Unassociated Document
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K

x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended: December 31, 2006
 
OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________ to __________
 
Commission File Number 0-11244
 
german logo
GERMAN AMERICAN BANCORP, INC.
(Exact name of registrant as specified in its charter)

INDIANA
35-1547518
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)

711 Main Street, Box 810, Jasper, Indiana
47546
(Address of Principal Executive Offices)
(Zip Code)
        
Registrant’s telephone number, including area code: (812) 482-1314
 
Securities registered pursuant to Section 12 (b) of the Act: None
Securities registered pursuant to Section 12 (g) of the Act:
Common Shares, No Par Value Preferred Stock Purchase Rights
(Titles of Classes)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
o Yes
x No
     
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
o Yes
x No
     
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.
x Yes
o No
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-Ko
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer:
 
Large accelerated filer o            Accelerated filer x            Non-accelerated filer o 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
o Yes
x  No
 
The aggregate market value of the registrant’s common shares held by non-affiliates of the registrant, computed by reference to the price at which the common shares were last sold, as of June 30, 2006 (the last business day of the registrant’s most recently completed second fiscal quarter) was approximately $132,632,000. This calculation does not reflect a determination that persons are affiliates for any other purposes.
 
As of March 1, 2007, there were outstanding 11,029,612 common shares, no par value, of the registrant.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement of German American Bancorp, Inc., for the Annual Meeting of its Shareholders to be held April 26, 2007, to the extent stated herein, are incorporated by reference into Part III.
 

 
GERMAN AMERICAN BANCORP, INC.
ANNUAL REPORT ON FORM 10-K
For Fiscal Year Ended December 31, 2006

Table of Contents

PART I
     
Item 1.
Business
 
3-5
Item 1A.
Risk Factors
 
6-7
Item 1B.
Unresolved Staff Comments
 
7
Item 2.
Properties
 
8
Item 3.
Legal Proceedings
 
8
Item 4.
Submission of Matters to a Vote of Security Holders
 
8
       
PART II
     
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases
   
 
of Equity Securities
 
8-9
Item 6.
Selected Financial Data
 
10
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
11-28
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
 
29
Item 8.
Financial Statements and Supplementary Data
 
30-65
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
 
66
Item 9A.
Controls and Procedures
 
66-67
Item 9B.
Other Information
 
68
       
PART III
     
Item 10.
Directors and Executive Officers of the Registrant
 
68
Item 11.
Executive Compensation
 
68
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
   
 
Matters
 
68-69
Item 13.
Certain Relationships and Related Transactions
 
69
Item 14.
Principal Accountant Fees and Services
 
69
 
     
PART IV
     
Item 15.
Exhibits and Financial Statement Schedules
 
70
SIGNATURES  
71
     
INDEX OF EXHIBITS  
72-74
 
2

 
Information included in or incorporated by reference in this Annual Report on Form 10-K, our other filings with the Securities and Exchange Commission and our press releases or other public statements, contain or may contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Please refer to a discussion of our forward- looking statements and associated risks in Item 1, “Business - Forward-Looking Statements and Associated Risks” and our discussion of risk factors in Item 1A, “Risk Factors” in this Annual Report on Form 10-K.

PART I
 
Item 1. Business.
 
General.

German American Bancorp, Inc. is a financial services holding company based in Jasper, Indiana. The Company’s Common Stock is traded on NASDAQ’s Global Select Market. under the symbol GABC. The principal subsidiary of German American Bancorp, Inc., is its banking subsidiary, German American Bancorp which operates through six community banking affiliates with 30 retail banking offices in the ten contiguous Southern Indiana counties of Daviess, Dubois, Gibson, Knox, Lawrence, Martin, Monroe, Perry, Pike, and Spencer. German American Bancorp, Inc., also owns a trust, brokerage, and financial planning subsidiary, which operates from the banking offices of the bank subsidiary and two insurance agencies with six insurance agency offices throughout its market area.

Throughout this report, when we use the term “Company”, we will usually be referring to the business and affairs (financial and otherwise) of the Company and its subsidiaries and affiliates as a whole. Occasionally, we will refer to the term “parent company” or “holding company” when we mean to refer to only German American Bancorp, Inc.

The Company’s lines of business include retail and commercial banking, mortgage banking, comprehensive financial planning, full service brokerage and trust administration, title insurance, and a full range of personal and corporate insurance products. Financial and other information by segment is included in Note 16 - Segment Information of the Notes to the Consolidated Financial Statements included in Item 8 of this Report and is incorporated into this Item 1 by reference. Substantially all of the Company’s revenues are derived from customers located in, and substantially all of its assets are located in, the United States.

Developments in the Company’s Business

Since January 1, 2006, the Company’s business has grown through both organic internal growth and acquisitions. Effective January 1, 2006, the Company completed its acquisition of Stone City Bancshares, Inc. and its subsidiary Stone City Bank of Bedford, Indiana, and effective October 1, 2006, the Company completed the acquisition of the insurance agency business of Keach and Grove Insurance, Inc. also of Bedford, Indiana. For a description of these acquisitions, see Note 18 to the consolidated financial statements included in Item 8 of this Report, which description is incorporated into this Item 1 by reference. During the first quarter of 2007, the Company established its first branch in Bloomington, Indiana, which is located in Monroe County, Indiana (immediately north of Lawrence County, in which Bedford is located). As a result of this acquisition and branching activity, the Company now operates in both the Bloomington (Monroe County) and Bedford (Lawrence County) banking markets.

In addition, during the second quarter of 2006, the Company purchased a non-controlling investment in the common stock of a small banking company based in Dana, Indiana (near Terre Haute, Indiana) that has since branched into Lafayette, Indiana. As a result of making this investment, the Company has the opportunity to bid to purchase participations in loans that may be originated by this other banking company from time to time, if and to the extent that the banking company desires to sell participations in such loans to third parties. During the fourth quarter of 2006, the Company expanded its agricultural lending business by acquiring the Southern Indiana based agricultural loan portfolio of a regional banking company.

Subsidiaries

The Company’s principal operating subsidiaries are described in the following table: 

1) Name
 
2) Type of Business
 
3) Principal Office Location
German American Bancorp
 
Commercial Bank
 
Jasper, IN
First Title Insurance Company
 
Title Insurance Agency
 
Vincennes, IN
German American Insurance, Inc.
 
Multi-Line Insurance Agency
 
Petersburg, IN
German American Financial Advisors & Trust Company
 
Trust, Brokerage, Financial Planning
 
Jasper, IN

Two of these subsidiaries (German American Bancorp and German American Insurance, Inc.) do business in the various communities served by the Company under distinctive trade names that relate to the names under which the Company (or a predecessor) has done banking and insurance business with the public in those communities in prior years.
 
3

 
Competition.

The industries in which the Company operates are highly competitive. The Company’s subsidiary bank competes for commercial and retail banking business within its core banking segment not only with financial institutions that have offices in the same counties but also with financial institutions that compete from other locations in Southern Indiana and elsewhere. The Company’s subsidiaries compete with commercial banks, savings and loan associations, savings banks, credit unions, production credit associations, federal land banks, finance companies, credit card companies, personal loan companies, investment brokerage firms, insurance agencies, insurance companies, lease finance companies, money market funds, mortgage companies, and other non-depository financial intermediaries. Many of these banks and other organizations have substantially greater resources than the Company.

Employees.

At March 1, 2007 the Company and its subsidiaries employed approximately 395 full-time equivalent employees. There are no collective bargaining agreements, and employee relations are considered to be good.

Regulation and Supervision.
 
The Company is subject to regulation and supervision by the Board of Governors of the Federal Reserve System (“FRB”) under the Bank Holding Company Act of 1956, as amended (“BHC Act”), and is required to file with the FRB annual reports and such additional information as the FRB may require. The FRB may also make examinations or inspections of the Company. Under FRB policy, the Company is expected to act as a source of financial strength to its bank subsidiary and to commit resources to support that subsidiary even in circumstances where the Company might not do so absent such an FRB policy.

The Company’s subsidiary bank is under the supervision of and subject to examination by the Indiana Department of Financial Institutions (“DFI”), and the Federal Deposit Insurance Corporation (“FDIC”). Regulation and examination by banking regulatory agencies are primarily for the benefit of depositors rather than shareholders.
 
With certain exceptions, the BHC Act prohibits a bank holding company from engaging in (or acquiring direct or indirect control of more than 5 percent of the voting shares of any company engaged in) nonbanking activities. One of the principal exceptions to this prohibition is for activities deemed by the FRB to be “closely related to banking.” Under current regulations, bank holding companies and their subsidiaries are permitted to engage in such banking-related business ventures as consumer finance; equipment leasing; credit life insurance; computer service bureau and software operations; mortgage banking; and securities brokerage.

Under the BHC Act, certain well-managed and well-capitalized bank holding companies may elect to be treated as a “financial holding company” and, as a result, be permitted to engage in a broader range of activities that are “financial in nature” and in activities that are determined to be incidental or complementary to activities that are financial in nature. These activities include underwriting, dealing in and making a market in securities; insurance underwriting and agency activities; and merchant banking. Banks may also engage through financial subsidiaries in certain of the activities permitted for financial holding companies, subject to certain conditions. The Company has not elected to become a financial holding company and its subsidiary bank has not elected to form financial subsidiaries.

The Company’s bank subsidiary and that bank’s subsidiaries may generally engage in activities that are permissible activities for state chartered banks under Indiana banking law, without regard to the limitations that might apply to such activities under the BHC Act if the Company were to engage directly in such activities at the parent company level or through parent company subsidiaries that were not also bank subsidiaries.

Indiana law and the BHC Act restrict certain types of expansion by the Company and its bank subsidiary. The Company and its subsidiaries may be required to apply for prior approval from (or give prior notice and an opportunity for review to) the FRB, the DFI, and/or other bank regulatory or other regulatory agencies, as a condition to the acquisition or establishment of new offices, or the acquisition (by merger or consolidation, purchase or otherwise) of the stock, business or properties of other banks or other companies.

The earnings of commercial banks and their holding companies are affected not only by general economic conditions but also by the policies of various governmental regulatory authorities. In particular, the FRB regulates money and credit conditions and interest rates in order to influence general economic conditions, primarily through open-market operations in U.S. Government securities, varying the discount rate on bank borrowings, and setting reserve requirements against bank deposits. These policies have a significant influence on overall growth and distribution of bank loans, investments and deposits, and affect interest rates charged on loans and earned on investments or paid for time and savings deposits. FRB monetary policies have had a significant effect on the operating results of commercial banks in the past and this is expected to continue in the future. The general effect, if any, of such policies upon the future business and earnings of the Company cannot accurately be predicted.
 
4

 
The Company and its bank subsidiary are required by law to maintain minimum levels of capital. These required capital levels are expressed in terms of capital ratios, known as the leverage ratio and the capital to risk-based assets ratios. The Company and its bank subsidiary each significantly exceeded the minimum required capital levels for each measure of capital adequacy as of December 31, 2006. See Note 9 to the Company’s consolidated financial statements that are presented in Item 8 of this Report, which Note 9 is incorporated herein by reference.

Also, federal regulations define five categories of financial institutions for purposes of implementing prompt corrective action and supervisory enforcement requirements of the Federal Deposit Insurance Corporation Improvements Act of 1991. The category to which the most highly capitalized institutions are assigned is termed “well-capitalized.” Institutions falling into this category must have a total risk-based capital ratio (the ratio of total capital to risk-weighted assets) of at least 10%, a Tier 1 risk-based capital ratio (the ratio of Tier 1, or “core”, capital to risk-weighted assets) of at least 6%, a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 5%, and must not be subject to any written agreement, order or directive from its regulator relative to meeting and maintaining a specific capital level. On December 31, 2006, the Company had a total risk-based capital ratio of 10.66%, a Tier 1 risk-based capital ratio of 8.69% (based on Tier 1 capital of $77,926,000 and total risk-weighted assets of $896,450,000), and a leverage ratio of 7.41%. The Company’s affiliate bank met all of the requirements of the “well-capitalized” category. In addition the Company meets the requirements of the FRB to be considered a “well-capitalized” bank holding company. Accordingly, the Company does not expect these regulations to significantly impact operations.

The Company is a corporation separate and distinct from its bank and other subsidiaries. Most of the Company’s revenues will be received by it in the form of dividends, fees, and interest paid by its bank subsidiary. This subsidiary is subject to statutory restrictions on its ability to pay dividends. The FRB possesses enforcement powers over bank holding companies and their non-bank subsidiaries that enable it to prevent or remedy actions that in its view may represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability in appropriate cases to proscribe the payment of dividends by banks and bank holding companies. The FDIC and DFI possess similar enforcement powers over the bank subsidiary of the Company for which they have supervision. The “prompt corrective action” provisions of federal banking law impose further restrictions on the payment of dividends by insured banks which fail to meet specified capital levels and, in some cases, their parent bank holding companies.
 
Internet Address; Internet Availability of SEC Reports.
 
The Company’s Internet address is www.germanamericanbancorp.com.
 
The Company makes available, free of charge through the Investors section of its Internet website, a link to the Internet website of the Securities and Exchange Commission (SEC) by which the public may view the Company’s annual report on Form 10-K, its quarterly reports on Form 10-Q, its current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after those reports are filed with or furnished to the SEC.

Forward-Looking Statements and Associated Risks.

The Company from time to time in its oral and written communications makes statements relating to its expectations regarding the future. These types of statements are considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements can include statements about the Company’s net interest income or net interest margin; adequacy of allowance for loan losses, and the quality of the Company’s loans, investment securities and other assets; simulations of changes in interest rates; litigation results; dividend policy; estimated cost savings, plans and objectives for future operations; and expectations about the Company’s financial and business performance and other business matters as well as economic and market conditions and trends. They often can be identified by the use of words like “expect,” “may,” “will,” “would,” “could,” “should,” “intend,” “project,” “estimate,” “believe” or “anticipate,” or similar expressions.

The Company may include forward-looking statements in filings with the SEC, such as this Form 10-K, in other written materials, and in oral statements made by senior management to analysts, investors, representatives of the media, and others. It is intended that these forward-looking statements speak only as of the date they are made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the forward-looking statement is made.

Readers are cautioned that, by their nature, forward-looking statements are based on assumptions and are subject to risks, uncertainties, and other factors. Actual results may differ materially from the expectations of the Company that are expressed or implied by any forward-looking statement. The discussions in Item 1A, “Risk Factors,” and in Item 7 of this Form 10-K, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” list some of the factors that could cause the Company’s actual results to vary materially from those expressed or implied by any forward-looking statements. Other risks, uncertainties, and factors that could cause the Company’s actual results to vary materially from those expressed or implied by any forward-looking statement include the unknown future direction of interest rates and the timing and magnitude of any changes in interest rates; the effects of changes in competitive conditions; acquisitions of other businesses or intangible customer relationships of other companies by the Company and costs of integrations of such acquired businesses and intangible customer relationships; the introduction, withdrawal, success, and timing of business initiatives and strategies; changes in customer borrowing, repayment, investment, and deposit practices; changes in fiscal, monetary, and tax policies; changes in financial and capital markets; changes in general economic conditions, either nationally or regionally, resulting in, among other things, credit quality deterioration; the impact, extent and timing of technological changes; capital management activities; actions of the Federal Reserve Board and legislative and regulatory actions and reforms; changes in accounting principles and interpretations; the inherent uncertainties involved in litigation and regulatory proceedings which could result in the Company’s incurring loss or damage regardless of the merits of the Company’s claims or defenses; and the continued availability of earnings and excess capital sufficient for the lawful and prudent declaration and payment of cash dividends. Investors should consider these risks, uncertainties, and other factors in addition to those mentioned by the Company in its other SEC filings from time to time when considering any forward-looking statement.
 
 

5

 
Item 1A. Risk Factors.

While we a have a history of profitability and operate in mature industries with capital that substantially exceeds the requirements of bank regulatory agencies, an investment in our common stock (like an investment in the equity securities of any business enterprise) is subject to investment risks and uncertainties. The following describes some of the principal risks and uncertainties to which we and our assets and businesses are subject; other risks are briefly identified in our cautionary statement that is included “Forward-Looking Statements and Associated Risks” in Part I, Item 1, “Business.” Although we seek ways to manage these risks and uncertainties and to develop programs to control those that we can, we ultimately cannot predict the future. Future results may differ materially from past results, and from our expectations and plans.

If our actual loan losses exceed our estimates, our earnings and financial condition will be impacted.

A significant source of risk for any bank or other enterprise that lends money arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail (because of financial difficulties or other reasons) to perform in accordance with the terms of their loan agreements. In our case, we originate many loans that are secured, but some loans are unsecured depending on the nature of the loan. With respect to secured loans, the collateral securing the repayment of these loans includes a wide variety of real and personal property that may be insufficient to cover the obligations owed under such loans. Collateral values may be adversely affected by changes in prevailing economic, environmental and other conditions, including declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government, wide-spread disease, terrorist activity, environmental contamination, natural disasters, and other external events. We have adopted underwriting and credit monitoring procedures and policies, including the establishment and review of the allowance for loan losses and regular review of appraisals and borrower financial statements, that we believe are appropriate to mitigate the risk of loss by assessing the likelihood of nonperformance and the value of available collateral, monitoring loan performance and diversifying our credit portfolio. Such policies and procedures, however, may not prevent unexpected losses that could have a material adverse effect on our business, financial condition, results of operations or liquidity. For additional information regarding our asset quality, see Part II, Item 7 (“Management’s Discussion and Analysis of Financial Condition and Results of Operations.”)

We could be adversely affected by changes in interest rates. 

Our earnings depend largely on the relationship between the yield on earning assets, primarily loans and investments, and the cost of funds, primarily deposits and borrowings. This relationship, known as the interest rate spread, is subject to fluctuation and is affected by economic and competitive factors which influence interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities and the level of non-performing assets. Fluctuations in interest rates affect the demand of customers for our products and services. We are subject to interest rate risk to the degree that our interest-bearing liabilities reprice or mature more slowly or more rapidly or on a different basis than its interest-earning assets. Significant fluctuations in interest rates could have a material adverse effect on our business, financial condition, results of operations or liquidity. For additional information regarding interest rate risk, see Part II, Item 7A, (“Quantitative and Qualitative Disclosures About Market Risk.”)

Our success is tied to the economic vitality of our Southern Indiana markets.

We conduct business from offices that are exclusively located in ten contiguous counties of Southern Indiana, from which substantially all of our customer base is drawn. Because of the geographic concentration of our operations and customer base, our results depend largely upon economic conditions in this area. Deterioration in economic conditions in this area could adversely affect the quality of our loan portfolio and the demand for our products and services, and accordingly, could have a material adverse effect on our business, financial condition, results of operations or liquidity. See also Part I, Item 1, “Business --- Competition.”
 
6

 
We face substantial competition.

The banking and financial services business in our markets is highly competitive. We compete with much larger regional, national, and international competitors. In addition, new banks could be organized in our market area which might bid aggressively for new business to capture market share in these markets. Developments increasing the nature or level of our competition, or decreasing the effectiveness by which we compete, could have a material adverse effect on our business, financial condition, results of operations or liquidity. See also “Competition,” and “Regulation and Supervision.”

Our business expansion and capital management strategies may be less successful than planned.

We from time to time consider opportunities to expand our business including strategies for launching new internal business initiatives and buying or investing in other businesses or business assets. Our earnings and financial condition could be adversely affected to the extent that the acquisitions or other business initiatives and strategies are not successful (or take longer than expected to achieve expected results) and such initiative or strategies could even result in losses. We also from time to time engage in activities (such as repurchasing and issuing our capital stock or other securities, and utilizing the borrowing capacity of our parent company to borrow funds from third party lenders on short and long term bases) in order to manage our capital structure and to finance acquisitions in a manner that we believe is most advantageous. These capital management activities and financing activities, however, also carry risks in the event that our business does not develop as expected or there are changes in the market for our common stock or in the capital and financial markets generally.

We operate in a highly regulated environment and changes in laws and regulations to which we are subject may adversely affect our results of operations.

The banking industry in which we operate is subject to extensive regulation and supervision under federal and state laws and regulations. The restrictions imposed by such laws and regulations limit the manner in which we conduct our business, undertake new investments and activities and obtain financing. These regulations are designed primarily for the protection of the deposit insurance funds and consumers and not to benefit our shareholders. Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation, none of which is in our control. Significant new laws or changes in, or repeals of, existing laws (including changes in federal or state laws affecting corporate taxpayers generally or financial institutions specifically) could have a material adverse effect on our business, financial condition, results of operations or liquidity. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects credit conditions, and any unfavorable change in these conditions could have a material adverse effect on our business, financial condition, results of operations or liquidity. See also Part I, Item 1, “Business -- Supervision and Regulation of Banking Activities.”

The manner in which we report our financial condition and results of operations may be affected by accounting changes.

Our financial condition and results of operations that are presented in the Consolidated Financial Statements, accompanying Notes to the Consolidated Financial Statements, and selected financial data appearing elsewhere within this report, are, to a large degree, dependent upon our accounting policies. The selection of and application of these policies involve estimates, judgments and uncertainties that are subject to change, and the effect of any change in estimates or judgments that might be caused by future developments or resolution of uncertainties could be materially adverse to our reported financial condition and results of operations. See the discussion of critical accounting policies and estimates that we have determined to be the most susceptible to change in the near term that is included in the section captioned “Critical Accounting Policies and Estimates” in Part II, Item 7 (“Management’s Discussion and Analysis of Financial Condition and Results of Operations”) for a complete discussion. In addition, authorities that prescribe accounting principles and standards for public companies from time to time change those principles or standards or adopt formal or informal interpretations of existing principles or standards, which changes or interpretations (to the extent applicable to us) could result in changes that would be materially adverse to our reported financial condition and results of operations.

Item 1B. Unresolved Staff Comments.

None.
 
7

 
Item 2. Properties.

The Company’s executive offices are located in the main office building of its bank subsidiary, German American Bancorp, at 711 Main Street, Jasper, Indiana. The main office building contains approximately 23,600 square feet of office space. The Company’s subsidiaries conduct their operations from 36 other locations in Southern Indiana.

Item 3. Legal Proceedings.

There are no material pending legal proceedings, other than routine litigation incidental to the business of the Company’s subsidiaries, to which the Company or any of its subsidiaries is a party or of which any of their property is the subject.

Item 4. Submission of Matters to a Vote of Security Holders.

There were no matters submitted during the fourth quarter of 2006 to a vote of security holders, by solicitation of proxies or otherwise.
 
PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Market and Dividend Information

German American Bancorp, Inc.’s stock is traded on NASDAQ’s Global Select Market under the symbol GABC. The quarterly high and low closing prices for the Company’s common stock as reported by NASDAQ and quarterly cash dividends declared and paid are set forth in the table below.

   
2006
 
 2005
 
   
High
 

Low
 
Cash
Dividend
 
High
 
Low
 
Cash
Dividend
 
                           
Fourth Quarter
 
$
14.41
 
$
13.59
 
$
0.140
 
$
13.64
 
$
12.71
 
$
0.140
 
Third Quarter
 
$
14.39
 
$
12.89
 
$
0.140
 
$
14.74
 
$
13.30
 
$
0.140
 
Second Quarter
 
$
13.65
 
$
12.90
 
$
0.140
 
$
15.21
 
$
12.53
 
$
0.140
 
First Quarter
 
$
13.70
 
$
12.83
 
$
0.140
 
$
15.98
 
$
15.18
 
$
0.140
 
               
$
0.560
             
$
0.560
 

The Common Stock was held of record by approximately 3,425 shareholders at March 1, 2007.

Cash dividends paid to the Company’s shareholders are primarily funded from dividends received by the Company from its bank subsidiary. The declaration and payment of future dividends will depend upon the earnings and financial condition of the Company and its subsidiaries, general economic conditions, compliance with regulatory requirements affecting the ability of the bank subsidiary to declare dividends, and other factors.

Transfer Agent:
 
UMB Bank, N.A.
 
Shareholder
 
Terri A. Eckerle
   
Securities Transfer Division
 
Information and
 
German American Bancorp, Inc
   
P.O. Box 410064
 
Corporate Office:
 
P. O. Box 810
   
Kansas City, MO 64141-0064
Contact: Shareholder Relations
(800) 884-4225
     
Jasper, Indiana 47547-0810
(800) 482-1314
(812) 482-1314

Stock Performance Graph

The following graph compares the Corporation’s five-year cumulative total returns with those of the Russell 2000 Stock Index and the Indiana Bank Peer Group. The Indiana Bank Peer Group (which is a custom peer group identified by Company management) includes all Indiana-based commercial bank holding companies (excluding companies owning thrift institutions that are not regulated as bank holding companies) that have been in existence as commercial bank holding companies throughout the five-year period ended December 2006, the stocks of which have been traded on an established securities market (NYSE, AMEX, NASDAQ) throughout that five-year period. The returns of each company in the Indiana Bank Peer Group have been weighted to reflect the company’s market capitalization. The Russell 2000 Stock Index is an index consisting of the 1,001st through 3,000th largest United States traded stocks, based on market capitalization, which is annually reconstituted at the end of each June. The Company’s stock was included in the Russell 2000 Index as it was constituted from July 2001 through June 2005.
 
8

 
stockperformancegraph logo

Stock Repurchase Program Information 
 
The following table sets forth information regarding the Company’s purchases of its common shares during each of the three months ended December 31, 2006.

Period
 
Total
Number
Of Shares
(or Units)
Purchased
 
Average Price
Paid Per Share
(or Unit)
 
Total Number of Shares
(or Units) Purchases as Part
of Publicly Announced Plans
or Programs
 
Maximum Number
(or Approximate Dollar
Value) of Shares (or Units)
that May Yet Be Purchased
Under the Plans or Programs (1)
 
                   
October 2006
   
   
   
   
272,789
 
   
   
   
   
272,789
 
December 2006
   
   
   
   
272,789
 
 
(1) On April 26, 2001, the Company announced that its Board of Directors had approved a stock repurchase program for up to 607,754 of its outstanding common shares, of which the Company had purchased 334,965 common shares through December 31, 2006 (both such numbers adjusted for subsequent stock dividends). The Board of Directors established no expiration date for this program. The Company purchased no shares under this program during the quarter ended December 31, 2006.
 
9

 
Item 6. Selected Financial Data.

The following selected data should be read in conjunction with the consolidated financial statements and related notes that are included in Item 8 of this Report, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which is included in Item 7 of this Report (dollars in thousands, except per share data).
 
   
2006
 
2005
 
2004
 
2003
 
2002
 
Summary of Operations:
                     
Interest Income
 
$
63,594
 
$
50,197
 
$
47,710
 
$
50,619
 
$
60,494
 
Interest Expense
   
27,398
   
17,984
   
16,471
   
21,084
   
28,492
 
Net Interest Income
   
36,196
   
32,213
   
31,239
   
29,535
   
32,002
 
Provision for Loan Losses
   
925
   
1,903
   
2,015
   
811
   
1,115
 
Net Interest Income after Provision
                               
For Loan Losses
   
35,271
   
30,310
   
29,224
   
28,724
   
30,887
 
Non-interest Income
   
15,390
   
14,194
   
9,620
(1)
 
12,934
   
9,509
 
Non-interest Expense
   
36,456
   
31,448
   
30,609
   
32,219
(2)
 
28,967
 
Income before Income Taxes
   
14,205
   
13,056
   
8,235
   
9,439
   
11,429
 
Income Tax Expense
   
3,984
   
3,335
   
996
   
1,271
   
1,987
 
Net Income
 
$
10,221
 
$
9,721
 
$
7,239
 
$
8,168
 
$
9,442
 
    
Year-end Balances:
                               
Total Assets
 
$
1,093,424
 
$
946,467
 
$
942,094
 
$
925,946
 
$
957,005
 
Total Loans, Net of Unearned Income
   
796,259
   
651,956
   
629,793
   
611,866
   
610,741
 
Total Deposits
   
867,618
   
746,821
   
750,383
   
717,133
   
707,194
 
Total Long-term Debt
   
68,333
   
66,606
   
69,941
   
76,880
(2)
 
121,687
 
Total Shareholders’ Equity
   
92,391
   
82,255
   
83,669
   
83,126
(3)
 
104,519
 
    
Average Balances:
                               
Total Assets
 
$
1,029,838
 
$
925,851
 
$
927,528
 
$
938,992
 
$
1,000,167
 
Total Loans, Net of Unearned Income
   
715,260
   
634,526
   
622,240
   
618,340
   
644,990
 
Total Deposits
   
814,440
   
730,220
   
731,467
   
711,310
   
718,763
 
Total Shareholders’ Equity
   
88,451
   
84,479
   
82,558
   
87,703
(3)
 
103,301
 
    
Per Share Data (4):
                               
Net Income
 
$
0.93
 
$
0.89
 
$
0.66
 
$
0.73
(3)
$
0.79
 
Cash Dividends
   
0.56
   
0.56
   
0.56
   
0.53
   
0.51
 
Book Value at Year-end
   
8.39
   
7.73
   
7.68
   
7.60
(3)
 
8.72
 
      
Other Data at Year-end:
                               
Number of Shareholders
   
3,438
   
3,494
   
3,219
   
3,198
   
3,299
 
Number of Employees
   
397
   
367
   
372
   
383
   
390
 
Weighted Average Number of Shares (4)
   
10,994,739
   
10,890,987
   
10,914,622
   
11,176,766
(3)
 
12,007,009
 
    
Selected Performance Ratios:
                               
Return on Assets
   
0.99
%
 
1.05
%
 
0.78
%
 
0.87
%
 
0.94
%
Return on Equity
   
11.56
%
 
11.51
%
 
8.77
%
 
9.31
%(3)
 
9.14
%
Equity to Assets
   
8.45
%
 
8.69
%
 
8.88
%
 
8.98
%(3)
 
10.92
%
Dividend Payout
   
60.30
%
 
62.83
%
 
84.46
%
 
73.26
%
 
64.99
%
Net Charge-offs to Average Loans
   
0.50
%
 
0.26
%
 
0.24
%
 
0.14
%
 
0.19
%
   
0.90
%
 
1.42
%
 
1.40
%
 
1.35
%
 
1.36
%
Net Interest Margin
   
3.96
%
 
3.92
%
 
3.86
%
 
3.61
%
 
3.67
%
 
(1)
In 2004, the Company recognized a $3.7 million non-cash pre-tax charge (which reduced Non-interest Income) for the other-than-temporary decline in value of its FHLMC and FNMA preferred stock portfolio. In 2006, the Company sold these same FHLMC and FNMA preferred stocks and recognized a pre-tax gain of $951.
 
(2)
In 2003, the Company prepaid $40.0 million of FHLB borrowings within its mortgage banking segment. The prepayment fees associated with the extinguishment of these borrowings totaled $1.9 million.
 
(3)
In March 2003, the Company purchased 1,110,444 (approximately 9% of the number of shares that were then outstanding) of its common shares at $19.05 per share pursuant to a self tender offer at a total cost, including fees and expenses incurred in connection with the offer, of approximately $21.4 million.
 
(4)
Share and Per Share Data has been retroactively adjusted to give effect for stock dividends and excludes the dilutive effect of stock options.
 
Year to year financial information comparability is affected by the purchase accounting treatment for mergers and acquisitions. See Note 18 to the Company’s consolidated financial statements included in Item 8 of this Report.
 
10

 
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

INTRODUCTION


German American Bancorp, Inc. is a financial services holding company based in Jasper, Indiana. The Company’s Common Stock is traded on NASDAQ’s Global Select Market, under the symbol GABC. The principal subsidiary of German American Bancorp, Inc., is its banking subsidiary, German American Bancorp, which operates through six community banking affiliates with 30 retail banking offices in the ten contiguous Southern Indiana counties of Daviess, Dubois, Gibson, Knox, Lawrence, Martin, Monroe, Perry, Pike, and Spencer. German American Bancorp, Inc., also owns a trust, brokerage, and financial planning subsidiary, which operates from the banking offices of the bank subsidiary, and two insurance agencies with six insurance agency offices throughout its market area.

Throughout this Management’s Discussion and Analysis, as elsewhere in this report, when we use the term “Company”, we will usually be referring to the business and affairs (financial and otherwise) of the Company and its subsidiaries and affiliates as a whole. Occasionally, we will refer to the term “parent company” or “holding company” when we mean to refer to only German American Bancorp, Inc.

The information in this Management’s Discussion and Analysis is presented as an analysis of the major components of the Company’s operations for the years 2004 through 2006 and its financial condition as of December 31, 2006 and 2005. This information should be read in conjunction with the accompanying consolidated financial statements and footnotes contained elsewhere in this report and with the description of business included in Item 1 of this Report (including the cautionary disclosure regarding “Forward Looking Statements and Associated Risks”). Financial and other information by segment is included in Note 16 to the Company’s consolidated financial statements included in Item 8 of this Report and is incorporated into this Item 7 by reference.

The statements of management’s expectations and goals concerning the Company’s future operations and performance that are set forth in the following Management Overview and in other sections of this Item 7 are forward-looking statements, and readers are cautioned that these forward-looking statements are based on assumptions and are subject to risks, uncertainties, and other factors. Actual results may differ materially from the expectations of the Company that is expressed or implied by any forward-looking statement. This Item 7, as well as the discussions in Item 1 (“Business”) entitled “Forward-Looking Statements and Associated Risks” and in Item 1A (“Risk Factors”) (which discussions are incorporated in this Item 7 by reference) list some of the factors that could cause the Company’s actual results to vary materially from those expressed or implied by any such forward-looking statements.
 
MANAGEMENT OVERVIEW
 
The Company’s net income increased 5% in 2006 compared with 2005. The Company’s 2006 net income totaled $10,221,000, or $0.93 per share, compared with $9,721,000, or $0.89 per share, for 2005. Current year earnings were positively affected by increases within the Company’s net interest income and non-interest income as well as a reduced level of provision for loan losses. The improvement in the level of net interest income was largely attributable to strong loan growth. Loans outstanding grew by $145.1 million or 22% during 2006. The increase in non-interest income was primarily credited to the gain derived from the sale of the Company’s portfolio of agency-issued preferred stock during the third quarter of 2006 and an increased level of insurance revenues. An offsetting factor to these positive earnings contributors was an increased level of non-interest related operating expenses due in large part to the inclusion of the recent banking and insurance acquisitions.

Effective January 1, 2006, the Company completed the acquisition of Stone City Bancshares, Inc. which was in an adjacent market to its primary market area and effective October 1, 2005, the Company completed the in-market acquisition of PCB Holding Company. In addition to these acquisitions, during the three-year period ended December 31, 2006, the Company invested in non-controlling interests in the common stocks of four separate banking companies that operate in the Indianapolis, Evansville, Louisville, and Terre Haute/Lafayette (Indiana) banking markets. As a result of making these four non-controlling investments, the Company has the opportunity to bid to purchase participations in loans that may be originated by these other banking companies from time to time, if and to the extent that the banking company desires to sell participations in such loans to third parties. During the fourth quarter of 2006, the Company expanded its agricultural lending business by acquiring the Southern Indiana-based agricultural loan portfolio of a regional banking company. Finally, effective October 1, 2006, the Company completed the acquisition of the insurance agency business of Keach and Grove Insurance, Inc. of Bedford, Indiana which was in the market of the Company’s recent banking acquisition of Stone City Bancshares, Inc. These acquisitions, purchases and investments have been undertaken to supplement organic growth within the Company’s primary markets. Management expects to continue to pursue similar strategic acquisition and investing opportunities should opportunities become available.
 
11

 
Effective September 30, 2006, the Company combined the charters of its six subsidiary banks into a single bank charter in order to simplify its corporate structure and better serve its customers, while retaining local direction of affiliate bank operations under the existing distinctive bank trade names in each of the markets served by the Company.

MERGERS AND ACQUISITIONS

On October 1, 2005 PCB Holding Company (“PCB”) merged with and into the Company. PCB’s sole banking subsidiary, Peoples Community Bank, operated two banking offices in Tell City, Indiana. PCB’s assets and equity (unaudited) as of September 30, 2005 totaled $34.6 million and $4.8 million, respectively. Under the terms of the merger, the shareholders of PCB received an aggregate of 257,029 shares of common stock of the Company valued at approximately $3.5 million and approximately $3.2 million of cash, representing a total transaction value of $6.7 million. This merger was accounted for under the purchase method of accounting.

On January 1, 2006, Stone City Bancshares, Inc. (“Stone City”) merged with and into the Company, and as a result acquired all of the stock of Stone City’s sole banking subsidiary, Stone City Bank of Bedford, Indiana, which operated two banking offices in Bedford, Indiana. Stone City’s assets and equity as of December 31, 2005 totaled $61.2 million and $5.4 million, respectively. Under the terms of the merger, the shareholders of Stone City received aggregate cash payments of approximately $6.4 million and 349,468 common shares of the Company valued during a pre-closing valuation period of approximately $4.6 million, representing a total transaction value of approximately $11.0 million. This merger was accounted for under the purchase method of accounting.

On October 1, 2006 the Company acquired substantially all of the assets, net of certain assumed liabilities of Keach and Grove Insurance, Inc. of Bedford, Indiana. The agency operations became a part of German American Insurance, Inc., the Company’s property and casualty insurance entity. The purchase price for this transaction was $2.26 million in cash. This merger was accounted for under the purchase method of accounting.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES


The financial condition and results of operations for German American Bancorp, Inc. presented in the Consolidated Financial Statements, accompanying Notes to the Consolidated Financial Statements, and selected financial data appearing elsewhere within this report, are, to a large degree, dependent upon the Company’s accounting policies. The selection of and application of these policies involve estimates, judgments and uncertainties that are subject to change. The critical accounting policies and estimates that the Company has determined to be the most susceptible to change in the near term relate to the determination of the allowance for loan losses, the valuation of securities available for sale, and the valuation allowance on deferred tax assets and loss contingencies related to exposure from tax examinations.
 
Allowance for Loan Losses
 
The Company maintains an allowance for loan losses to cover probable incurred credit losses at the balance sheet date. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. A provision for loan losses is charged to operations based on management’s periodic evaluation of the necessary allowance balance. Evaluations are conducted at least quarterly and more often if deemed necessary. The ultimate recovery of all loans is susceptible to future market factors beyond the Company’s control.

The Company has an established process to determine the adequacy of the allowance for loan losses. The determination of the allowance is inherently subjective, as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on other classified loans and pools of homogeneous loans, and consideration of past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors, all of which may be susceptible to significant change. The allowance consists of two components of allocations, specific and general. These two components represent the total allowance for loan losses deemed adequate to cover losses inherent in the loan portfolio.

Commercial and agricultural loans are subject to a standardized grading process administered by an internal loan review function. The need for specific reserves is considered for credits when graded substandard or special mention, or when: (a) the customer’s cash flow or net worth appears insufficient to repay the loan; (b) the loan has been criticized in a regulatory examination; (c) the loan is on non-accrual; or, (d) other reasons where the ultimate collectibility of the loan is in question, or the loan characteristics require special monitoring. Specific allowances are established in cases where management has identified significant conditions or circumstances related to an individual credit that we believe indicates the loan is impaired. Specific allocations on impaired loans are determined by comparing the loan balance to the present value of expected cash flows or expected collateral proceeds. Allocations are also applied to categories of loans not considered individually impaired but for which the rate of loss is expected to be greater than historical averages, including those graded substandard or special mention and non-performing consumer or residential real estate loans. Such allocations are based on past loss experience and information about specific borrower situations and estimated collateral values.
 
12

 
General allocations are made for other pools of loans, including non-classified loans, homogeneous portfolios of consumer and residential real estate loans, and loans within certain industry categories believed to present unique risk of loss. General allocations of the allowance are primarily made based on a five-year historical average for loan losses for these portfolios, judgmentally adjusted for economic factors and portfolio trends.

Due to the imprecise nature of estimating the allowance for loan losses, the Company’s allowance for loan losses includes a minor unallocated component. The unallocated component of the allowance for loan losses incorporates the Company’s judgmental determination of inherent losses that may not be fully reflected in other allocations, including factors such as economic uncertainties, lending staff quality, industry trends impacting specific portfolio segments, and broad portfolio quality trends. Therefore, the ratio of allocated to unallocated components within the total allowance may fluctuate from period to period.

Mortgage Servicing Rights Valuation

Mortgage servicing rights (MSRs) were recognized and included with other assets for the allocated value of retained servicing rights on loans sold. Servicing rights were expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment was evaluated based on the fair value of the rights, using groupings of the underlying loans as to type and age. Fair value was determined based upon discounted cash flows using market-based assumptions.

To determine the fair value of MSRs, the Company used a valuation model that calculated the present value of estimated future net servicing income. In using this valuation method, the Company incorporated assumptions that market participants would use in estimating future net servicing income, which included estimates of prepayment speeds, discount rate, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, late fees, and float income.

The Company sold its mortgage servicing rights portfolio during the second quarter of 2006. Currently, all residential loans that are sold in the secondary market are sold on a servicing released basis.

Securities Valuation

Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported separately in accumulated other comprehensive income (loss), net of tax. The Company obtains market values from a third party on a monthly basis in order to adjust the securities to fair value. Additionally, all securities are required to be written down to fair value when a decline in fair value is other than temporary; therefore, future changes in the fair value of securities could have a significant impact on the Company’s operating results. In determining whether a market value decline is other than temporary, management considers the reason for the decline, the extent of the decline and the duration of the decline. See Note 2 in the accompanying Consolidated Financial Statements for information regarding unrealized losses on the securities.

Income Tax Expense

Income tax expense involves estimates related to the valuation allowance on deferred tax assets and loss contingencies related to exposure from tax examinations.

A valuation allowance reduces deferred tax assets to the amount management believes is more likely than not to be realized. In evaluating the realization of deferred tax assets, management considers the likelihood that sufficient taxable income of appropriate character will be generated within carryback and carryforward periods, including consideration of available tax planning strategies. As of December 31, 2006, the Company had a deferred tax asset of $1.9 million representing various tax credit carryforwards. Based on the long carryforward periods available, management has assessed it more likely than not that these credits will be realized and no valuation allowance has been established on this asset.

Loss contingencies, including assessments arising from tax examinations and tax strategies, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. In considering the likelihood of loss, management considers the nature of the contingency, the progress of any examination or related protest or appeal, the views of legal counsel and other advisors, experience of the Company or other enterprises in similar matters, if any, and management’s intended response to any assessment.
 
13

 
During the first quarter of 2005, the Company received notices of proposed assessments of unpaid financial institutions tax for the years 2001 and 2002 of approximately $691,000 ($456,000 net of federal tax), including interest and penalties of approximately $100,000. The Company filed a protest with the Indiana Department of Revenue contesting the proposed assessments and vigorously defended its position that the income of the Nevada subsidiaries was not subject to the Indiana financial institutions tax. Therefore, no tax provision was recognized for the potential assessment of additional financial institutions tax for 2001 and 2002 or for financial institutions tax with respect to any of the Nevada subsidiaries in any period subsequent to 2002, including the year ended December 31, 2006.

During the first quarter of 2007, the Company and the Indiana Department of Revenue entered into an agreement regarding the proposed assessment for tax years 2001 and 2002. As a result of this agreement the Company was not required to pay any tax liability as assessed by the Indiana Department of Revenue for tax years 2001 and 2002. In addition, tax years 2001 and 2002 are closed to further examination.

RESULTS OF OPERATIONS


NET INCOME

Net income increased $500,000 or 5% to $10,221,000 or $0.93 per share in 2006 compared to $9,721,000 or $0.89 per share during 2005. The increase in net income during 2006 compared with 2005 was attributable principally to an increase in net interest income of $3,983,000, a reduction in provision for loan losses of $978,000, and a gain on the sale of the Company’s portfolio of agency preferred stock of $951,000, which were partially mitigated by an increase of $5,008,000 in non-interest expense. The increases in net interest income and non-interest expenses were largely attributable to acquisitions of PCB Holding Company and Stone City Bancshares, Inc., which are discussed in Note 18 to the consolidated financial statements included in Item 8 of this Report.

Net income increased $2,482,000 or 34% to $9,721,000 or $0.89 per share in 2005 compared to $7,239,000 or $0.66 per share during 2004. The earnings increase was largely attributable to the inclusion in 2004’s results of an after-tax charge of $2,430,000 or $0.23 per share, related to other-than-temporary impairment of the Company’s portfolio of Federal Home Loan Mortgage Corporation (“FHLMC”) and Federal National Mortgage Association (“FNMA”) preferred stocks. In addition to the effect of the securities impairment charge, the earnings comparison of 2005 to 2004 was positively impacted by improvements in net interest income of $974,000, as well as increases in the level of other non-interest income. Non-interest income, excluding the impairment charge on equity securities in 2004, increased by approximately $891,000 in 2005 compared to 2004. Those increases were partially mitigated by increased non-interest expense of $839,000, a significant portion of which related to increased employee health insurance costs, and increased income tax expense of $2,339,000 ($1,087,000 excluding the tax effect of the impairment charge in 2004).

NET INTEREST INCOME

Net interest income is the Company’s single largest source of earnings, and represents the difference between interest and fees realized on earning assets, less interest paid on deposits and borrowed funds. Several factors contribute to the determination of net interest income and net interest margin, including the volume and mix of earning assets, interest rates, and income taxes. Many factors affecting net interest income are subject to control by management policies and actions. Factors beyond the control of management include the general level of credit and deposit demand, Federal Reserve Board monetary policy, and changes in tax laws.

Net interest income increased $3,983,000 or 12% (an increase of $3,809,000 or 11% on a tax-equivalent basis) for the year ended 2006 compared with 2005. The increase in net interest income was primarily attributable to an increased level of average earning assets and an increased net interest margin for the year ended 2006 compared with 2005. The higher level of earning assets was primarily attributable to an increase in the average level of loans outstanding that resulted from new loan activity and from the previously discussed banking acquisitions completed effective October 1, 2005 and effective January 1, 2006. Average earning assets totaled $941.6 million during 2006 compared with $853.3 million during 2005.

For 2006, the net interest margin increased to 3.96% compared to 3.92% during 2005. Net interest margin is tax equivalent net interest income expressed as a percentage of average earning assets. The Company’s yield on earning assets totaled 6.87% compared with a cost of funds (expressed as a percentage of average earning assets) of 2.91% producing the net interest margin of 3.96% for the year ended December 31, 2006. The Company’s yield on earning assets was 6.03% compared with a cost of funds of 2.11% netting to a net interest margin of 3.92% for the year ended December 31, 2005.
 
14


Net interest income increased $974,000 or 3% ($576,000 or 2% on a tax-equivalent basis) in 2005 compared with 2004. For 2005, the net interest margin increased to 3.92% compared with 3.86% in 2004. The Company’s increase in net interest income during 2005 compared with 2004 was largely attributable to the increase in the net interest margin. The Company’s yield on earning assets increased to 6.03% during 2005 compared with 5.79% for 2004. The increased yield on earning assets was primarily attributable to higher short-term interest rates and an increased level of loans outstanding during 2005 compared with 2004. The Company’s cost of funds (expressed as a percentage of average earning assets) during 2005 was 2.11% compared with 1.93% for 2004. The increase in the cost of funds was due to a rise in short-term market interest rates tempered by an increased level of non-maturity deposits including non-interest bearing demand accounts, less reliance on time deposits and borrowings and a decline in interest rates on outstanding borrowings from the Federal Home Loan Bank due to repayments of higher-cost advances that were outstanding in 2004.
 
15

 
The following table summarizes net interest income (on a tax-equivalent basis) for each of the past three years. For tax-equivalent adjustments, an effective tax rate of 34% was used for all years presented (1).

Average Balance Sheet
(Tax-equivalent basis / dollars in thousands)
 
   
Twelve Months
Ended
 
Twelve Months
Ended
 
Twelve Months
Ended
 
   
December 31, 2006
 
December 31, 2005
 
December 31, 2004
 
 
 
Principal
 
Income/
 
Yield /
 
Principal
 
Income/
 
Yield /
 
Principal
 
Income/
 
Yield /
 
 
 
Balance
 
Expense
 
Rate
 
Balance
 
Expense
 
Rate
 
Balance
 
Expense
 
Rate
 
                                       
ASSETS
                                     
Federal Funds Sold and Other
                                     
Short-term Investments
 
$
10,971
 
$
545
   
4.97
%
$
10,632
 
$
316
   
2.97
%
$
10,635
 
$
129
   
1.21
%
                                                         
Securities:
                                                       
Taxable
   
174,007
   
7,763
   
4.46
%
 
161,499
   
5,954
   
3.69
%
 
161,601
   
5,455
   
3.38
%
Non-taxable
   
41,312
   
2,721
   
6.59
%
 
46,666
   
3,297
   
7.07
%
 
57,729
   
4,347
   
7.53
%
Total Loans and Leases (2)
   
715,260
   
53,621
   
7.50
%
 
634,526
   
41,860
   
6.60
%
 
622,240
   
39,407
   
6.33
%
                                                         
TOTAL INTEREST
                                                       
EARNING ASSETS
   
941,550
   
64,650
   
6.87
%
 
853,323
   
51,427
   
6.03
%
 
852,205
   
49,338
   
5.79
%
                                                         
Other Assets
   
97,570
               
81,771
               
83,960
             
Less: Allowance for Loan Losses
   
(9,282
)
             
(9,243
)
             
(8,637
)
           
                                                         
TOTAL ASSETS
 
$
1,029,838
             
$
925,851
             
$
927,528
             
                                                         
LIABILITIES AND
                                                       
SHAREHOLDERS’ EQUITY
                                                       
Interest-Bearing Demand Deposits
 
$
140,786
 
$
2,625
   
1.86
%
$
137,318
 
$
1,436
   
1.05
%
$
121,173
 
$
557
   
0.46
%
Savings Deposits
   
174,095
   
4,263
   
2.45
%
 
156,820
   
2,212
   
1.41
%
 
163,272
   
1,188
   
0.73
%
Time Deposits
   
369,800
   
14,441
   
3.91
%
 
314,420
   
9,741
   
3.10
%
 
330,898
   
10,002
   
3.02
%
FHLB Advances and
                                                       
Other Borrowings
   
113,559
   
6,069
   
5.34
%
 
98,932
   
4,595
   
4.64
%
 
101,067
   
4,724
   
4.67
%
                                                         
TOTAL INTEREST-BEARING
                                                       
LIABILITIES
   
798,240
   
27,398
   
3.43
%
 
707,490
   
17,984
   
2.54
%
 
716,410
   
16,471
   
2.30
%
                                                         
Demand Deposit Accounts
   
129,759
               
121,662
               
116,124
             
Other Liabilities
   
13,388
               
12,220
               
12,436
             
TOTAL LIABILITIES
   
941,387
               
841,372
               
844,970
             
                                                         
Shareholders’ Equity
   
88,451
               
84,479
               
82,558
             
                                                         
TOTAL LIABILITIES AND
                                                       
SHAREHOLDERS’ EQUITY
 
$
1,029,838
             
$
925,851
             
$
927,528
             
                                                         
NET INTEREST INCOME
       
$
37,252
             
$
33,443
             
$
32,867
       
                                                         
NET INTEREST MARGIN
               
3.96
%
             
3.92
%
             
3.86
%
 
(1)
 
Effective tax rates were determined as though interest earned on the Company’s investments in municipal bonds and loans was fully taxable.
 
(2)
Loans held-for-sale and non-accruing loans have been included in average  loans. Interest income on loans includes loan fees of $1,727, $1,326, and $1,442 for 2006, 2005, and 2004, respectively.
 
16

 
The following table sets forth for the periods indicated a summary of the changes in interest income and interest expense resulting from changes in volume and changes in rates:
 
Net Interest Income - Rate/Volume Analysis:
(Tax-Equivalent basis, dollars in thousands)
 
   
2006 compared to 2005
 
2005 compared to 2004
 
 
 
Increase / (Decrease) Due to (1)
 
Increase / (Decrease) Due to (1)
 
 
 
Volume
 
Rate
 
Net
 
Volume
 
Rate
 
Net
 
Interest Income:
                         
Federal Funds Sold and Other
                         
Short-term Investments
 
$
10
 
$
219
 
$
229
 
$ 
 
$
 187
 
$
187
 
Taxable Securities
   
487
   
1,322
   
1,809
   
(3
)
 
502
   
499
 
Non-taxable Securities
   
(362
)
 
(214
)
 
(576
)
 
(794
)
 
(256
)
 
(1,050
)
Loans and Leases
   
5,677
   
6,084
   
11,761
   
788
   
1,665
   
2,453
 
Total Interest Income
   
5,812
   
7,411
   
13,223
   
(9
)
 
2,098
   
2,089
 
                                       
Interest Expense:
                                     
Savings and Interest-bearing Demand
   
274
   
2,966
   
3,240
   
61
   
1,842
   
1,903
 
Time Deposits
   
1,896
   
2,804
   
4,700
   
(506
)
 
245
   
(261
)
FHLB Advances and Other Borrowings
   
730
   
744
   
1,474
   
(99
)
 
(30
)
 
(129
)
Total Interest Expense
   
2,900
   
6,514
   
9,414
   
(544
)
 
2,057
   
1,513
 
                                       
Net Interest Income
 
$
2,912
 
$
897
 
$
3,809
 
$
535
 
$
41
 
$
576
 
 
(1)
The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

See the Company’s Average Balance Sheet and the discussions headed USES OF FUNDS, SOURCES OF FUNDS, and “RISK MANAGEMENT - Liquidity and Interest Rate Risk Management” for further information on the Company’s net interest income, net interest margin, and interest rate sensitivity position.

PROVISION FOR LOAN LOSSES

The Company provides for loan losses through regular provisions to the allowance for loan losses. The provision is affected by net charge-offs on loans and changes in specific and general allocations required on the allowance for loan losses. Provisions for loan losses totaled $925,000, $1,903,000, and $2,015,000, in 2006, 2005 and 2004, respectively.

The Company’s provision for loan losses declined during 2006 in conjunction with a decline in the Company’s level of non-performing loans. The largest factor in the Company’s ability to recognize the reduced level of provision for loan losses was the finalization of settlement of a previously identified large nonperforming credit in the second quarter of 2006. The Company recognized a charge-off of approximately $393,000 on this individual credit facility. The specific allocation as of year end 2005 was for considerably more than the level of charge-off allowing the Company to recover the balance of the specific allocation assigned to this credit. For further discussion of non-performing loans refer to “Risk Management - Lending and Loan Administration.”

Loan loss provision remained relatively stable during 2005 compared with 2004. While net charge-offs increased in 2005, a portion of the increase in charge-offs was provided for prior to 2005.
 
These provisions were made at a level deemed necessary by management to absorb estimated, probable incurred losses in the loan portfolio. A detailed evaluation of the adequacy of the allowance for loan losses is completed quarterly by management, the results of which are used to determine provisions for loan losses. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Refer also to the sections entitled CRITICAL ACCOUNTING POLICIES AND ESTIMATES and “RISK MANAGEMENT - Lending and Loan Administration” for further discussion of the provision and allowance for loan losses.
 
17

 
NON-INTEREST INCOME

During 2006, Non-interest Income totaled $15,390,000, an increase of 8% compared with 2005. The increase during 2006 was largely attributable to the gain on the sale of the Company’s FHLMC and FNMA preferred stock portfolio and an increase in revenues generated by the Company’s insurance operations. During 2005, all categories of Non-interest Income increased. Non-interest Income for 2005 was $14,194,000, an increase of $4,574,000 or 48%, as compared to $9,620,000 in 2004. The increase in 2005 was predominantly attributable to an other-than-temporary impairment charge on the Company’s FHLMC and FNMA preferred stock portfolio recognized in the fourth quarter of 2004.
 
 
Years Ended December 31,
 
% Change From
Prior Year
 
Non-interest Income (dollars in thousands) 
   
2006
 
 
2005
 
 
2004
 
 
2006
 
 
2005
 
                                 
Trust and Investment Product Fees
 
$
2,210
 
$
2,081
 
$
2,046
   
     6%
 
 
    2%
 
Service Charges on Deposit Accounts
   
3,901
   
3,723
   
3,537
   
5
   
5
 
Insurance Revenues
   
5,094
   
4,703
   
4,666
   
8
   
1
 
Other Operating Income
   
2,384
   
2,687
   
2,074
   
(11)
 
 
30
 
Subtotal
   
13,589
   
13,194
   
12,323
   
3
   
7
 
Net Gains on Sales of Loans and Related Assets
   
850
   
1,000
   
975
   
(15)
 
 
3
 
Net Gain / (Loss) on Securities
   
951
       
(3,678
)
 
n/m(1)
 
 
n/m(1)
 
TOTAL NON-INTEREST INCOME
 
$
15,390
 
$
14,194
 
$
9,620
   
8
   
48
 
 
(1)
n/m = not meaningful

Insurance Revenues increased 8% for 2006 as compared 2005. The increased Insurance Revenues were primarily the result of a higher level of contingency revenues during 2006 compared with 2005 and the revenues generated from the insurance agency acquisition completed in the fourth quarter of 2006. For more information on the business combination, see Note 18 to the Company’s consolidated financial statements included in Item 8 of this Report. Insurance Revenues remained relatively stable for the year ended December 31, 2005 compared with 2004.

For the year ended 2006, Other Operating Income declined 11% compared with 2005. The decline for the year ended December 31, 2006 was predominately due to a gain on the sale of a former branch facility of approximately $313,000 that was recorded during the second quarter of 2005 and a higher level of recovery of mortgage servicing rights impairment charges during 2005 than during 2006. For the year ended 2005, Other Operating Income increased 30% as compared to the prior year. The increase during 2005 compared with 2004 was primarily due to the aforementioned gain from the sale of a former branch facility and a higher level of impairment recovery for mortgage servicing rights.
 
Net Gains on Sales of Loans and Related Assets declined 15% during 2006 following an increase of 3% in 2005. Loan sales for 2006, 2005, and 2004 were $55.6 million, $64.1 million, and $61.4 million, respectively. The decline during 2006 compared with the 2005 was largely due to a reduced level of sales of residential mortgage loans and a lower margin on those loans sold in the secondary market. The decline in gains from the sales of loans was somewhat offset by the sale of the Company’s mortgage servicing rights portfolio during the second quarter of 2006. The Company sold its mortgage servicing rights relating to approximately $344.5 million of mortgage loans serviced for others for a total sales price of $3.6 million resulting in a net gain of $198,000.

The Company recognized a gain on the sale of its portfolio of FHLMC and FNMA preferred stock during the third quarter of 2006. The gain from the sale of this agency preferred stock portfolio totaled $951,000. The portfolio had a book value at the time of the sale of approximately $12.1 million. The Company had previously recorded a non-cash other-than-temporary impairment charge of $3.7 million on this portfolio during 2004.
 
18

 
NON-INTEREST EXPENSE

For the year ended 2006, Non-interest Expense increased 16%. These increases in non-interest expense were largely attributable to the acquisitions of PCB Holding Company as of October 1, 2005 and Stone City Bancshares, Inc. as of January 1, 2006. For the year ended 2005, Non-interest Expense increased 3%.

 
Years Ended December 31,
 
% Change From
Prior Year
 
Non-interest Expense (dollars in thousands)
 
2006
 
2005
 
2004
 
2006
 
2005
 
                                 
Salaries and Employee Benefits
 
$
21,491
 
$
18,511
 
$
17,814
   
     16%
 
 
   4%
 
Occupancy, Furniture and Equipment Expense
   
4,988
   
4,404
   
4,292
   
13
   
3
 
FDIC Premiums
   
108
   
101
   
106
   
7
   
(5)
 
Data Processing Fees
   
1,646
   
1,322
   
1,186
   
25
   
11
 
Professional Fees
   
1,786
   
1,703
   
1,690
   
5
   
1
 
Advertising and Promotion
   
940
   
784
   
888
   
20
 
 
(12)
 
Supplies
   
619
   
544
   
527
   
14
   
3
 
Other Operating Expenses
   
4,878
   
4,079
   
4,106
   
20
   
(1)
 
TOTAL NON-INTEREST EXPENSE
 
$
36,456
 
$
31,448
 
$
30,609
   
16
   
3
 

Salaries and Employee Benefits increased 16% during 2006. The increase in Salaries and Employee Benefits Expense was primarily due to an increase in full-time equivalent employees attributable to the banking acquisitions completed effective October 1, 2005 and January 1, 2006 and to a lesser degree the insurance agency acquisition completed effective October 1, 2006. Also contributing to the increase in Salaries and Employee Benefits Expense to a lesser degree was the adoption of FAS 123R, “Share Based Payments,” as of January 1, 2006. In 2005, Salaries and Employee Benefits Expense increased 4%. The increase was primarily attributable to increased employee health insurance costs of $528,000.
 
Occupancy, Furniture and Equipment Expense increased 13% during 2006 compared with 2005. The increase was primarily attributable to the acquisition activity during 2005 and 2006. Occupancy, Furniture and Equipment Expense increased 3% in 2005. The increase was primarily attributable to a lowered amount of real estate and personal property tax expense recognized in 2004.

Data Processing Fees increased 25% during 2006 following an increase of 11% during 2005. These increases were largely attributable to the banking acquisition activity completed during 2005 and 2006. Advertising and Promotion expense increased 20% following a decline of 12% in 2005. The increase in 2006 compared with 2005 was largely attributable to the acquisition activity during 2006. The decline during 2005 was the result of more directed marketing campaigns during the year.

Other Operating Expenses increased 20% during 2006 following a modest decline of 1% during 2005. The increase was primarily attributable to a higher level of intangible amortization of $265,000 which resulted from the Company’s banking and insurance acquisitions during 2005 and 2006 and increased amortization and impairment charges during 2006 associated with one of the Company’s affordable housing limited partnership investments of $313,000. For further discussion of intangible amortization, see Note 18 to the Company’s consolidated financial statements included in Item 8 of this Report.

PROVISION FOR INCOME TAXES

The Company records a provision for current income taxes payable, along with a provision for deferred taxes payable in the future. Deferred taxes arise from temporary differences, which are items recorded for financial statement purposes in a different period than for income tax returns. The Company’s effective tax rate was 28.0%, 25.5%, and 12.1%, respectively, in 2006, 2005, and 2004. The higher effective tax rate in 2006 compared with both 2005 and 2004 was the result of higher levels of before tax net income combined with a lower level of tax-exempt investment income and a lower level of tax credits generated by investments in affordable housing projects. The effective tax rate in all periods is lower than the blended statutory rate of 39.6%. The lower effective rate in all periods primarily resulted from the Company’s tax-exempt investment income on securities and loans, income tax credits generated by investments in affordable housing projects, and income generated by subsidiaries domiciled in a state with no state or local income tax. See Note 11 to the Company’s consolidated financial statements included in Item 8 of this Report for additional details relative to the Company’s income tax provision.

Since December 31, 2001, the Company’s effective tax rate has been favorably impacted by Indiana financial institution tax savings resulting from the Company’s formation of investment subsidiaries in the state of Nevada by four of the Company’s banking subsidiaries.  The state of Nevada has no state or local income tax. During the first quarter of 2005, the Company received notices of proposed assessments of unpaid Indiana financial institutions tax for the years 2001 and 2002 of approximately $691,000 ($456,000 net of federal tax), including interest and penalties of approximately $100,000. The Company filed a protest with the Indiana Department of Revenue contesting the proposed assessments and vigorously defended its position that the income of the Nevada subsidiaries was not subject to the Indiana financial institutions tax. Therefore, no tax provision was recognized for the potential assessment of additional financial institutions tax for 2001 and 2002 or for financial institutions tax with respect to any of the Nevada subsidiaries in any period subsequent to 2002, including the year ended December 31, 2006.
 
19

 
During the first quarter of 2007, the Company and the Indiana Department of Revenue entered into an agreement regarding the proposed assessment for tax years 2001 and 2002. As a result of this agreement the Company was not required to pay any tax liability as assessed by the Indiana Department of Revenue for tax years 2001 and 2002. In addition, tax years 2001 and 2002 are closed to further examination.

CAPITAL RESOURCES


The Company and its affiliate bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. The prompt corrective action regulations provide five classifications, including well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, although these terms are not used to represent overall financial condition. The Company and its affiliate bank at year-end 2006 were categorized as well-capitalized as that term is defined by applicable regulations. The Company has agreed with its parent-company correspondent bank lender, JPMorgan Chase Bank, N.A., as a term of its credit facilities with that lender (see “SOURCES OF FUNDS - Parent Company Funding sources”, below) that it will maintain the capital ratios of the Company and its affiliate bank at levels that would qualify it as well-capitalized as that term is defined by the prompt corrective action regulations. See Note 9 to the Company’s consolidated financial statements included in Item 8 of this Report for actual and required capital ratios and for additional information regarding capital adequacy.

The Company continues to maintain a strong capital position. Shareholders’ equity totaled $92.4 million and $82.3 million at December 31, 2006 and 2005, respectively. Total equity represented 8.5% and 8.7%, respectively, of year-end total assets. The Company paid cash dividends of $6.2 million and $6.1 million or $0.56 per share in 2006 and 2005. The increase in shareholders’ equity during 2006 compared with 2005 was primarily the result of retained earnings, shares issued in conjunction with the Stone City Bancshares, Inc. acquisition, and a reduction in the unrealized loss on available for sale securities.

USES OF FUNDS

LOANS

Total loans at year-end 2006 increased $145.1 million or 22% compared with year-end 2005 including increases in each category of loans. The Company’s commercial and industrial loans increased $82.6 million or 26% and agricultural based loans increased $47.5 million or 47% during 2006. Consumer loans increased $3.2 million or 2% and residential mortgage loans increased $11.8 million or 11% during 2006. The growth during 2006 was generated from a variety of sources, including approximately $55.0 million of internally generated growth, $48.0 million related to the acquisition of Stone City Bancshares, Inc., and $42.1 million from the purchase of a Southern Indiana-based agricultural loan portfolio of a regional banking company in December 2006.

Total loans at year-end 2005 increased $22.5 million or 4% compared with year-end 2004 including increases in each category of loans. The Company’s commercial and industrial loans increased $5.9 million or 2% and agricultural based loans increased $1.8 million or 2% during 2005. Consumer loans increased $6.7 million or 6% during 2005. Residential mortgage loans increased $8.1 million or 9% during 2005. This increase reversed a trend over the past several years and was due in large part to the acquisition of Peoples Community Bank during the fourth quarter of 2005.

The Company’s loan portfolio is diversified, with the heaviest concentration in commercial and industrial loans. The composition of the loan portfolio remained relatively stable at year-end 2006 compared with year-end 2005. The acquisition of the agricultural loan portfolio in December 2006 increased the concentration of agricultural based loans to approximately 19% of the total loan portfolio. The largest concentration of loans continued to be in commercial and industrial loans, which comprised 50% of the total loan portfolio at year-end 2006, compared with 49% in 2005. The Company’s commercial lending is extended to various industries, including hotel, agribusiness and manufacturing, as well as health care, wholesale, and retail services.
 
20

 
Loan Portfolio
 
December 31,
 
dollars in thousands
 
2006
 
2005
 
2004
 
2003
 
2002
 
                       
Residential Mortgage Loans
 
$
114,687
 
$
102,891
 
$
94,800
 
$
110,325
 
$
156,180
 
Agricultural Loans
   
148,872
   
101,355
   
99,557
   
92,095
   
84,984
 
Commercial and Industrial Loans
   
402,285
   
319,681
   
314,354
   
296,661
   
254,776
 
Consumer Loans
   
132,791
   
129,587
   
122,888
   
114,816
   
116,987
 
Total Loans
   
798,635
   
653,514
   
631,599
   
613,897
   
612,927
 
Less: Unearned Income
   
(2,376
)
 
(1,558
)
 
(1,806
)
 
(2,031
)
 
(2,186
)
Subtotal
   
796,259
   
651,956
   
629,793
   
611,866
   
610,741
 
Less: Allowance for Loan Losses
   
(7,129
)
 
(9,265
)
 
(8,801
)
 
(8,265
)
 
(8,301
)
Loans, Net
 
$
789,130
 
$
642,691
 
$
620,992
 
$
603,601
 
$
602,440
 
                                 
Ratio of Loans to Total Loans:
                               
Residential Mortgage Loans
   
14
%
 
16
%
 
15
%
 
18
%
 
26
%
Agricultural Loans
   
19
%
 
15
%
 
16
%
 
15
%
 
14
%
Commercial and Industrial Loans
   
50
%
 
49
%
 
50
%
 
48
%
 
41
%
Consumer Loans
   
17
%
 
20
%
 
19
%
 
19
%
 
19
%
Totals
   
100
%
 
100
%
 
100
%
 
100
%
 
100
%

The Company’s policy is generally to extend credit to consumer and commercial borrowers in its primary geographic market area in Southern Indiana. Commercial extensions of credit outside this market area are generally concentrated in real estate loans within a 120 mile radius of the Company’s primary market and are granted on a selective basis. These out-of-market credits include participations that the Company may purchase from time to time in loans that are originated by the four banks in which the Company owns non-controlling common stock investments. These banks operate from headquarters in Indianapolis, Evansville, and Dana, Indiana (near Terre Haute) and Louisville, Kentucky; the bank in Dana, Indiana has branched into Lafayette, Indiana.

The following table indicates the amounts of loans (excluding residential mortgages on 1-4 family residences and consumer loans) outstanding as of December 31, 2006, which, based on remaining scheduled repayments of principal, are due in the periods indicated (dollars in thousands).

   
Within
One Year
 
One to Five
Years
 
After
Five Years
 
Total
 
                   
Commercial and Agricultural
 
$
211,032
 
$
229,485
 
$
110,640
 
$
551,157
 

   
Interest Sensitivity
 
   
Fixed Rate
 
Variable Rate
 
           
Loans maturing after one year
 
$
96,265
 
$
243,860
 

INVESTMENTS

The investment portfolio is a principal source for funding the Company’s loan growth and other liquidity needs of its subsidiaries. The Company’s securities portfolio consists of money market securities, uncollateralized U.S. Treasury and federal agency securities, municipal obligations of state and political subdivisions, asset- / mortgage-backed securities issued by U.S. government agencies and other intermediaries, and corporate investments. Money market securities include federal funds sold, interest-bearing balances with banks, and other short-term investments. The composition of the year-end balances in the investment portfolio is presented in Note 2 to the Company’s consolidated financial statements included in Item 8 of this Report and in the table below:

Investment Portfolio, at Amortized Cost
 
December 31,
 
dollars in thousands
 
2006
 
 %
 
 
2005
 
 %
 
 
2004
 
 %
 
                               
Federal Funds Sold and Short-term Investments
 
$
5,935
   
3
% 
 
$
5,287
   
3
% 
 
$
24,354
   
11%
 
U.S. Treasury and Agency Securities
   
28,083
   
15
     
13,631
   
7
     
4,060
   
2
 
Obligations of State and Political Subdivisions
   
25,788
   
13
     
31,759
   
16
     
43,125
   
20
 
Asset- / Mortgage-backed Securities
   
125,340
   
66
     
128,602
   
65
     
131,614
   
60
 
Corporate Securities
       
     
500
   
n/m(1)
 
 
 
503
   
n/m(1)
 
Equity Securities
   
6,236
   
3
     
17,350
   
9
 
   
15,149
   
7
 
Total Securities Portfolio
 
$
191,382
   
100
% 
 
$
197,129
   
100
%
 
$
218,805
   
100%
 

(1)
n/m = not meaningful
 
21

 
The amortized cost of investment securities, including federal funds sold and short-term investments, decreased $5.7 million at year-end 2006 compared with year-end 2005. The largest concentration in the investment portfolio continues to be in mortgage related securities. The Company’s level of obligations of state and political subdivisions declined $6.0 million or 19% during 2006 and $11.4 million or 26% during 2005. The decline in obligations of state and political subdivisions has been primarily the result of the Company’s strategy to not invest in these traditionally longer-term securities during periods of relatively low longer-term interest rates. The Company continues to believe that at the proper time, investment in tax-advantaged obligations of state and political subdivisions is prudent. However, in the relatively low longer-term interest rate environment, investments in these types of securities have not been undertaken.

The Company’s equity securities portfolio at year-end 2006 consisted of non-controlling common stock investments in five unaffiliated banking companies. In prior years the equity securities also included the Company’s portfolio of floating rate preferred stock issued by FHLMC and FNMA. The Company sold its portfolio of FHLMC and FNMA preferred stock during the third quarter of 2006. The gain from the sale of this agency preferred stock portfolio totaled $951,000. The portfolio had a book value at the time of the sale of approximately $12.1 million. The Company had previously recorded a non-cash other-than-temporary impairment charge of $3.7 million on this portfolio during 2004.

Investment Securities, at Carrying Value
dollars in thousands

   
December 31,
 
Securities Held-to-Maturity:
 
2006
 
2005
 
2004
 
Obligations of State and Political Subdivisions
 
$
6,135
 
$
8,684
 
$
13,318
 
                     
Securities Available-for-Sale:
                   
                     
U.S. Treasury and Agency Securities
 
$
28,133
 
$
13,492
 
$
4,034
 
Obligations of State and Political Subdivisions
   
19,928
   
23,527
   
30,621
 
Asset- / Mortgage-backed Securities
   
123,859
   
125,844
   
131,201
 
Corporate Securities
       
500
   
503
 
Equity Securities
   
7,302
   
17,787
   
15,317
 
Subtotal of Securities Available-for-Sale
   
179,222
   
181,150
   
181,676
 
                     
Total Securities
 
$
185,357
 
$
189,834
 
$
194,994
 
 
The Company’s $179.2 million available-for-sale portion of the investment portfolio provides an additional funding source for the liquidity needs of the Company’s subsidiaries and for asset/liability management requirements. Although management has the ability to sell these securities if the need arises, their designation as available-for-sale should not be interpreted as an indication that management anticipates such sales.

The amortized cost of debt securities at December 31, 2006 are shown in the following table by expected maturity. Asset- / mortgage-backed securities are based on estimated average lives. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations. Equity securities do not have contractual maturities, and are excluded from the table below.

Maturities and Average Yields of Securities at December 31, 2006 (dollars in thousands):

   
Within
One Year
 
After One But
Within Five Years
 
After Five But
Within Ten Years
 
After Ten
Years
 
   
Amount
 
Yield
 
Amount
 
Yield
 
Amount
 
Yield
 
Amount
 
Yield
 
U.S. Treasuries and
                                 
Agencies
 
$
3,005
   
3.14%
 
$
25,078
   
5.05%
 
$
 
N/A
 
$
 
 
N/A
 
State and Political
                                                 
Subdivisions
   
2,955
   
6.89%
 
 
7,813
   
7.27%
 
 
10,187
   
7.42%
 
 
4,833
   
7.49%
 
Asset- / Mortgage-backed
                                                 
Securities
   
18,404
   
3.27%
 
 
85,686
   
4.61%
 
 
21,040
   
5.56%
 
 
210
   
3.52%
 
Corporate Securities
       
N/A
       
N/A
       
N/A
       
N/A
 
                                                   
Totals
 
$
24,364
   
3.69%
 
$
118,577
   
4.88%
 
$