy based on the unobservable inputs used.

Interest rate swap agreements

The fair value of the Company’s interest rate swap agreements is estimated by a third party using inputs that are primarily unobservable including a yield curve, adjusted for liquidity and credit risk, contracted terms and discounted cash flow analysis, and therefore, are classified within Level 2 of the valuation hierarchy.

The following table presents the fair value measurements of assets and liabilities recognized in the accompanying condensed consolidated financial statements measured at fair value on a recurring basis and the level within the FASB ASC fair value hierarchy in which the fair value measurements fall at the following:


	Fair Value			Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
September 30, 2014
Available-for-sale securities
U.S. Treasury and federal agencies	$	26,825		$	—	$	26,825		$	—
State and municipal		48,595			—		48,595			—
Federal agency collateralized mortgage obligations		123,128			—		123,128			—
Federal agency mortgage-backed pools		124,109			—		124,109			—
Private labeled mortgage-backed pools		786			—		786			—
Corporate notes		49			—		49			—

Total available-for-sale securities		323,492			—		323,492			—

Hedged loans		102,450			—		102,450			—
Forward sale commitments		641			—		641			—
Interest rate swap agreements		(3,368	)		—		(3,368	)		—
Commitments to originate loans		(22	)		—		(22	)		—

December 31, 2013
Available-for-sale securities
U.S. Treasury and federal agencies	$	43,134		$	—	$	43,134		$	—
State and municipal		177,898			—		177,898			—
Federal agency collateralized mortgage obligations		114,706			—		114,706			—
Federal agency mortgage-backed pools		170,894			—		170,894			—
Private labeled mortgage-backed pools		1,226			—		1,226			—
Corporate notes		733			—		733			—

Total available-for-sale securities		508,591			—		508,591			—

Hedged loans		95,372			—		95,372			—
Forward sale commitments		212			—		212			—
Interest rate swap agreements		(2,773	)		—		(2,773	)		—
Commitments to originate loans		(22	)		—		(22	)		—

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

Realized gains and losses included in net income for the periods are reported in the condensed consolidated statements of income as follows:


	Three Months Ended September 30						Nine Months Ended September 30
Non Interest Income	2014			2013			2014			2013
Total gains and losses from:	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)
Hedged loans	$	(326	)	$	211		$	425		$	(1,635	)
Fair value interest rate swap agreements		326			(211	)		(425	)		1,635
Derivative loan commitments		(22	)		169			(1	)		(239	)

	$	(22	)	$	169		$	(1	)	$	(239	)

Certain other assets are measured at fair value on a nonrecurring basis in the ordinary course of business and are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment):


	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
September 30, 2014
Impaired loans	$	7,316	$	—	$	—	$	7,316
Mortgage servicing rights		7,472		—		—		7,472

December 31, 2013
Impaired loans	$	6,114	$	—	$	—	$	6,114
Mortgage servicing rights		7,039		—		—		7,039

Impaired (collateral dependent): Loans for which it is probable that the Company will not collect all principal and interest due according to contractual terms are measured for impairment. Allowable methods for determining the amount of impairment include estimating fair value using the fair value of the collateral for collateral-dependent loans.

If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. 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.

Mortgage Servicing Rights (MSRs): MSRs do not trade in an active market with readily observable prices. Accordingly, the fair value of these assets is classified as Level 3. The Company determines the fair value of MSRs using an income approach model based upon the Company’s month-end interest rate curve and prepayment assumptions. The model utilizes assumptions to estimate future net servicing income cash flows, including estimates of time decay, payoffs and changes in valuation inputs and assumptions. The Company reviews the valuation assumptions against this market data for reasonableness and adjusts the assumptions if deemed appropriate. The carrying amount of the MSR’s fair value increased by $28,000 during the first nine months of 2014 and increased by $208,000 during the first nine months of 2013.

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

The following table presents qualitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements, other than goodwill.


	Fair Value at September 30, 2014		Valuation Technique	Unobservable Inputs	Range (Weighted Average)

Impaired loans	$	7,316	Collateral based measurement	Discount to reflect current market conditions and ultimate collectability	10% - 15% (12%)
Mortgage servicing rights	$	7,472	Discounted cashflows	Discount rate, Constant prepayment rate, Probably of default	10% - 15% (12%), 4% - 7% (4.6%), 1% - 10% (4.5%)

	Fair Value at December 31, 2013		Valuation Technique	Unobservable Inputs	Range (Weighted Average)

Impaired loans	$	6,114	Collateral based measurement	Discount to reflect current market conditions and ultimate collectability	10% - 15% (12%)
Mortgage servicing rights	$	7,039	Discounted cashflows	Discount rate, Constant prepayment rate, Probably of default	10% - 15% (12%), 4% - 7% (4.6%), 1% - 10% (4.5%)

Note 10 – Fair Value of Financial Instruments

The estimated fair value amounts of the Company’s financial instruments were determined using available market information, current pricing information applicable to Horizon and various valuation methodologies. Where market quotations were not available, considerable management judgment was involved in the determination of estimated fair values. Therefore, the estimated fair value of financial instruments shown below may not be representative of the amounts at which they could be exchanged in a current or future transaction. Due to the inherent uncertainties of expected cash flows of financial instruments, the use of alternate valuation assumptions and methods could have a significant effect on the estimated fair value amounts.

The estimated fair values of financial instruments, as shown below, are not intended to reflect the estimated liquidation or market value of Horizon taken as a whole. The disclosed fair value estimates are limited to Horizon’s significant financial instruments at September 30, 2014 and December 31, 2013. These include financial instruments recognized as assets and liabilities on the condensed consolidated balance sheet as well as certain off-balance sheet financial instruments. The estimated fair values shown below do not include any valuation of assets and liabilities, which are not financial instruments as defined by the FASB ASC fair value hierarchy.

The following methods and assumptions were used to estimate the fair value of each class of financial instrument:

Cash and Due from Banks — The carrying amounts approximate fair value.

Held-to-Maturity Securities — For debt securities held to maturity, fair values are based on quoted market prices or dealer quotes. For those securities where a quoted market price is not available, carrying amount is a reasonable estimate of fair value based upon comparison with similar securities.

Loans Held for Sale — The carrying amounts approximate fair value.

Net Loans — The fair value of portfolio loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. The carrying amounts of loans held for sale approximate fair value.

HORIZON BANCORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Table Dollar Amounts in Thousands, Except Per Share Data)

FHLB and FRB Stock — Fair value of FHLB and FRB stock is based on the price at which it may be resold to the FHLB and FRB.

Interest Receivable/Payable — The carrying amounts approximate fair value.

Deposits — The fair value of demand deposits, savings accounts, interest-bearing checking accounts and money market deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated by discounting the future cash flows using rates currently offered for deposits of similar remaining maturity.

Borrowings — Rates currently available to Horizon for debt with similar terms and remaining maturities are used to estimate fair values of existing borrowings.

Subordinated Debentures — Rates currently available for debentures with similar terms and remaining maturities are used to estimate fair values of existing debentures.

Commitments to Extend Credit and Standby Letters of Credit — The fair value of commitments 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 value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. Due to the short-term nature of these agreements, carrying amounts approximate fair value.

The following table presents estimated fair values of the Company’s financial instruments and the level within the fair value hierarchy in which the fair value measurements fall (unaudited).


	September 30, 2014
	Carrying Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets
Cash and due from banks	$	37,318	$	37,318	$	—	$	—
Investment securities, held to maturity		172,449		—		—		175,838
Loans held for sale		4,167		—		—		4,167
Loans excluding loan level hedges, net		1,224,411		—		—		1,238,805
Stock in FHLB and FRB		16,912		—		16,912		—
Interest receivable		8,411		—		8,411		—

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