TOWER FINANCIAL CORP - FORM 10-Q

Attached files

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EX-32.1 - EXHIBIT 32.1 - TOWER FINANCIAL CORP	ex32_1.htm
EX-32.2 - EXHIBIT 32.2 - TOWER FINANCIAL CORP	ex32_2.htm
EX-31.1 - EXHIBIT 31.1 - TOWER FINANCIAL CORP	ex31_1.htm
EX-31.2 - EXHIBIT 31.2 - TOWER FINANCIAL CORP	ex31_2.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2011

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

For the transition period from ____________ to ____________

Commission file number 000-25287

TOWER FINANCIAL CORPORATION

(Exact name of Registrant as specified in its charter)

INDIANA	35-2051170
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

116 East Berry Street, Fort Wayne, Indiana 46802

(Address of principal executive offices)

(260) 427-7000

(Registrant’s telephone number)

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

Yes T No £

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

	Large accelerated filer £	Accelerated filer £
	Non-accelerated filer £	Smaller reporting company T

(Do not check if a smaller reporting company.)

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

Yes £ No T

Number of shares of the issuer’s common stock, without par value, outstanding as of April 29, 2011: 4,827,843.

Index

Forward-Looking Statements

This report, including the section on “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, includes "forward-looking statements." All statements regarding our anticipated results or expectations, including our financial position, business plan and strategies, are intended to be forward-looking statements within the meaning of the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict.

Typically, forward-looking statements are predictive and are not statements of historical fact, and the words "anticipate," "believe," "estimate," "seek," "expect," "plan," "intend," “think” and similar conditional expressions, as they relate to us or to management, are intended to identify forward-looking statements. Although we believe that the expectations reflected in these forward-looking statements are reasonable, and although we have based these expectations upon beliefs and assumptions we believe to be reasonable, these expectations may prove to be incorrect. Important factors that could cause actual results to differ materially from our expectations include, without limitation, the following:

The impact of a prolonged recession on our asset quality, the adequacy of our allowance for loan losses and the sufficiency of our capital;

the continued weakness of the local economy in our primary service area;

the effect of general economic and monetary conditions and the regulatory environment on the Bank’s ability to attract deposits, make loans and achieve satisfactory interest spreads;

the risk of further loan delinquencies and losses due to loan defaults by both commercial loan customers or a significant number of other borrowers;

general changes in real estate, business and general property valuations underlying secured loans;

the level of our non-performing substandard or doubtful assets;

restrictions or additional capital requirements imposed on us by our regulators; and

dependence on our key banking and management personnel.

We also refer you to a discussion of the many other risks and uncertainties described under “Risk Factors” in our Annual Report on Form 10-K, in our Quarterly Reports on Form 10-Q, or in other reports we file from time to time with the Securities and Exchange Commission, which are available on the Commission’s website at www.sec.gov.

Index

INDEX

PART I. FINANCIAL INFORMATION

	Item 1.	Financial Statements	page no.

		Consolidated Condensed Balance Sheets at March 31, 2011 (unaudited) and December 31, 2010	4

		Consolidated Condensed Statements of Operations for the three months ended March 31, 2011 and March 31, 2010 (unaudited)	5

		Consolidated Condensed Statements of Changes in Stockholders’ Equity for the three months ended March 31, 2011 and March 31, 2010 (unaudited)	7

		Consolidated Condensed Statements of Cash Flows for the three months March 31, 2011 and March 31, 2010 (unaudited)	8

		Notes to Consolidated Condensed Financial Statements (unaudited)	9

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	30

	Item 4.	Controls and Procedures	35

PART II. OTHER INFORMATION

	Item 1.	Legal Proceedings	36

	Item 1a.	Risk Factors	36

	Item 6.	Exhibits	37

SIGNATURES			37

Index

PART I. FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

Tower Financial Corporation

Consolidated Condensed Balance Sheets

At March 31, 2011 (unaudited) and December 31, 2010

	March 31,			December 31,
	2011			2010
ASSETS
Cash and due from banks	$	12,983,538		$	24,717,935
Short-term investments and interest-earning deposits		662,736			3,313,006
Federal funds sold		2,221,872			1,648,441
Total cash and cash equivalents		15,868,146			29,679,382
Long-term interest earning deposits		996,000			996,000
Securities available for sale, at fair value		123,635,639			110,108,656
FHLB and FRB stock		4,075,100			4,075,100
Loans held for sale		432,413			2,140,872

Loans		489,249,575			486,914,115
Allowance for loan losses		(11,907,795	)		(12,489,400	)
Net loans		477,341,780			474,424,715
Premises and equipment, net		8,237,010			8,329,718
Accrued interest receivable		2,486,910			2,391,953
Bank owned life insurance		16,647,270			13,516,789
Other real estate owned (OREO)		4,740,592			4,284,263
Prepaid FDIC Insurance		2,377,570			2,864,527
Other assets		7,278,403			7,116,280
Total assets	$	664,116,833		$	659,928,255
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Deposits:
Noninterest-bearing	$	87,598,846		$	92,872,957
Interest-bearing		487,926,557			483,483,179
Total deposits		575,525,403			576,356,136
Federal funds purchased		100,000			-
Federal Home Loan Bank (FHLB) advances		11,500,000			7,500,000
Junior subordinated debt		17,527,000			17,527,000
Accrued interest payable		1,641,739			1,415,713
Other liabilities		3,409,668			4,000,654
Total liabilities		609,703,810			606,799,503
STOCKHOLDERS' EQUITY
Preferred stock, no par value, 4,000,000 shares authorized; 1,500 shares and 7,750 shares issued and outstanding at March 31, 2011 and December 31, 2010, respectively		146,558			757,213
Common stock and paid-in-capital, no par value, 6,000,000 shares authorized; 4,892,843 and 4,789,023 issued; and 4,827,843 and 4,724,023 shares outstanding at March 31, 2011 and December 31, 2010		44,362,537			43,740,155
Treasury stock, at cost, 65,000 shares at March 31, 2011 and December 31, 2010		(884,376	)		(884,376	)
Retained earnings		9,233,222			8,450,579
Accumulated other comprehensive income, net of tax of $801,103 at March 31, 2011 and $548,730 at December 31, 2010		1,555,082			1,065,181
Total stockholders' equity		54,413,023			53,128,752
Total liabilities and stockholders' equity	$	664,116,833		$	659,928,255

The following notes are an integral part of the financial statements.

Index

Tower Financial Corporation

Consolidated Condensed Statements of Operations

For the three months ended March 31, 2011 and 2010

	(unaudited)
	Three Months Ended
	March 31,
	2011			2010
Interest income:
Loans, including fees	$	6,288,964		$	6,883,002
Securities - taxable		579,369			639,091
Securities - tax exempt		393,162			244,551
Other interest income		14,262			6,248
Total interest income		7,275,757			7,772,892
Interest expense:
Deposits		1,361,146			1,759,498
Federal funds purchased		189			-
FHLB advances		72,071			169,858
Junior subordinated debt		199,353			280,226
Total interest expense		1,632,759			2,209,582
Net interest income		5,642,998			5,563,310
Provision for loan losses		1,220,000			1,340,000
Net interest income after provision for loan losses		4,422,998			4,223,310
Noninterest income:
Trust and brokerage fees		884,000			882,966
Service charges		290,850			290,386
Loan broker fees		108,388			114,049
Gain on sale/calls of securities		58,669			840
Other-than-temporary loss:
Total impairment loss		(124,999	)		(18,844	)
Loss recognized in other comprehensive income		-			8,254
Net impairment loss recognized in earnings		(124,999	)		(10,590	)
Other income		430,305			320,043
Total noninterest income		1,647,213			1,597,694
Noninterest expense:
Salaries and benefits		2,559,082			2,387,076
Occupancy and equipment		619,606			629,278
Marketing		89,784			96,692
Data processing		309,305			308,912
Loan and professional costs		361,442			438,407
Office supplies and postage		48,947			63,189
Courier services		53,724			55,334
Business development		90,619			79,008
Communication		46,376			36,359
FDIC insurance premiums		506,848			502,205
OREO Expenses		191,920			55,797
Other expense		215,054			252,909
Total noninterest expense		5,092,707			4,905,166
Income before income taxes		977,504			915,838
Income taxes expense		194,861			194,802

Net income	$	782,643		$	721,036

The following notes are an integral part of the financial statements

Index

Tower Financial Corporation

Consolidated Condensed Statements of Operations (Continued)

For the three months ended March 31, 2011 and 2010

	(unaudited)
	Three Months Ended
	March 31,
	2011		2010

Net income:	$	782,643	$	721,036

Other comprehensive income net of tax:
Unrealized appreciation on available for sale securities		489,901		307,047
Total comprehensive income	$	1,272,544	$	1,028,083

Basic earnings per common share	$	0.16	$	0.18
Diluted earnings per common share	$	0.16	$	0.16
Average common shares outstanding		4,754,892		4,090,432
Average common shares and dilutive potential common shares outstanding		4,852,761		4,394,419

Dividends declared per share	$	-	$	-

The following notes are an integral part of the financial statements

Index

Tower Financial Corporation

Consolidated Condensed Statements of Changes in Stockholders’ Equity

For the three months ended March 31, 2011 and 2010 (unaudited)

				Common				Accumulated
				Stock and				Other
	Preferred			Paid-in		Retained		Comprehensive		Treasury
	Stock			Capital		Earnings		Income (Loss)		Stock			Total

Balance, January 1, 2010	$	1,788,000		$	39,835,648	$	5,286,808	$	910,029	$	(884,376	)	$	46,936,109

Net income for 2010							721,036							721,036

Other Comprehensive Income (See Note 4)
									307,047					307,047
Total Comprehensive Income														1,028,083

Stock based compensation expense					11,728									11,728

Balance, March 31, 2010	$	1,788,000		$	39,847,376	$	6,007,844	$	1,217,076	$	(884,376	)	$	47,975,920

Balance, January 1, 2011	$	757,213		$	43,740,155	$	8,450,579	$	1,065,181	$	(884,376	)	$	53,128,752

Net income for 2011							782,643							782,643

Other Comprehensive Income (See Note 4)
									489,901					489,901
Total Comprehensive Income														1,272,544

Stock based compensation expense					11,727									11,727

Conversion of 6,250 preferred shares into 103,820 common shares		(610,655	)		610,655									-

Balance, March 31, 2011	$	146,558		$	44,362,537	$	9,233,222	$	1,555,082	$	(884,376	)	$	54,413,023

The following notes are an integral part of the financial statements

Index

Tower Financial Corporation

Consolidated Condensed Statements of Cash Flows

For the three months ended March 31, 2011 and 2010

	(unaudited)			(unaudited)
	Three Months ended			Three Months ended
	March 31, 2011			March 31, 2010
Cash flows from operating activities:
Net income	$	782,643		$	721,036
Adjustments to reconcile net income to net cash from operating activities:
Depreciation and amortization		489,628			359,942
Provision for loan losses		1,220,000			1,340,000
Stock based compensation expense		11,727			11,728
Earnings on life insurance		(130,481	)		(115,280	)
Gain on sale of securities AFS		(58,669	)		(840	)
Impairment on AFS securities		124,999			10,590
Loans originated for sale		(3,704,941	)		(5,539,352	)
(Gain)Loss on sale of other real estate owned		15,807			57
Proceeds from sale of loans		5,413,400			8,350,674
Write-down on OREO		113,780			-
Change in accrued interest receivable		(94,957	)		(73,417	)
Change in other assets		72,461			1,064,963
Change in accrued interest payable		226,026			134,051
Change in other liabilities		(590,986	)		(118,079	)
Net cash from operating activities		3,890,437			6,146,073
Cash flows from investing activities:
Net change in loans		(5,414,160	)		3,107,507
Purchase of securities AFS		(21,237,075	)		(5,761,030	)
Proceeds from calls and maturities of securities AFS		7,284,120			5,373,220
Purchase of securities HTM		-			(1,112,773	)
Proceeds from calls and maturities of securities HTM		-			211,702
Proceeds from sale of securities AFS		783,300			-
Proceeds from sale of OREO		691,180			190,721
Purchase of bank owned life insurance		(3,000,000	)		-
Purchase of FHLB stock		-			(75,000	)
Purchase of premises and equipment		(78,305	)		(449,523	)
Net cash from (used in) investing activities		(20,970,940	)		1,484,824
Cash flows from financing activities:
Net change in deposits		(830,733	)		(9,089,076	)
Repayment of long-term FHLB advances		(2,000,000	)		(2,000,000	)
Net change in short-term borrowings		6,100,000			4,000,000
Net cash from (used in) financing activities		3,269,267			(7,089,076	)
Net change in cash and cash equivalents		(13,811,236	)		541,821
Cash and cash equivalents, beginning of period		29,679,382			24,664,309
Cash and cash equivalents, end of period	$	15,868,146		$	25,206,130

Supplemental disclosures of cash flow information
Cash paid during the year for:
Interest	$	1,406,733		$	2,075,531
Income taxes		570,000			-
Noncash items:
Transfer of loans to other real estate owned		1,277,095			-

The following notes are an integral part of the financial statements.

Index

Tower Financial Corporation

Notes to Consolidated Condensed Financial Statements

Note 1 – Basis of Presentation

The accompanying unaudited consolidated financial statements are filed for Tower Financial Corporation and its wholly-owned subsidiary, Tower Bank & Trust (or the “Bank” or “Tower Bank”), and two unconsolidated subsidiary guarantor trusts, Tower Capital Trust 2, and Tower Capital Trust 3. Also included are the Bank’s wholly-owned subsidiaries, Tower Trust Company (or the “Trust Company”) and Tower Capital Investments, which owns Tower Funding Corporation, a real estate investment trust.

The accompanying unaudited consolidated condensed financial statements were prepared in accordance with generally accepted accounting principles in the United States of America for interim periods and with instructions for Form 10-Q and, therefore, do not include all disclosures required by generally accepted accounting principles in the United States of America for complete presentation of the Company’s financial statements. In the opinion of management, the unaudited consolidated condensed financial statements contain all adjustments necessary to present fairly its consolidated financial position at March 31, 2011 and its consolidated results of operations and comprehensive income for the three-month periods ended March 31, 2011 and March 31, 2010 and change in stockholders’ equity and cashflows for the three-month periods ended March 31, 2011 and March 31, 2010. The results for the period ended March 31, 2011 should not be considered as indicative of results for a full year. These consolidated condensed financial statements should be read in conjunction with the audited financial statements for the years ended December 31, 2010 and 2009 and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

Note 2 – Summary of Critical Accounting Policies

A comprehensive discussion of our critical accounting policies is disclosed in Note 1 of our Annual Report on Form 10-K for the year ended December 31, 2010. Certain accounting policies require management to use estimates and make assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and disclosures provided, and actual results could differ. There were no material changes in the information regarding our critical accounting policies since December 31, 2010.

Index

Note 3 – Securities Available for Sale

The following table summarizes the amortized cost and fair value of the available for sale investment securities portfolio at March 31, 2011 and December 31, 2010 and the corresponding amounts of unrealized gains and losses therein:

	March 31, 2011
	Amortized		Gross Unrealized		Gross Unrealized			Fair
	Cost		Gains		Losses			Value

Available for sale securities:
U.S. Government agency debt obligations	$	3,392,750	$	38,814	$	-		$	3,431,564
Obligations of states and political subdivisions		49,102,804		871,471		(430,765	)		49,543,510
Mortgage-backed securities (residential)		64,353,606		2,005,925		(316,416	)		66,043,115
Mortgage-backed securities (commercial)		4,430,296		187,154		-			4,617,450
Collateralized debt obligations		-		-		-			-

Total Securities	$	121,279,456	$	3,103,364	$	(747,181	)	$	123,635,639

	December 31, 2010
	Amortized		Gross Unrealized		Gross Unrealized			Fair
	Cost		Gains		Losses			Value

Available for sale securities:
U.S. Government agency debt obligations	$	4,112,957	$	59,710	$	-		$	4,172,667
Obligations of states and political subdivisions		45,852,349		546,212		(639,159	)		45,759,402
Mortgage-backed securities (residential)		53,960,788		1,854,148		(325,966	)		55,488,970
Mortgage-backed securities (commercial)		4,458,652		224,365		-			4,683,017
Collateralized debt obligations		110,000		-		(105,400	)		4,600
Total Securities	$	108,494,746	$	2,684,435	$	(1,070,525	)	$	110,108,656

Total other-than-temporary impairment recognized in accumulated other comprehensive income was $157,282 and $274,596 for securities available for sale at March 31, 2011 and December 31, 2010, respectively.

Index

The fair values of debt securities available for sale at March 31, 2011 and December 31, 2010, by contractual maturity, are shown below. Securities not due at a single date, primarily mortgage-backed securities, are shown separately. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties.

	3/31/2011
	Weighted Average			Amortized		Fair
	Yield			Cost		Value
Available for sale securities:
Agencies:
Due after one to five years		2.16	%	$	799,208	$	816,104
Due after five to ten years		2.58	%		2,593,542		2,615,460
Total Agencies		2.48	%	$	3,392,750	$	3,431,564

Mortgage-backed securities:
Mortgage-backed securities (residential)		2.96	%	$	64,353,606	$	66,043,115
Mortgage-backed securities (commercial)		4.37	%		4,430,296		4,617,450
		3.05	%	$	68,783,902	$	70,660,565
Obligations of state and political subdivisions:
Due in one year or less		4.99	%	$	130,109	$	130,709
Due after one to five years		5.41	%		3,835,225		3,967,328
Due after five to ten years		5.33	%		15,951,711		16,254,156
Due after ten years		5.69	%		29,185,759		29,191,317
Total Obligations of state and political subdivisions		5.55	%	$	49,102,804	$	49,543,510

Collateralized debt obligations
Due after ten years		0.00	%	$	-	$	-

	12/31/2010
	Weighted
	Average			Amortized		Fair
	Yield			Cost		Value
Available for sale securities:
Agencies:
Due in one year or less		3.25	%	$	700,000	$	703,997
Due after one to five years		2.16	%		799,138		822,336
Due after five to ten years		2.58	%		2,613,819		2,646,334
Total Agencies		2.61	%	$	4,112,957	$	4,172,667

Mortgage-backed securities:
Mortgage-backed securities (residential)		3.86	%	$	53,960,788	$	55,488,970
Mortgage-backed securities (commercial)		4.22	%		4,458,652		4,683,017
		3.89	%	$	58,419,440	$	60,171,987

Obligations of state and political subdivisions:
Due in one year or less		4.99	%	$	260,457	$	262,621
Due after one to five years		5.24	%		3,168,388		3,270,587
Due after five to ten years		5.28	%		13,676,918		13,820,407
Due after ten years		5.77	%		28,746,586		28,405,787
Total Obligations of state and political subdivisions		5.58	%	$	45,852,349	$	45,759,402

Collateralized debt obligations
Due after ten years		1.15	%	$	110,000	$	4,600

Proceeds from securities sold classified as available for sale totaled $783,300 for the three months ended March 31, 2011. There were no securities sold for the three months ended March 31, 2010.

Index

Gross gains realized were $58,879 and $840 for the three months ended March 31, 2011 and March 31, 2010, respectively. There were $210 and $0 gross losses realized on the sale of available for sale securities during the three-month periods ending March 31, 2011 and March 31, 2010. The approximate tax expense on the net gains (losses) for the three months ended March 31, 2011 and March 31, 2010 was $19,947 and $286, respectively.

Securities with a carrying value of $1.0 million and $1.1 million were pledged to secure borrowings from the FHLB at March 31, 2011 and December 31, 2010, respectively. Securities with a carrying value of $3.2 million and $4.2 million were pledged to the Federal Reserve to secure potential borrowings at the Discount Window at March 31, 2011 and December 31, 2010, respectively. Securities with a carrying value of $17.9 million and $17.8 million were pledged at correspondent banks, including Wells Fargo, First Tennessee, First Merchants and Pacific Coast Bankers Bank, to secure federal funds lines of credit at March 31, 2011 and December 31, 2010, respectively. At March 31, 2011, there were no holdings of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of stockholders' equity.

Securities with unrealized losses at March 31, 2011 not recognized in income are as follows:

	Continuing Unrealized					Continuing Unrealized
	Losses for					Losses for
	Less than 12 months					More than 12 months					Total
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses

Available for sale securities:
U.S. Government agency debt obligations	$	-	$	-		$	-	$	-		$	-	$	-
Obligations of states and political subdivisions		12,068,080		(404,976	)		1,449,442		(25,789	)		13,517,522		(430,765	)
Mortgage-backed securities (residential)		15,906,979		(159,133	)		401,717		(157,283	)		16,308,696		(316,416	)
Mortgage-backed securities (commercial)		-		-			-		-			-		-
Collateralized debt obligations		-		-			-		-			-		-
Total temporarily impaired securities	$	27,975,059	$	(564,109	)	$	1,851,159	$	(183,072	)	$	29,826,218	$	(747,181	)

Securities with unrealized losses at December 31, 2010 not recognized in income are as follows:

	Continuing Unrealized					Continuing Unrealized
	Losses for					Losses for
	Less than 12 months					More than 12 months					Total
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses

Available for sale securities:
U.S. Government agency debt obligations	$	-	$	-		$	-	$	-		$	-	$	-
Obligations of states and political subdivisions		16,033,664		(588,556	)		1,427,946		(50,603	)		17,461,610		(639,159	)
Mortgage-backed securities (residential)		5,772,263		(156,769	)		416,929		(169,197	)		6,189,192		(325,966	)
Mortgage-backed securities (commercial)		-		-			-		-			-		-
Collateralized debt obligations		-		-			4,600		(105,400	)		4,600		(105,400	)
Total available for sale securities	$	21,805,927	$	(745,325	)	$	1,849,475	$	(325,200	)	$	23,655,402	$	(1,070,525	)

Unrealized losses on mortgage-backed securities and state and municipality bonds have not been recognized into income because the issuers’ bonds are of high credit quality and management does not have the intent to sell and it is likely that they will not be required to sell the securities before their anticipated recovery. The fair value is expected to recover as the bonds approach their maturity and/or as market conditions improve.

Index

As of March 31, 2011, Tower Financial Corporation’s security portfolio consisted of 230 securities, 40 of which were in an unrealized loss position. The majority of unrealized losses are related to the Company’s mortgage-backed securities, as discussed below:

Mortgage-backed Securities

At March 31, 2011, approximately 82% of the mortgage-backed securities we held were issued by U.S. government-sponsored entities and agencies, primarily Fannie Mae and Freddie Mac, institutions which the government has affirmed its commitment to support. Because the decline in market value is attributable to changes in interest rates and illiquidity, and not credit quality, and because the Company does not have the intent to sell these mortgage-backed securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at March 31, 2011.

As of March 31, 2011, we held $11.8 million of non-agency backed CMO investments. These investments were purchased as loan alternatives. The eight securities purchased all had AAA rating from Standard & Poors. These bonds make up less than 10% of capital. The Company continues to monitor these securities and obtain current market prices at least on a quarterly basis. Based on this review, the Company does not consider these securities to be other-than-temporarily impaired at March 31, 2011.

Private Label Collateralized Mortgage Obligation

The Company owns a Private Label Collateralized Mortgage Obligation (CMO) with an original investment of $1.0 million. At March 31, 2011, the fair value of the investment was $401,717 and the amortized cost was $558,999. The investment was rated Caa2 by Moody’s and CCC by S&P. At December 31, 2010, the fair value of the investment was $416,929 and the amortized cost was $586,125.

This bond is classified as a “super senior” tranche because its cash flow is not subordinated to any other tranche in the deal and is classified as a mortgage-backed security (residential). We used the Intex database to evaluate and model each individual loan in the underlying collateral of this security. In 2009, we noticed that the credit quality of the underlying collateral was marginally deteriorating causing us to more aggressively monitor and analyze for other-than-temporary-impairment. To monitor this investment, management has evaluated loan delinquencies, foreclosures, other real estate owned (OREO) and bankruptcies as a percentage of principal remaining on the loans as shown in the table below prior to making assumptions on the performing loans.

	March 31			December 31			September 30			June 30			March 31
	2011			2010			2010			2010			2010
Delinquency 60+		25.16	%		22.58	%		20.76	%		22.48	%		24.37	%
Delinquency 90+		22.36	%		19.79	%		18.42	%		20.73	%		22.07	%
Other Real Estate Owned		2.58	%		1.73	%		0.20	%		0.17	%		1.27	%
Foreclosure		10.70	%		9.42	%		9.11	%		10.79	%		11.43	%
Bankruptcy		3.08	%		4.08	%		4.09	%		3.35	%		3.87	%

We utilized Intex data to determine the default assumptions for all loans that are classified as “past due,” OREO or in foreclosure. A 50% severity rate was assumed on all defaults. This number was derived from the pool average over the last 12 months. The default rate differs for each State based on the severity of that State’s home price depreciation and the number of days the loan is past due. Any foreclosure or loan classified as other real estate owned is immediately liquidated at a 50% severity. The current loan category is stratified by FICO scores and the level of asset documentation (full documentation, low documentation, or no documentation). The Loan Performance Database driven by Intex data is mined for historical probabilities of loans meeting these characteristics moving into default. This was done for loans originated in 2006, 2007, and 2008 periods. The average default rate is then calculated, as well as its standard deviation. Two standard deviations are then added to this mean to derive the current loan CDR assumptions; representing what management feels is a “stressed” scenario. We used the yield at the time of purchase as the discount rate for the cash flow analysis. At the time of purchase the bond was yielding 6%. Therefore, all cash flows in the OTTI analysis were discounted by 6% to get a present value. To determine the fair value, we surveyed two bond desks to see what yield it would take to sell the bond in the open market. Both desks said it would take a yield of 12%-15% to get someone to buy this bond. Management decided to use the conservative figure and discounted the cash flows by 15%. The two bond desks that were surveyed are Sterne Agee and Performance Trust.

Based on the analysis performed using the assumptions above, we have determined that this Private Label CMO is other-than-temporarily-impaired requiring us to record total credit impairment of $72,730 through March 31, 2011. We had previously recorded impairment of $57,731 as of December 31, 2010, therefore an OTTI charge of $14,999 was recorded during the first three months of 2011.

Trust Preferred Securities

The Company, through the Bank’s investment subsidiary, owns a $1 million original investment in PreTSL XXV out of a pooled $877.4 million investment at the time of purchase. This is the Company’s only pooled trust preferred security and it is classified as a collateralized debt obligation. At March 31, 2011, the Company took an additional OTTI charge to write-off the remaining investment. At December 31, 2010, the fair value of the investment was $4,600 and the amortized cost was $110,000. The investment was rated Ca by Moody’s and C by Fitch at March 31, 2011 and December 31, 2010.

Index

The investment is divided into seven tranches. Tower’s investment is in the fifth tranche (C-1), meaning the cashflows on the investment are subordinated to the higher placed tranches. There are sixty-eight (68) issuing participants in PreTSL XXV. Fifty-eight (58) of the issuers are banks or bank holding companies, with the remaining issuers being insurance companies. As of March 31, 2011, the amount of deferrals and defaults was $326.6 million, or 37% of the total pool. Of the total $877.4 million of original collateral, $550.8 million is currently paying interest. The defaults and deferrals occurred as follows:

	Deferral		Default
March 31, 2008	$	-	$	25,000,000
September 30, 2008		20,000,000		-
December 31, 2008		15,000,000		35,000,000
March 31, 2009		22,500,000		-
June 30, 2009		35,600,000		25,000,000
September 30, 2009		86,000,000		-
December 31, 2009*		7,500,000		25,000,000
March 31, 2010		-		-
June 30, 2010		-		-
September 30, 2010		14,000,000		-
December 31, 2010		29,000,000		-
March 31, 2011		12,000,000		-

*$25.0 million of defaults at December 31, 2009 were reported as deferrals in September 30, 2009

The Company uses the OTTI evaluation model to compare the present value of expected cash flows to the previous estimate to determine whether an adverse change in cash flows has occurred during the period. The OTTI model considers the structure and term of the collateralized debt obligation (“CDO”) and the financial condition of the underlying issuers. Specifically, the model details interest rates, principal balances of note classes and underlying issuers, the timing and amount of interest and principal payments of the underlying issuers, and the allocation of the payments to the note classes. The current estimates of expected cash flows are based on the most recent trustee reports and any other relevant market information including announcements of interest payment deferrals or defaults of underlying loans or trust preferred securities. Assumptions used in the model include expected future default rates and prepayments. We assume that all interest payment deferrals will become defaults prior to their next payment dates and that there will be no recoveries on defaults. In addition we use the model to “stress” each CDO, or make assumptions more severe than expected activity, to determine the degree to which assumptions could deteriorate before the CDO could no longer fully support repayment of Tower’s note class. We evaluate the credit quality of each underlying issuer in the pool and apply a risk rating for each issuer and then put this risk rating into a relevant risk model to identify immediate default risk. Upon completion of the March 31, 2011 analysis, our model indicated that the security was other-than-temporarily impaired. Based on this conclusion at March 31, 2011, the investment had OTTI of 100%. The March 31, 2011 OTTI charge was $110,000 resulting in an ending book value of $0. This security cannot experience any additional OTTI charges.

The table below presents a roll-forward of the credit losses relating to debt securities recognized in earnings for the three months ended March 31, 2011:

For the three months ended March 31	2011		2010
Beginning Balance, January 1	$	909,073	$	750,770
Additions for amounts related to credit loss for which an OTTI was not previously recognized		-		-
Increases to the amount related to the credit loss for which other-than-temporary was previously recognized		124,999		10,590
Ending Balance, March 31	$	1,034,072	$	761,360

Index

Note 4 – Comprehensive Income

Comprehensive income consists of net income and other comprehensive income (“OCI”). Other comprehensive income includes unrealized gains and losses on securities available-for-sale. Following is a summary of other comprehensive income for the three months ended March 31, 2011 and 2010:

	Three months ended March 31,
	2011			2010
Net Income	$	782,643		$	721,036
Change in securities available for sale:
Unrealized holding gains (losses) on securities for which other-than-temporary impairment has been recorded		(7,685	)		(18,844	)
Other-than-temporary impairment on available for sale securities associated with credit losses realized in income		124,999			10,590
Unrealized holding gains (losses) recorded in other comprehensive income		117,314			(8,254	)

Unrealized holding gains (losses) on available for sale securities arising during the period		683,629			474,317
Reclassification adjustment for (gains) losses realized in income on available for sale securities		(58,669	)		(840	)
Net unrealized gains (losses)		624,960			473,477
Income tax expense		252,373			158,176
Total other comprehensive income		489,901			307,047
Comprehensive Income	$	1,272,544		$	1,028,083

Note 5 - Earnings Per Share

The following table reflects the calculation of basic and diluted earnings per common share for the three-month periods ended March 31, 2011 and March 31, 2010. Options not considered in the calculation of diluted earnings per common share because they were antidilutive, totaled 74,654 and 79,404 for the three-month period ended March 31, 2011 and 2010, respectively. The Company also has preferred stock which can be converted at the option of the shareholders into 24,917 and 303,987 shares of common stock as of March 31, 2011 and 2010, respectively.

	Three Months Ended
	March 31,
	2011		2010
Basic
Net income available to common stockholders	$	782,643	$	721,036
Weighted average common shares outstanding		4,754,892		4,090,432
Basic earnings per common share	$	0.16	$	0.18

Diluted
Net income available to common stockholders	$	782,643	$	721,036
Weighted average common shares outstanding		4,754,892		4,090,432
Add: dilutive effect of assumed preferred stock conversion and stock options		97,869		303,987
Weighted average common shares and dilutive potential common shares outstanding and preferred stock conversion		4,852,761		4,394,419
Diluted earnings per common share	$	0.16	$	0.16

Index

Note 6 – Equity Incentive Plans

Options to buy stock were previously granted to directors, officers and employees under the 1998 and 2001 Stock Option and Incentive Plans (the “Plans”), which together provided for issuance of up to 435,000 shares of common stock of the Company. Options for all 435,000 shares were issued under the Plans, of which 74,654 remain outstanding as of March 31, 2011. Option awards were granted with an exercise price equal to the market price of the Company’s stock at the date of each grant, vesting over a four-year period, and issued with a ten-year contractual term. There was no compensation cost charged against income for options granted under the Plans in accordance with accounting standards for the three months ended March 31, 2011 and March 31, 2010. No income tax benefit was recognized in the income statement for the share-based compensation arrangements.

A summary of the option activity under the Plans as of March 31, 2011 and changes during the three-month period then ended are presented below:

				Weighted-		Weighted-
				Average		Average
				Aggregate		Remaining
				Exercise		Contractual		Instrinsic
Options	Shares			Price		Term		Value
Outstanding at January 1, 2011		76,154		$	13.37		2.72	$	-

Granted		-			-		-		-

Exercised		-			-		-		-

Forfeited or expired		(1,500	)		8.38		-		-

Outstanding at March 31, 2011		74,654			13.47		2.52		-

Vested or expected to vest at March 31, 2011		74,654			13.47		2.52		-

Exercisable at March 31, 2011		74,654			13.47		2.52		-

No further options will be granted under either of these Plans, but the plans will remain in effect for purposes of administering already existing options previously granted and still outstanding under the Plans. As of March 31, 2011 there was no unrecognized compensation expense for the 1998 and 2001 Stock Options plan.

On April 19, 2006, at our annual meeting of stockholders, stockholders approved Tower Financial Corporation’s 2006 Equity Incentive Plan, under which 150,000 shares have been reserved for issuance as incentive stock options, nonstatutory stock options, restricted stock awards, unrestricted stock awards, performance awards, or stock appreciation rights. As of March 31, 2011, 19,500 shares have been granted in the form of restricted stock, of which 10,750 shares have vested. The compensation cost that has been charged against income for restricted shares awarded under the Plan was $11,727 and $11,728 for the three months ended March 31, 2011 and 2010, respectively. Future expense related to this award will be $35,183 in 2011 and $14,062 in 2012. The total fair value of shares vested during the quarter ended March 31, 2011 was $7,750.

A summary of the restricted stock activity as of March 31, 2011 and changes during the three-month period then ended are presented below:

				Weighted-Average
				Grant-Date
Restricted Stock	Shares			Fair Value

Outstanding at January 1, 2011		9,750		$	8.95

Granted		-			-

Vested		(1,000	)		6.58

Forfeited		-			-

Outstanding at March 31, 2011		8,750			9.22

Index

Note 7 – Business Segments

Management separates Tower Financial Corporation into three distinct businesses for reporting purposes. The three segments are Banking, Wealth Management, and Corporate and Intercompany. The segments are evaluated separately on their individual performance, as well as their contribution as a whole.

The majority of assets and income result from the Banking segment. The Bank is a full-service commercial bank with six Allen County locations and one Warsaw location. The Wealth Management segment is made up of Tower Trust Company. The Trust Company provides estate planning, investment management, and retirement planning, as well as investment brokerage services. The Corporate and Intercompany segment includes the holding company and subordinated debentures. We incur general corporate expenses, as well as interest expense on the subordinated debentures.

Information reported internally for performance assessment follows:

	As of and for the three months ending March 31, 2011
			Wealth		Corporate &
	Bank		Management		Intercompany			Eliminations			Total
Income Statement Information
Net interest income	$	5,820,305	$	22,046	$	(199,353	)	$	-		$	5,642,998

Non-interest income		754,927		886,039		1,043,801			(1,037,554	)		1,647,213

Non-interest expense		4,289,994		609,592		193,121			-			5,092,707

Noncash items
Provision for loan losses		1,220,000		-		-			-			1,220,000
Depreciation/Amortization		476,435		13,193		-			-			489,628

Income tax expense(benefit)		226,572		99,605		(131,316	)		-			194,861

Segment Profit		838,666		198,888		782,643			(1,037,554	)		782,643

Balance Sheet Information
Segment Assets		658,382,461		6,648,921		78,009,855			(78,924,404	)		664,116,833

	As of for the three months ending March 31, 2010
			Wealth		Corporate &
	Bank		Management		Intercompany			Eliminations			Total
Income Statement Information
Net interest income	$	5,827,267	$	16,269	$	(280,226	)	$	-		$	5,563,310

Non-interest income		900,819		886,732		1,011,249			(1,201,106	)		1,597,694

Non-interest expense		4,150,734		599,282		155,150			-			4,905,166

Noncash items
Provision for loan losses		1,340,000		-		-			-			1,340,000
Depreciation/Amortization		350,845		9,097		-			-			359,942

Income tax expense(benefit)		234,529		105,436		(145,163	)		-			194,802

Segment Profit		1,002,823		198,283		721,036			(1,201,106	)		721,036

Balance Sheet Information
Segment Assets		676,696,637		5,935,873		70,543,441			(79,050,186	)		674,125,765

Index

Note 8 – Loans and Allowance for Loan Losses

Loans at March 31, 2011 and December 31, 2010 were as follows:

	March 31, 2011						December 31, 2010
	Balance			%			Balance			%

Commercial	$	235,880,318			48.2	%	$	233,882,777			48.0	%
Commercial real estate
Construction		25,890,839			5.3	%		24,588,088			5.1	%
Other		95,329,531			19.5	%		94,056,119			19.3	%
Residential real estate
Traditional		52,163,061			10.7	%		54,236,553			11.1	%
Jumbo		29,467,708			6.0	%		25,833,656			5.3	%
Home equity		35,688,855			7.3	%		38,395,005			7.9	%
Consumer		14,919,453			3.0	%		15,979,973			3.3	%
Total loans		489,339,765			100.0	%		486,972,171			100.0	%
Net deferred loan costs (fees)		(90,190	)					(58,056	)
Allowance for loan losses		(11,907,795	)					(12,489,400	)

Net loans	$	477,341,780					$	474,424,715

The following tables summarize changes in the Company’s allowance for loan losses for the periods indicated:

For the three months ended March 31, 2011:


	Commercial			Commercial Real Estate			Residential Real Estate			Home Equity			Consumer			Unallocated			Total
Beginning balance 1/1/2011		5,790,945			6,183,365			386,992			77,051			28,711			22,336			12,489,400
Provision expense		1,377,219			(91,840	)		(70,458	)		18,457			(5,367	)		(8,011	)		1,220,000
Charge-offs		(822,867	)		(1,049,110	)		-			(17,408	)		-			-			(1,889,385	)
Recoveries		37,075			47,363			-			1,767			1,575			-			87,780
Ending Balance 3/31/2011		6,382,372			5,089,778			316,534			79,867			24,919			14,325			11,907,795

For the three months ended March 31, 2010:

Beginning balance 1/1/2010	11,598,389
Provision expense	1,340,000
Charge-offs	(812,446	)
Recoveries	23,942
Ending Balance 3/31/2010	12,149,885

Index

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based on impairment method as of March 31, 2011 and December 31, 2010:

March 31, 2011	Individually evaluated for impairment		Collectively evaluated for impairment		Total
Allowance for loan losses:
Ending allowance balance attributable to loans:
Commercial	$	1,361,920	$	5,020,452	$	6,382,372
Commercial Real Estate
Construction		1,467,000		651,318		2,118,318
Other		585,000		2,386,460		2,971,460
Residential Real Estate
Traditional		-		202,269		202,269
Jumbo		-		114,265		114,265
Home Equity		-		79,867		79,867
Consumer		-		24,919		24,919
Unallocated		-		14,325		14,325
Total	$	3,413,920	$	8,493,875	$	11,907,795

Loans:
Commercial	$	16,971,628	$	219,617,138	$	236,588,766
Commercial Real Estate
Construction		6,367,965		19,574,159		25,942,124
Other		6,085,261		89,420,950		95,506,211
Residential Real Estate
Traditional		-		52,266,252		52,266,252
Jumbo		-		29,526,003		29,526,003
Home Equity		-		35,909,221		35,909,221
Consumer		-		15,123,879		15,123,879
Unallocated		-		-		-
Total	$	29,424,854	$	461,437,602	$	490,862,456

December 31, 2010	Individually evaluated for impairment		Collectively evaluated for impairment		Total
Allowance for loan losses:
Ending allowance balance attributable to loans:
Commercial	$	794,796	$	4,996,149	$	5,790,945
Commercial Real Estate
Construction		2,547,000		664,665		3,211,665
Other		445,000		2,526,700		2,971,700
Residential Real Estate
Traditional		-		262,134		262,134
Jumbo		-		124,858		124,858
Home Equity		-		77,051		77,051
Consumer		-		28,711		28,711
Unallocated		-		22,336		22,336
Total	$	3,786,796	$	8,702,604	$	12,489,400

Loans:
Commercial	$	17,755,408	$	216,751,782	$	234,507,190
Commercial Real Estate
Construction		8,020,168		16,632,723		24,652,891
Other		5,853,845		88,362,580		94,216,425
Residential Real Estate
Traditional		-		54,373,838		54,373,838
Jumbo		-		25,899,046		25,899,046
Home Equity		-		38,620,639		38,620,639
Consumer		-		16,186,219		16,186,219
Unallocated		-		-		-
Total	$	31,629,421	$	456,826,827	$	488,456,248

Index

The following table presents loans individually evaluated for impairment by class of loans as of March 31, 2011 and December 31, 2010:

March 31, 2011	Unpaid Principal Balance		Recorded Investment		Allowance for Loan Losses Allocated
With no related allowance recorded:
Commercial	$	11,815,368	$	11,842,016	$	-
Commercial Real Estate
Construction		1,314,369		1,314,913		-
Other		1,475,872		1,482,866		-
Residential Real Estate
Traditional		-		-		-
Jumbo		-		-		-
Home Equity		-		-		-
Consumer		-		-		-
		14,605,609		14,639,795		-
With related allowance recorded:
Commercial		5,120,215		5,129,612		1,361,920
Commercial Real Estate
Construction		5,051,275		5,053,052		1,467,000
Other		4,598,566		4,602,395		585,000
Residential Real Estate
Traditional		-		-		-
Jumbo		-		-		-
Home Equity		-		-		-
Consumer		-		-		-
		14,770,056		14,785,059		3,413,920

	$	29,375,665	$	29,424,854	$	3,413,920

December 31, 2010	Unpaid Principal Balance		Recorded Investment		Allowance for Loan Losses Allocated
With no related allowance recorded:
Commercial	$	12,803,552	$	12,826,772	$	-
Commercial Real Estate
Construction		1,850,416		1,862,150		-
Other		2,208,130		2,208,205		-
Residential Real Estate
Traditional		-		-		-
Jumbo		-		-		-
Home Equity		-		-		-
Consumer		-		-		-
		16,862,098		16,897,127		-
With related allowance recorded:
Commercial		4,910,918		4,928,636		794,796
Commercial Real Estate
Construction		6,156,859		6,158,018		2,547,000
Other		3,640,193		3,645,640		445,000
Residential Real Estate
Traditional		-		-		-
Jumbo		-		-		-
Home Equity		-		-		-
Consumer		-		-		-
		14,707,970		14,732,294		3,786,796

	$	31,570,068	$	31,629,421	$	3,786,796

Index

The following tables present the average impaired loans, interest recognized on impaired loans, and cash-basis interest income recognized on impaired loans for the three months ended March 31, 2011 and March 31, 2010:

	For the three months ended	March 31, 2011

Average impaired loans during the period:
Commercial		$	15,987,011
Commercial Real Estate
Construction			3,560,177
Other			11,015,678

Interest recognized on impaired loans:
Commercial			159,397
Commercial Real Estate
Construction			47,245
Other			70,047

Cash-basis interest income recognized:
Commercial			134,391
Commercial Real Estate
Construction			43,318
Other			64,577

	For the three months ended	March 31, 2010

Average impaired loans during the period		$	25,396,342

Interest recognized on impaired loans			178,971

Cash-basis interest income recognized			178,971

The following table presents the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of March 31, 2011 and December 31, 2010:

March 31, 2011	Nonaccrual		Loans Past Due Over 90 Days Still Accruing
Commercial	$	7,581,886	$	1,897,231
Commercial Real Estate
Construction		3,306,335		-
Other		1,197,890		678,007
Residential Real Estate
Traditional		651,925		183,512
Jumbo		-		-
Home Equity		-		118,341
Consumer		-		7,352
Total	$	12,738,036	$	2,884,443

Index

December 31, 2010	Nonaccrual		Loans Past Due Over 90 Days Still Accruing
Commercial	$	6,413,675	$	1,961,597
Commercial Real Estate
Construction		3,476,643		482,512
Other		2,208,205		-
Residential Real Estate
Traditional		825,432		229,213
Jumbo		-		-
Home Equity		17,292		179
Consumer		-		27,843
Total	$	12,941,247	$	2,701,344

The following table presents the aging of the recorded investment in past due loans as of March 31, 2011 and December 31, 2010:

March 31, 2011	30 - 59 Days Past Due		60 - 89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Total Loans Not Past Due
Commercial	$	1,824,016	$	4,304,047	$	4,639,386		10,767,449	$	225,821,317
Commercial Real Estate
Construction		2,596,702		-		3,167,098		5,763,800		20,178,324
Other		749,663		132,249		1,875,897		2,757,809		92,748,402
Residential Real Estate
Traditional		60,156		-		835,437		895,593		51,370,659
Jumbo		-		-		-		-		29,526,003
Home Equity		41,487		-		118,341		159,828		35,749,393
Consumer		335,817		49,303		7,352		392,472		14,731,407
Total	$	5,607,841	$	4,485,599	$	10,643,511	$	20,736,951	$	470,125,505

December 31, 2010	30 - 59 Days Past Due		60 - 89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Total Loans Not Past Due
Commercial	$	3,377,433	$	444,713	$	5,571,355		9,393,501	$	225,113,689
Commercial Real Estate
Construction		3,487,072		-		1,862,150		5,349,222		19,303,669
Other		-		239,392		2,208,205		2,447,597		91,768,828
Residential Real Estate
Traditional		738,767		121,252		1,054,645		1,914,664		52,459,174
Jumbo		1,183,388		-		-		1,183,388		24,715,658
Home Equity		48,433		-		17,471		65,904		38,554,735
Consumer		250,040		95,625		27,843		373,508		15,812,711
Total	$	9,085,133	$	900,982	$	10,741,669	$	20,727,784	$	467,728,464

Troubled Debt Restructurings:

The Company has allocated $445,000 and $485,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of March 31, 2011 and December 31, 2010. The Company has committed to lend additional amounts totaling up to $497 and $8,962 as of March 31, 2011 and December 31, 2010, respectively, to customers with outstanding loans that are classified as troubled debt restructurings.

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes non-homogeneous loans, such as commercial and commercial real estate loans. This analysis is performed on a quarterly basis. The Company uses the following definitions for risk ratings:

Index

Special Mention: Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution's credit position at some future date.

Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

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

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. Loans listed as not rated are included in groups of homogeneous loans. As of March 31, 2011 and December 31, 2010, and based on the most recent analysis performed, the risk category of the recorded investment of loans by class of loans is as follows:

March 31, 2011	Not Rated		Pass		Special Mention		Substandard		Doubtful
Commercial	$	-	$	197,988,301	$	19,342,991		11,830,588	$	7,426,886
Commercial Real Estate
Construction		-		8,060,591		3,282,154		11,293,045		3,306,334
Other		-		82,031,287		7,537,356		4,739,678		1,197,890
Residential Real Estate
Traditional		52,266,252		-		-		-		-
Jumbo		29,526,003		-		-		-		-
Home Equity		35,909,221		-		-		-		-
Consumer		15,123,879		-		-		-		-
Total	$	132,825,355	$	288,080,179	$	30,162,501	$	27,863,311	$	11,931,110

December 31, 2010	Not Rated		Pass		Special Mention		Substandard		Doubtful
Commercial	$	-	$	197,230,795	$	15,507,296		15,459,634	$	6,309,465
Commercial Real Estate
Construction		-		5,725,698		3,104,775		12,345,774		3,476,644
Other		-		79,158,412		8,485,742		4,364,067		2,208,204
Residential Real Estate
Traditional		54,373,838		-		-		-		-
Jumbo		25,899,046		-		-		-		-
Home Equity		38,620,639		-		-		-		-
Consumer		16,186,219		-		-		-		-
Total	$	135,079,742	$	282,114,905	$	27,097,813	$	32,169,475	$	11,994,313

The Company considers the performance of the loan portfolio and its impact on the allowance for loan losses. For residential, home equity, and consumer classes, the Company also evaluates the credit quality based on the aging status of the loan, which was previously presented, and by activity. The following table presents the recorded investment in residential, home equity, and consumer loans based on aging status as of March 31, 2011 and December 31, 2010:

March 31, 2011	Not Past Due		30 - 89 Days Past Due		Greater than 90 Days Past Due Still Accruing		Nonaccrual
Residential Real Estate
Traditional	$	51,370,659	$	60,156	$	183,512	$	651,925
Jumbo		29,526,003		-		-		-
Home Equity		35,749,393		41,487		118,341		-
Consumer		14,731,407		385,120		7,352		-
Total	$	131,377,462	$	486,763	$	309,205	$	651,925

Index

December 31, 2010	Not Past Due		30 - 89 Days Past Due		Greater than 90 Days Past Due Still Accruing		Nonaccrual
Residential Real Estate
Traditional	$	52,459,174	$	860,019	$	229,213	$	825,432
Jumbo		24,715,658		1,183,388		-		-
Home Equity		38,554,735		48,433		179		17,292
Consumer		15,812,711		345,665		27,843		-
Total	$	131,542,278	$	2,437,505	$	257,235	$	842,724

The following table summarizes the Company’s nonperforming assets at the dates indicated:

	March 31, 2011			December 31, 2010

Loans past due over 90 days and still accruing	$	2,872,769		$	2,688,135
Nonperforming restructured loans		2,119,335			7,501,958
Nonaccrual loans		12,738,444			12,939,331
Total nonperforming loans	$	17,730,548		$	23,129,424
Other real estate owned		4,740,592			4,284,263
Impaired Securities		401,717			421,529
Total nonperforming assets	$	22,872,857		$	27,835,216

Nonperforming assets to total assets		3.44	%		4.22	%

Nonperforming loans to total loans		3.62	%		4.75	%

Note:Loan balances disclosed in the chart above are reported at unpaid principal.

Note 9 – Federal Home Loan Bank

Advances from the Federal Home Loan Bank (“FHLB”) were:

	March 31, 2011		December 31, 2010

3.19% bullet advance, principal due at maturity March 28, 2011	$	-	$	2,000,000
3.60% bullet advance, principal due at maturity April 28, 2011		1,500,000		1,500,000
0.48% variable rate advance, principal due at maturity September 13, 2011		1,500,000		-
0.48% variable rate advance, principal due at maturity September 26, 2011		4,500,000		-
3.55% bullet advance, principal due at maturity March 26, 2012		2,000,000		2,000,000
3.81% bullet advance, principal due at maturity March 26, 2013		2,000,000		2,000,000

	$	11,500,000	$	7,500,000

Of the total FHLB borrowings at March 31, 2011 and December 31, 2010, no advances had callable options.

At March 31, 2011 scheduled principal reductions on these FHLB advances were as follows:

Year	Advances
2011	$	7,500,000
2012		2,000,000
2013		2,000,000
	$	11,500,000

Index

Note 10 – Fair Value Measurement

The fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods and significant assumptions to estimate fair value:

Investment Securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2), which include our agencies, municipal bonds, and the majority of our mortgage-backed securities. In certain cases where market data is not readily available because of lack of market activity or little public disclosure, values may be based on unobservable inputs and classified in Level 3 of the fair value hierarchy, which include our collateralized debt obligations and some mortgage-backed securities. Collateralized debt obligations, such as Trust Preferred Securities, which are issued by financial institutions and insurance companies have seen a decline in the level of observable inputs and market activity in this class of investments has been significant and resulted in unreliable external pricing. Broker pricing and bid/ask spreads, when available, vary widely. The once active market has become comparatively inactive. The same is true for the mortgage-backed securities that are categorized as Level 3. As such, these investments are priced at March 31, 2011 and December 31, 2010 using Level 3 inputs. Due to current market conditions as well as the limited trading activity of these securities, the fair value is highly sensitive to assumption changes and market volatility.

Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent collateral appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Other Real Estate Owned: Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned (OREO) are measured at fair value, less costs to sell. Fair values are based on recent real estate appraisals. These appraisals may use a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Index

The following tables present for each of the fair-value hierarchy levels our assets that are measured at fair value on a recurring basis.

			March 31, 2011
	Level 1		Level 2		Level 3		Total
Available for sale securities:
U.S. Government agency debt obligations	$	-	$	3,431,564	$	-	$	3,431,564
Obligations of states and political subdivisions		-		49,543,510		-		49,543,510
Mortgage-backed securities (residential)		-		58,392,943		7,650,172		66,043,115
Mortgage-backed securities (commercial)		-		4,617,450		-		4,617,450
Collateralized debt obligations		-		-		-		-
Total	$	-	$	115,985,467	$	7,650,172	$	123,635,639

			December 31, 2010
	Level 1		Level 2		Level 3		Total
Available for sale securities:
U.S. Government agency debt obligations	$	-	$	4,172,667	$	-	$	4,172,667
Obligations of states and political subdivisions		-		45,759,402		-		45,759,402
Mortgage-backed securities (residential)		-		47,097,328		8,391,642		55,488,970
Mortgage-backed securities (commercial)		-		4,683,017		-		4,683,017
Collateralized debt obligations		-		-		4,600		4,600
Total	$	-	$	101,712,414	$	8,396,242	$	110,108,656

The following table represents the changes in the Level 3 fair-value category for the periods ended March 31, 2011 and March 31, 2010. We classify financial instruments in Level 3 of the fair-value hierarchy when there is reliance on at least one significant unobservable input in the valuation model. In addition to these unobservable inputs, the valuation models for Level 3 financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Thus, the gains and losses presented below include changes in the fair value related to both observable and unobservable inputs.

	Available-for-sale securities						Available-for-sale securities
	March 31, 2011						March 31, 2010
For the three months ended	Collateralized Debt Obligation			Mortgage Backed Securities (residential)			Collateralized Debt Obligation		Mortgage Backed Securities (residential)

Beginning Balance, January 1	$	4,600		$	8,391,642		$	10,000	$	5,091,556
Principal paydowns		-			(747,556	)		-		(255,943	)
Net realized/unrealized gains (losses)
Included in earnings:
Interest income on securities		-			(1,980	)		-		24,624
Credit loss recognized in earnings		(110,000	)		(14,999	)		-		(10,590	)
Included in other comprehensive income		105,400			23,065			28		167,607
Purchases of Level 3 securities					-					1,112,773
Transfers in (out) of Level 3		-			-			-		-
Ending Balance, March 31	$	-		$	7,650,172		$	10,028	$	6,130,027

Index

The table below summarizes changes in unrealized gains and losses recorded in earnings for the three-month period ending March 31 for Level 3 assets that are still held at March 31.

	Changes in Unrealized Gains (Losses) Relating to Assets Held at Reporting Date for the Quarter Ended March 31
Collateralized Debt Obligation	2011		2010
Impairment recognized in earnings	$	110,000	$	-
Total	$	110,000	$	- 0 -

	Changes in Unrealized Gains (Losses) Relating to Assets Held at Reporting Date for the Year Ended March 31
Mortgage backed securities (residential)	2011		2010
Impairment recognized in earnings	$	14,999	$	10,590
Total	$	14,999	$	10,590

Assets Measured at Fair Value on a Non-recurring Basis

Other certain assets and liabilities are measured at fair value on a non-recurring basis and are therefore not included in the tables above. These include impaired loans, which are measured at fair value based on the fair value of the underlying collateral, and other real estate owned. Fair value is determined, where possible, using market prices derived from an appraisal or evaluation. However, certain assumptions and unobservable inputs are used many times by the appraiser, therefore, qualifying the assets as Level 3 in the fair-value hierarchy.

The following tables present for each of the fair-value hierarchy levels our assets that are measured at fair value on a non-recurring basis.

			March 31, 2011
	Level 1		Level 2		Level 3		Total
Impaired loans:
Commercial	$	-	$	-	$	4,431,757	$	4,431,757
Commercial Real Estate
Construction		-		-		431,986		431,986
Other		-		-		3,641,323		3,641,323
Other real estate owned:
Commercial Real Estate
Construction	$	-	$	-	$	51,700	$	51,700
Other		-		-		1,230,315		1,230,315
Residential Real Estate
Traditional		-		-		228,420		228,420
Jumbo		-		-		-		-

Index

			December 31, 2010
	Level 1		Level 2		Level 3		Total
Impaired loans:
Commercial	$	-	$	-	$	5,491,859	$	5,491,859
Commercial Real Estate
Construction		-		-		763,986		763,986
Other		-		-		4,617,865		4,617,865
Other real estate owned:
Commercial Real Estate
Construction	$	-	$	-	$	1,878,255	$	1,878,255
Other		-		-		917,000		917,000
Residential Real Estate
Traditional		-		-		279,000		279,000
Jumbo		-		-		-		-

Impaired loans with specific allocations which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $10.8 million, with a valuation allowance of $2.3 million at March 31, 2011, resulting in an additional provision for loan losses of $428,000 for the three months ended March 31, 2011 compared to additional provision expense of $337,000 recorded for the three months ended March 31, 2010. Impaired loans with a carrying amount totaling $4.3 million at March 31, 2011 and $5.4 million at December 31, 2010 were excluded from the chart above as these were measured using the present value of expected future cashflows, which is not considered fair value. At December 31, 2010, impaired loans had a carrying amount of $12.5 million, with a valuation allowance of $1.6 million.

Our internal policy on OREO properties requires an updated appraisal once every 12 months. Several appraisals were received during the fourth quarter of 2010 at which time those properties were written down to fair value. Based on receiving new appraisals on a few OREO properties over the last three months, we have marked four of them to fair value. At March 31, 2011, the carrying value of those properties was $1.6 million, with a valuation allowance of $60,000, resulting in additional OREO expense of approximately $113,780 for the three months ended March 31, 2011. We added one residential real estate property and one commercial real estate property totaling $1.3 million, which was offset by two sales with a carrying value that totaled $664,000. Subsequent to March 31, 2011, a purchase agreement was signed on one of the new OREO properties that are expected to close by the end of the second quarter, which would reduce OREO by approximately $900,000. At December 31, 2010 the carrying value was $3.5 million, with a valuation allowance of $446,043, resulting in additional OREO expense of approximately $446,000 for the year ended December 31, 2010.

In accordance with accounting standards the carrying values and estimated fair values of our financial instruments at March 31, 2011 and December 31, 2010 are as follows:

	March 31, 2011						December 31, 2010
	Carrying			Fair			Carrying			Fair
	Value			Value			Value			Value
Financial assets:
Cash and cash equivalents	$	15,868,146		$	15,868,146		$	29,679,382		$	29,679,382
Long-term interest earning deposits		996,000			996,000			996,000			996,000
Securities available for sale		123,635,639			123,635,639			110,108,656			110,108,656
FHLBI and FRB stock		4,075,100			N/A			4,075,100			N/A
Loans held for sale		432,413			432,413			2,140,872			2,140,872
Loans, net		477,341,780			481,043,587			474,424,715			477,931,195
Accrued interest receivable		2,486,910			2,486,910			2,391,953			2,391,953
Financial liabilities:
Deposits	$	(575,525,403	)	$	(577,661,891	)	$	(576,356,136	)	$	(579,132,112	)
Federal funds purchased		(100,000	)		(100,000	)		-			-
FHLB advances		(11,500,000	)		(11,667,250	)		(7,500,000	)		(7,716,450	)
Junior subordinated debt		(17,527,000	)		(16,818,812	)		(17,527,000	)		(16,537,065	)
Accrued interest payable		(1,641,739	)		(1,641,739	)		(1,415,713	)		(1,415,713	)

Index

Estimated fair value for securities available for sale is consistent with the hierarchy regarding fair value measurements. For securities where quoted market prices are not available, fair values are estimated based on market prices of similar securities and in some cases on unobservable inputs due to inactive market activity. Estimated fair value of FHLBI and FRB stock cannot be determined due to restrictions placed on its transferability. Estimated fair value for loans is based on the rates charged at period-end for new loans with similar maturities, applied until the loan is assumed to reprice or be paid and the allowance for loan losses is considered to be a reasonable estimate of discount for credit quality concerns. Estimated fair value for IRAs, CDs, short-term borrowings, fixed rate advances from the FHLB and the junior subordinated debt is based on the rates at period-end for new deposits or borrowings, applied until maturity. Estimated fair value for other financial instruments and off-balance-sheet loan commitments is considered to approximate carrying value.

Note 11 – Reclassifications

Certain items in the financial statements and notes thereto were reclassified to conform to the current presentation. The reclassifications had no effect on net income or stockholders’ equity as previously reported.

Index

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following presents management’s discussion and analysis of the consolidated financial condition of the Company as of March 31, 2011 and December 31, 2010 and results of operations for the three month periods ended March 31, 2011 and March 31, 2010. This discussion should be read in conjunction with the Company’s consolidated condensed financial statements and the related notes appearing elsewhere in this report and the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

Executive Overview

Net income for the first quarter 2011 was $782,643, an increase of $61,607 from the first quarter of 2010. The increase in net income was primarily due to a decrease in provision expense of $120,000 and an increase in net interest income of $79,688. These increases to income were offset by an increase in noninterest expenses of $187,541. Net interest income increased primarily due to a drop in our cost of funds. Interest expense decreased by $576,823 compared to the same three-month period in 2010 ending March 31. Noninterest income also increased in 2011 compared to 2010 primarily due to an increase in the gain on the sale of securities by $57,829 and an increase in our net debit card interchange income by $46,822. Operating expenses increased primarily due to an increase of $172,006 in employment expenses and an increase of $136,123 in other real estate owned expenses. Most of the other expense categories remained the same or showed a slight decrease from the first quarter of 2010 to the first quarter of 2011, each of which was less than $100,000, including loan and professional costs, office supplies and occupancy and equipment expenses.

Total assets increased by $4.2 million from December 31, 2010 to March 31, 2011. The increase in total assets was primarily due to an increase in long-term investments and bank owned life insurance totaling $16.7 million offset by a decrease in cash and cash equivalents by $13.8 million. We also experienced an increase of $2.3 million in total loans, which primarily came from our commercial and commercial real estate portfolios.

Total deposits decreased by $830,733 to $575.5 million as of March 31, 2011, primarily due to decreases of $6.7 million, $6.1 million, and $5.3 million in certifcates of deposit, money market accounts, and noninterest bearing checking accounts, respectively. These decreases were offset by increases of $13.8 million in our interest bearing checking and $4.9 million in our brokered deposits. Core deposits decreased by $2.6 million, and now comprise 74.5% of total deposits.

Financial Condition

Total assets were $664.1 million at March 31, 2011 compared to total assets at December 31, 2010 of $659.9 million. The 0.6% increase in assets was primarily due to an increase in long-term investments and bank owned life insurance of $16.7 million, which was offset by a decrease in cash and cash equivalents by $13.8 million.

Cash and Investments. Cash and cash equivalents, which include federal funds sold, were $15.9 million at March 31, 2011, a decrease of $13.8 million, or 46.5%, from December 31, 2010. The cash was used to purchase securities available for sale, which increased by $13.5 million from December 31, 2010 to $123.6 million at the end of the first quarter of 2011. The increase in long-term investments was primarily in municipal bonds and residential mortgage-backed securities, which increased by $3.8 million and $10.6 million, respectively. Long-term investments now comprise 18.6% of total assets, as we continue to focus on liquidity and repositioning of the balance sheet.

Loans. Total loans were $489.2 million at March 31, 2011 reflecting a 0.5% increase from total loans of $486.9 million at December 31, 2010. The increase in loans during the first three months of 2011 occurred mainly in the commercial and commercial real estate loan categories, which increased by a total of $4.5 million

Nonperforming Assets. Nonperforming assets include impaired securities, nonperforming loans, and other real estate owned (OREO). Nonperforming loans include loans past due over 90 days and still accruing interest, nonperforming restructured loans, and all nonaccrual loans. Nonperforming assets have decreased from $27.8 million, or 4.2% of total assets, at December 31, 2010 to $22.9 million, or 3.4% of total assets, at March 31, 2011. The decrease was primarily attributable to two restructured loans totaling $5.4 million moving to performing status. These two relationships have demonstrated their ability to consistently make scheduled payments based on the restructured terms. Included in delinquencies greater than 90 days as of March 31, 2011 and December 31, 2010 is an accruing $1.8 million loan that has matured. The Bank has elected not to renew the loan and is seeking collection via legal process. The loan remains in accruing status because it is further supported by the unlimited guaranty of a third party whose guaranty is fully secured by a mortgage on a performing commercial real estate property that is unrelated to the borrower’s enterprise and cash collateral of $645,000 on deposit in the Bank’s name. This loan is expected to remain nonperforming during the pendency of our legal collection efforts but ultimate collection is not currently in doubt. Without this item, non-performing assets would have totaled $21.1 million, or 3.2% of total assets and $26.0 million, or 3.9% of total assets at March 31, 2011 and December 31, 2010, respectively.

Index

Non-accrual loans decreased by $200,887 during the first quarter of 2011 primarily due to the sale of a $1.9 million commercial loan and the transfer of two loans to OREO in the amount of $1.3 million. The reductions to non-accruals were offset by adding four commercial and one commercial real estate relationship totaling $3.2 million. These additions to non-accruals resulted in $130,000 of additional provision expense for the quarter ending March 31, 2011.

The increase in OREO of $456,329 was a direct result of the addition of two loan foreclosures, one commercial real estate and one residential real estate property, totaling $1.3 million since December 31, 2010. Offsetting the additions was the sale of two residential real estate properties and one commercial real estate property, which caused a reduction of $706,987 in other real estate owned. Subsequent to March 31, 2011, a purchase agreement was signed on a commercial real estate property that will reduce other real estate owned by approximately $900,000 before the end of the second quarter of 2011.

Loans are deemed impaired when it is probable that we will not be able to collect all principal and interest amounts due according to their contractual terms, which includes most nonperforming loans. Total impaired loans at March 31, 2011 were $29.4 million, compared to $31.6 million at December 31, 2010. At March 31, 2011, management believes it has allocated adequate specific reserves for these risks.

Allowance for Loan Losses. In each quarter the allowance for loan loss is adjusted to the amount management believes is necessary to maintain the allowance at adequate levels. Management allocates specific portions of the allowance for loan losses to specific problem loans. Problem loans are identified through a loan risk rating system and monitored through watchlist reporting. Specific reserves are determined for each identified problem loan based on delinquency rates, collateral and other risk factors specific to that problem loan. Management’s allocation of the allowance to other loan pools considers various factors including historical loss experience, the present and prospective financial condition of borrowers, industry concentrations within the loan portfolio, general economic conditions, and peer industry data of comparable banks.

The allowance for loan losses at March 31, 2011 was $11.9 million, or 2.43% of total loans outstanding, a decrease of $581,605 from $12.5 million, or 2.57% of total loans outstanding, at December 31, 2010. The provision for loan losses during the first three months of 2011 was $1.2 million compared to $1.3 million in the first three months of 2010 as a result of management’s focus on reducing classified assets over the last year.

For the first three months of 2011, we were in a net charge-off position of $1.8 million compared to a net charge-off position of $788,504 for the three months of 2010. The increase in the charge-offs from the first quarter 2010 compared to the first quarter 2011 was a result of management’s decision to aggressively reduce classified assets. The reduction occurred through the sale of loans and OREO properties, discounts taken on loans to allow the customer to refinance through other institutions, payoffs, and write-downs to fair value. Nonperforming loans decreased by $5.4 million during the first three months of 2011. The specific allowance allocations decreased by $372,876 to $3.4 million in the first three months of 2011 primarily due to charging down one commercial real estate relationship by $1.0 million that was previously reserved and did not require additional reserves as of March 31, 2011.

Other Assets. Other assets, which includes bank owned life insurance and prepaid FDIC insurance, increased by $2.8 million, primarily from the $3.0 million purchase of bank owned life insurance. Prepaid FDIC insurance decreased $486,957 and will continue to decrease as the quarterly amounts are expensed.

Deposits. Total deposits were $575.5 million at March 31, 2011 compared to total deposits at December 31, 2010 of $576.4 million. The decrease of $830,733 during the first three months of 2011 was a combination of an increase in interest bearing deposits, primarily in health savings accounts, of $13.8 million and an increase in brokered deposits of $4.9 million offset by decreases of $6.7 million, $6.1 million, and $5.3 million in certifcates of deposit, money market accounts, and noninterest bearing accounts, respectively. Core deposits decreased by $2.6 million over the first three months of 2011, but remain at 74.5% of total deposits. Total brokered deposits were $110.4 million at March 31, 2011, which includes brokered certifcates of deposit of $98.4 million and brokered money market accounts of $12.0 million. Brokered deposits were $105.5 million at December 31, 2010. We have strategically increased our brokered deposits, in both certificates of deposit for the long-term funding and money market accounts for the short-term funding. We have been able to lock in rates on brokered certificates of deposits over a period ranging from two to ten years. Based on the current interest rate environment and the competition in the local market, funding is and will continue to be the primary way to manage net interest margin.

Index

The following table summarizes the Company’s deposit balances at the dates indicated:

	March 31, 2011					December 31, 2010
	Balance		%			Balance		%
Core deposits:
Noninterest-bearing demand	$	87,598,846		15.2	%	$	92,872,957		16.1	%
Interest-bearing checking		114,920,403		20.0	%		101,158,162		17.6	%
Money market		153,225,501		26.6	%		159,336,066		27.7	%
Savings		21,247,225		3.7	%		22,672,555		3.9	%
Time, under $100,000		51,881,437		9.0	%		55,450,402		9.6	%
Total core deposits		428,873,412		74.5	%		431,490,142		74.9	%
Non-core deposits:
In-market non-core deposits: Time, $100,000 and over		36,220,770		6.3	%		39,356,777		6.8	%
Out-of-market non-core deposits:
Money market		12,020,676		2.1	%		12,015,936		2.1	%
Brokered certificate of deposits		98,410,545		17.1	%		93,493,281		16.2	%
Total out-of-market deposits		110,431,221		19.2	%		105,509,217		18.3	%
Total non-core deposits		146,651,991		25.5	%		144,865,994		25.1	%

Total deposits	$	575,525,403		100.0	%	$	576,356,136		100.0	%

Borrowings. The Company had borrowings in the amount of $11.5 million in Federal Home Loan Bank (“FHLB”) advances at March 31, 2011 and $7.5 million at December 31, 2010. Of the outstanding FHLB advances at March 31, 2011, $5.5 million are bullet advances and mature in a range from March 2011 through March 2013. The remaining $6.0 million are variable rate advances that mature in September 2011.

Other Liabilities. Other liabilities and accrued interest payable decreased from $5.4 million at December 31, 2010 to $5.1 million at March 31, 2011. Accrued interest payable increased by $226,026, primarily from the deferral of our interest payments related to our Junior Subordinated debt. This was offset by a decrease in accrued bonus due to the 2010 bonus being paid out in February.

Results of Operations

For The Three-Month Periods Ended March 31

Results of operations for the three-month period ended March 31, 2011 reflected net income of $782,643, or $0.16 per diluted share. This was a $61,607 increase from 2010’s first quarter net income of $721,036, or $0.16 per diluted share. The operating results for the three-month period ended March 31, 2011 were favorable as we experienced an increase in our net interest income of $79,688, a decrease in loan loss provision of $120,000, and an increase in non-interest income by $49,519. Noninterest expenses increased by $187,541, or 3.8%, from the same three-month period in 2010.

Performance Ratios	March 31
	2011			2010

Return on average assets *		0.48	%		0.43	%
Return on average equity *		5.91	%		6.17	%
Net interest margin (TEY) *		3.83	%		3.66	%
Efficiency ratio		69.86	%		68.50	%

* annualized

Net Interest Income. Interest income for the three-month periods ended March 31, 2011 and 2010 was $7.3 million and $7.8 million, respectively, while interest expense for the first quarter was $1.6 million in 2011 and $2.2 million in 2010, resulting in net interest income of $5.6 million for the same three-month period in 2011 and 2010. The tax equivalent net interest margin for the first quarter of 2011 was 3.83%, while the tax equivalent net interest margin for the first quarter of 2010 was 3.66%. The improvement in our net interest margin came primarily from an aggressive reduction in cost of funding, which was consistent with our strategy to decrease higher cost deposits and replace them with lower cost out-of-market deposits that can be structured to reduce interest rate risk in the future. We have been able to take advantage of the low interest rate environment by increasing brokered deposits as discussed previously under the section “Financial Condition – Deposits.” The increase in our net interest margin was offset by a decrease in earning assets of $11.3 million from the first quarter 2010. While we estimate the interest rates will remain relatively flat for the remainder of the year, we expect some minimal margin compression to occur over the next few quarters as we look to mitigate some of our interest rate risk by locking in funding costs over a longer term, two to ten years, through the use of brokered deposits.

Index

The following table reflects the average balance, interest earned or paid, and yields or costs of the Company’s assets, liabilities and stockholders’ equity at and for the dates indicated:

	As of and For The Three Month Period Ended
	March 31, 2011								March 31, 2010
				Interest		Annualized						Interest		Annualized
	Average			Earned		Yield			Average			Earned		Yield
($ in thousands)	Balance			or Paid		or Cost			Balance			or Paid		or Cost
Assets
Short-term investments and interest-earning deposits	$	2,785		$	13		1.89	%	$	2,432		$	4		0.67	%
Federal funds sold		2,013			1		0.20	%		3,720			2		0.22	%
Securities - taxable		80,112			579		3.00	%		71,040			639		3.65	%
Securities - tax exempt (1)		41,668			596		5.81	%		24,419			371		6.16	%
Loans held for sale		1,689			-		0.00	%		1,157			-		0.00	%
Loans		489,999			6,289		5.21	%		526,814			6,883		5.30	%
Total interest-earning assets		618,266			7,478		4.91	%		629,582			7,899		5.09	%
Allowance for loan losses		(12,964	)							(12,040	)
Cash and due from banks		19,509								19,284
Other assets		39,753								41,141
Total assets	$	664,564							$	677,967
Liabilities and Stockholders' Equity
Interest-bearing checking	$	115,584		$	46		0.16	%	$	106,890		$	106		0.40	%
Savings		23,156			15		0.26	%		19,152			19		0.40	%
Money market		167,363			194		0.47	%		149,750			323		0.87	%
Certificates of deposit		185,183			1,106		2.42	%		200,216			1,312		2.66	%
Short-term borrowings		67			-		0.00	%		-			-		0.00	%
FHLB advances		10,489			72		2.78	%		44,765			170		1.54	%
Junior subordinated debt		17,527			200		4.63	%		17,527			280		6.48	%
Total interest-bearing liabilities		519,369			1,633		1.28	%		538,300			2,210		1.67	%
Noninterest-bearing checking		86,368								88,231
Other liabilities		5,165								4,016
Stockholders' equity		53,662								47,420
Total liabilities and stockholders' equity	$	664,564							$	677,967
Net interest income				$	5,845							$	5,689
Rate spread							3.63	%							3.42	%
Net interest income as a percent of average earning assets							3.83	%							3.66	%

(1) Computed on a tax equivalent basis for tax exempt securities using a 34% statutory tax rate.

Provision for Loan Losses. A provision for loan losses was recorded in the amount of $1.2 million, or 101 basis points, annualized, on average loans during the first quarter of 2011 as compared to $1.3 million, or 103 basis points, annualized, on average loans for the first quarter of 2010. The allowance for loan losses at March 31, 2011 totaled $11.9 million and was 2.43% of total loans outstanding on that date. For the three-month period ended March 31, 2011 we were in a net charge-off position of $1.8 million, or 149 basis points, annualized, on average loans compared to net charge-off of $788,504, or 61 basis points, annualized, on average loans during the same period a year ago. The charge-offs taken in 2011 were mainly made up of three loans. One commercial real estate loan recorded a $1.0 million charge-off, which had been reserved for previously. Two commercial loans made up another $681,514 of the net charge-offs, of which one loan was sold causing a $1.9 million reduction in non-accruals and the other loan was charged down to the remaining collateral value.

Noninterest Income. Noninterest income was $1.6 million during the first quarter of 2011. This was a $49,519 increase compared to the first quarter of 2010. The majority of the increase relates to increase of $46,822 in net debit card interchange income primarily due to the increase in the number of debit cards outstanding and the conversion to another service provider in February of 2011. The increase in the gain on sale of available for sale securities of $57,829 contributed to the increase in noninterest income, but was offset by an increase in the other-than-temporary-impairment charge of $114,409 compared to the first quarter of 2010.

Noninterest Expense. Noninterest expense was $5.1 million for the first quarter of 2011 while noninterest expense for the three-month period ended March 31, 2010 was $4.9 million. The main components of noninterest expense for the first quarter of 2011 were salaries and benefits of $2.6 million, occupancy and equipment costs of $619,606, FDIC insurance premiums of $506,848, loan and professional expenses of $361,442, and data processing costs of $309,305. Employee benefits and OREO expenses displayed the largest increases of $172,006 and $136,123, respectively. The increase in employee benefits was caused by a standard increases in salaries, new incentive plans, and increase in payroll taxes. The increased payroll tax is primarily due to the unplanned increase in the state’s unemployment tax for 2011. The increase in OREO expense was due to write-downs caused by the decrease in property values based on receiving updated appraisals on several properties. FDIC premiums remained relatively unchanged compared to the same three-month period in 2010. The FDIC has announced a reduction of their assessment rates effective April 1, 2011. We expect an immediate 8 to 10 basis point reduction in our assessment rates based on our current deposit balances.

Index

Income Taxes. During the quarters ended March 31, 2011 and 2010, the Company recorded $194,861 and $194,802 in income taxes expense, respectively. The effective tax rate recorded was 19.9% for 2011 as compared to 21.3% for 2010. The reduction in the effective tax rate from 2010 was caused by an increase in tax exempt income, including bank owned life insurance and municipal interest income.

Liquidity and Capital Resources

Liquidity. Our general liquidity strategy is to fund growth with deposits and to maintain an adequate level of short- and medium-term investments to meet typical daily loan and deposit activity needs. We experienced a decrease of $830,733 in total deposits during the first three months of 2011. While we continue to encourage the growth of in-market deposits, we believe we have positioned ourselves to increase our out-of-market brokered deposits and FHLB advances while allowing higher cost in-market certificates of deposit to leave as they mature. This strategy has allowed us to reduce interest rate risk by purchasing brokered deposits and maintain an adequate net interest margin. Currently, $5.5 million of our FHLB advances are fixed rate bullet advances with no callable options; therefore, we must wait until maturity to repay. We also have $6.0 million in variable rate FHLB advances that can be repaid anytime with scheduled maturities in September 2011. Included in our out-of-market funding base are borrowings from the FHLB, brokered deposits, and trust preferred securities. In the aggregate these out-of-market deposits and borrowings represented $139.6 million, or 23.1% of our total funding, at March 31, 2011. This was up from $130.5 million, or 21.7%, at December 31, 2010. Total deposits at March 31, 2011 were $575.5 million and the loan to deposit ratio was 85.0%. Total borrowings at March 31, 2011 were $29.1 million. We expect to experience minimal to moderate loan growth in the near-term due to current economic conditions, as well as the continuation of management’s strategy, which focuses on profitability, rather than growth. We expect to continue funding the majority of any loan growth with a mix of in-market and out-of-market sources that will be structured to mitigate future interest rate risk.

Capital Resources. Stockholders’ equity is a noninterest-bearing source of funds, which provides support for asset growth. Stockholders’ equity was $54.4 million and $53.1 million at March 31, 2011 and December 31, 2010, respectively. Affecting the increase in stockholders’ equity during the first three months of 2011 was $782,643 in net income and $489,901 in unrealized gains, net of tax, on available for sale securities. Additionally, we recorded $11,727 of restricted stock compensation expense.

During the first three months of 2011, we made no dividend payments. We have not made dividend payments since the first quarter of 2008, based on our desire to retain capital and hedge against challenging economic and banking industry conditions as well as to maintain Tower Bank’s current “well capitalized” status within the Federal Reserve System. Under the terms of our current agreement with our regulatory agencies, we must first be granted permission by them in order to declare and pay any dividends.

The following table summarizes the capital ratios of the Company and the Bank at the dates indicated:

	March 31, 2011									December 31, 2010
				Well-			Minimum						Well-			Minimum
	Actual			Capitalized			Required			Actual			Capitalized			Required

The Company
Leverage capital		10.59	%		5.00	%		4.00	%		10.55	%		5.00	%		4.00	%
Tier 1 risk-based		13.27	%		6.00	%		4.00	%		13.10	%		6.00	%		4.00	%
Total risk-based		14.53	%		10.00	%		8.00	%		14.30	%		10.00	%		8.00	%

The Bank
Leverage capital		10.15	%		5.00	%		4.00	%		10.08	%		5.00	%		4.00	%
Tier 1 risk-based		12.64	%		6.00	%		4.00	%		12.46	%		6.00	%		4.00	%
Total risk-based		13.90	%		10.00	%		8.00	%		13.72	%		10.00	%		8.00	%

Index

Commitments and Off-Balance Sheet Risk

The Bank maintains off-balance-sheet instruments in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized, if any, in the balance sheet. The Bank’s maximum exposure to loan loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of these instruments. Such financial instruments are recorded when they are funded. Fair value of the Bank’s off-balance-sheet instruments (commitments to extend credit and standby letters of credit) is based on rates currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. At March 31, 2011, the rates on existing off-balance-sheet instruments were equivalent to current market rates, considering the underlying credit standing of the counterparties.

Tabular disclosure of the Company’s contractual obligations as of the end of our latest fiscal year was provided in our Annual Report on Form 10-K for the year ended December 31, 2010. There have been no material changes outside the ordinary course of business in such contractual obligations during the first three months of 2011.

Item 4. CONTROLS AND PROCEDURES

a. Evaluation of disclosure controls and procedures

As of the end of the period covered by this report, we carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934), under the supervision and the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based upon their evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by Securities and Exchange Commission rules and forms. Furthermore, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed is accumulated and communicated to our management in an appropriate manner so as to allow timely decisions regarding required disclosures. In designing and evaluating the disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

c. Changes in internal control over financial reporting

There were no changes in our internal control over financial reporting or in our procedures during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting, nor were we required to take nor did we take any corrective actions with regard to any significant deficiencies or material weaknesses in internal control over financial reporting.

Index

PART II. OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

No material litigation

Item 1a. RISK FACTORS

As reported in our Form 10-K, we are subject to extensive regulation, supervision and examination by the Indiana Department of Financial Institutions (the IDFI), the Federal Reserve and the FDIC, as insurer of its deposits. Such regulation and supervision govern the activities in which a financial institution and its holding company may engage, and are intended primarily for the protection of the depositors and borrowers of Tower Bank and for the protection of the FDIC insurance fund. The regulation and supervision by the Federal Reserve, the IDFI and the FDIC are not intended to protect the interests of investors in our common stock. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, the adverse classification of our assets and determination of the level of our allowance for loan losses. Starting in 2010, this risk factor has increased in importance with the passing of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the uncertainty of the exact impact it will have on financial institutions.

In addition to the information set forth above and throughout this report, you should carefully consider the factors discussed in Part I, Item 1a “Risk Factors” contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010, which could materially affect our business, financial condition or future results.

Index

Item 6. EXHIBITS

(a)

Exhibits.

31.1	Certification of Chief Executive Officer required by Item 307 of Regulation S-K as promulgated by the Securities and Exchange Commission and Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

31.2	Certification of Chief Financial Officer required by Item 307 of Regulation S-K as promulgated by the Securities and Exchange Commission and Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

32.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

32.2.

Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

*Filed with concurrently herewith.

SIGNATURES

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

	TOWER FINANCIAL CORPORATION


Dated: April 29, 2011	/ s / Michael D. Cahill
	Michael D. Cahill, President
	and Chief Executive Officer


Dated: April 29, 2011	/ s / Richard R. Sawyer
	Richard R. Sawyer
	Chief Financial Officer

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