Summary of LINCOLN BANCORP /IN/

Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations

General

The Company was organized in September 1998. On December 30, 1998, it acquired the common stock of Lincoln upon the conversion of Lincoln from a federal mutual savings bank to a federal stock savings bank. The Bank converted from a federal thrift charter to a state commercial bank charter on November 1, 2006.

Lincoln Bank was originally organized in 1884 as Ladoga Federal Savings and Loan Association, located in Ladoga, Indiana. In 1979 Ladoga Federal merged with Plainfield First Federal Savings and Loan Association, a federal savings and loan association located in Plainfield, Indiana, which was originally organized in 1896. Following the merger, the Bank changed its name to Lincoln Federal Savings and Loan Association and, in 1984, adopted the name, Lincoln Federal Savings Bank. On September 1, 2003, the Bank adopted the name Lincoln Bank. On August 2, 2004, the Company acquired First Shares Bancorp, Inc., the holding company of First Bank, an Indiana commercial bank. First Shares was merged with and into the Company and immediately thereafter, First Bank was merged into Lincoln Bank. As noted above, the Bank converted from a federal thrift charter to a state commercial bank charter on November 1, 2006, and provides full banking services in a single significant business segment. As a state chartered bank, the Bank is subject to regulation by the Department of Financial Institutions, State of Indiana and the Federal Deposit Insurance Corporation.

Lincoln currently conducts its business from 17 full-service offices located in Hendricks, Johnson, Morgan, Clinton, Montgomery, and Brown Counties, Indiana, with its main office located in Plainfield. The Bank also has 2 loan production offices located in Carmel and Greenwood, Indiana. Lincoln offers a variety of lending, deposit and other financial services to its retail and commercial customers. The Bank's principal business consists of attracting deposits from the general public and originating fixed-rate and adjustable-rate loans secured by commercial real estate, inventory, accounts receivable as well as first mortgage liens on one- to four-family residential real estate. Lincoln's deposit accounts are insured up to applicable limits by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation. Lincoln offers a number of financial services, which include: (i) one-to-four-family residential real estate loans;
(ii) commercial real estate loans; (iii) real estate construction loans; (iv) land loans; (v) multi-family residential loans; (vi) consumer loans, including home equity loans and automobile loans; (vii) commercial loans; (viii) money market demand accounts; (ix) savings accounts; (x) checking accounts; (xi) NOW accounts; (xii) certificates of deposit; and (xiii) financial planning.

Lincoln currently owns three subsidiaries. First, LF Service's, assets consist of an investment in Bloomington Housing Associates, L.P. ("BHA"). BHA is an Indiana limited partnership that was organized to construct, own and operate a 130-unit apartment complex in Bloomington, Indiana (the "BHA Project"). Development of the BHA Project was completed in 1993 and the project is performing as planned. Second, Citizens Loan and Service Corporation ("CLSC") primarily engages in the purchase and development of tracts of undeveloped land. Because CLSC engages in activities that are not permissible for a national bank, FDIC regulations prohibit Lincoln from including its investment in CLSC in its calculation of regulatory capital. CLSC purchases undeveloped land, constructs improvements and infrastructure on the land, and then sells lots for residential home construction. Third, LF Portfolio, which is located in Nevada, holds and manages a significant portion of Lincoln's investment portfolio. As noted above, effective November 1, 2006, the Bank changed its charter from a federal savings bank charter to an Indiana commercial bank charter. Unlike federal savings banks, commercial banks are not permitted to participate in real estate development joint ventures. Under terms of the approval granted by the Federal Reserve Bank of Chicago the Company agreed to cause Lincoln Bank to conform the existing direct and indirect nonbanking activities and investments conducted by CLSC, including by divestiture if necessary, to the requirements of the Bank Holding Company Act within two years of the consummation of the charter conversion.

Lincoln's results of operations depend primarily upon the level of net interest income, which is the difference between the interest income earned on interest-earning assets, such as loans and investments, and costs incurred with respect to interest-bearing liabilities, primarily deposits and borrowings. Results of operations also depend upon the level of Lincoln's non-interest income, including fee income and service charges and the level of its non-interest expenses, including general and administrative expenses.

As noted in our 2007 Annual Report on Form 10-K, because we focus our business in central Indiana, an economic slowdown in this area could hurt our business. An economic slowdown could have the following consequences:

• Loan delinquencies may increase;
• Problem assets and foreclosures may increase;
• Demand for the products and services of Lincoln Bank may decline; and

• Collateral for loans made by Lincoln Bank may decline in value, in turn reducing customers' borrowing power, and making existing loans less secure.

The Company has not experienced many of the challenges facing the banking industry as a whole due in large part to its policy of not investing in sub-prime mortgage loans or any (so-called "off-balance sheet") activity related to the structuring and sale of such loans. As the economy worsens some of the Company's customers will experience stress, in some cases severe enough to impact their ability to repay loans in a timely manner. Our plan is to work closely with our customers to help them work through the stress if possible and, where necessary, to liquidate the credit. Our policy of requiring prudent underwriting and the fact that Midwest property values have not been as severely impacted as other areas of the country should help mitigate the level of losses that the Company may incur.

As previously announced, On September 2, 2008, Lincoln Bancorp ("Lincoln") and First Merchants Corporation ("First Merchants") jointly announced the signing of a definitive agreement (the "Merger Agreement") pursuant to which Lincoln will be merged with and into First Merchants (the "Merger"). The Merger Agreement provides that upon the effective date of the Merger, each Lincoln shareholder will have the option of receiving 0.7004 shares of First Merchants common stock or $15.76 in cash for each share of Lincoln stock owned as of the effective date of the merger. However, no more than 3,576,417 shares of First Merchants' common stock and no more than $16,800,000 in cash may be paid to the Lincoln shareholders in the Merger, and there may be re-allocations of cash and stock to certain Lincoln shareholders if either threshold is exceeded. Based on the closing price of First Merchants' common stock on September 2, 2008, the transaction has an estimated aggregate value between $74 million and $77 million, depending on the elections of shareholders. The transaction is expected to be a tax-free stock exchange for those Lincoln shareholders electing to receive First Merchants common stock. The Merger is expected to close December 31, 2008. The Agreement has been approved by the boards of directors of Lincoln and First Merchants. However, it is subject to certain other conditions, including the approval of the shareholders of Lincoln and the approval of regulatory authorities.

Critical Accounting Policies

Note 1 to the consolidated financial statements contains a summary of the
Company's significant accounting policies presented on pages 31 through 33 of the Annual Report to Shareholders for the year ended December 31, 2007, which was filed on Form 10-K with the Securities and Exchange Commission on March 14, 2008. Certain of these policies are important to the portrayal of the Company's financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Management believes that its critical accounting policies include determining the allowance for loan losses, the valuation of mortgage servicing rights, and the valuation of intangible assets.

Allowance for loan losses

The allowance for loan losses represents management's estimate of probable losses inherent in the Company's loan portfolios. In determining the appropriate amount of the allowance for loan losses, management makes numerous assumptions, estimates and assessments.

The Company's strategy for credit risk management includes conservative, centralized credit policies, and uniform underwriting criteria for all loans as well as an overall credit limit for each customer below legal lending limits. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit quality reviews and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit quality. A standard credit scoring system is used to assess credit risks during the loan approval process of all consumer loans while commercial loans are individually reviewed by a credit analyst with formal presentations to the Bank's Loan Committee.

The Company's allowance consists of three components. The Company estimates probable losses from individual reviews of specific loans and probable losses from historical loss rates. Also, factors affecting probable losses resulting from economic or environmental factors that may not be captured in the first two components of the allowance are considered.

Larger commercial loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropriate, reserves are allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Company. Included in the review of individual loans are those that are impaired as provided in SFAS No. 114, Accounting by Creditors for Impairment of a Loan. Any allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or fair value of the underlying collateral.

The Company evaluates the collectability of both principal and interest when assessing the need for a loss accrual. Estimated loss rates are applied to other commercial loans not subject to specific reserve allocations.

Homogenous loans, such as consumer installment and residential mortgage loans are not individually risk graded. Rather, standard credit scoring systems are used to assess credit risks. Loss rates are based on the average net charge-off estimated by loan category. Allowances on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions.

The Company's primary market area for lending is central Indiana. When evaluating the adequacy of the allowance, consideration is given to this regional geographic concentration and the closely associated effect changing economic conditions have on the Company's customers. The Company has not substantively changed any aspect to its overall approach in the determination of the allowance for loan losses. There have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period allowance.

Mortgage servicing rights

The Company recognizes the rights to service sold mortgage loans as separate assets in the consolidated balance sheet. The total cost of loans when sold is allocated between loans and mortgage servicing rights based on the relative fair values of each. Mortgage servicing rights are subsequently carried at the lower of the initial carrying value, adjusted for amortization, or fair value. Mortgage servicing rights are evaluated for impairment based on the fair value of those rights.

Factors included in the calculation of fair value of the mortgage servicing rights include, estimating the present value of future net cash flows, market loan prepayment speeds for similar loans, discount rates, servicing costs, and other economic factors. Servicing rights are amortized over the estimated period of net servicing revenue. It is likely that these economic factors will change over the life of the mortgage servicing rights, resulting in different valuations of the mortgage servicing rights. The differing valuations will affect the carrying value of the mortgage servicing rights on the consolidated balance sheet as well as the amounts recorded in the consolidated income statement. See Note 4 for a discussion of (SFAS) No. 156, Accounting for Servicing of Financial Assets-an amendment of FASB Statement No. 140.

Intangible assets

As discussed more fully in management's review of operating results below, the announced merger with First Merchants Corporation and the exchange ratio contained in the Merger Agreement triggered an evaluation of goodwill for impairment. This evaluation determined that goodwill recorded from previous acquisitions of the Corporation should be eliminated. As such, a charge against current earnings totaling $23,907,000 was recorded in the quarter ending September 30, 2008.

Financial Condition

Assets totaled $830.9 million at September 30, 2008, a decrease from December 31, 2007 of $58.4 million. The net decrease in assets occurred primarily in investment securities available for sale, down $26.0 million and total loans including loans held for sale, down $9.4 million. Also, as noted above, management reviewed its goodwill asset for impairment during the third quarter and determined that it was fully impaired. The decline in goodwill totaled $23.9 million. Investments declined as several callable securities were called as interest rates declined. The proceeds of these securities were used to offset reductions in certificates of deposit and money market deposits including public funds. The largest components of the decline in loans occurred in residential real estate mortgages, down $13.6 million and indirect consumer loans, down $8.8 million. Both of these declines are in line with management's expectations. The majority of our fixed rate mortgage product is currently being sold in the secondary market and indirect activity has been substantially reduced due to competition. Home equity loans increased by $14.2 million and commercial loans increased by $2.7 million from December 31, 2007. The increase in home equity loans included $6.9 million of home equity loans referred by local, central Indiana, brokers with the customer and homes being located in central Indiana. As of September 30, 2008 this program has been curtailed as target goals for this channel were met. The allowance for loan losses increased since December 31, 2007. This was partially in reaction to an increase in nonperforming loans to 2.08% of total loans at September 30, 2008 from 1.22% at year end 2007.

Total deposits were $594.5 million at September 30, 2008, a decline of $61.9 million since December 31, 2007. The decline occurred primarily in money market deposits down $49.0 million and certificates of deposit, down $36.3 million. The decline in money market deposits was due to the outflow of public fund deposits as local governments paid bills as well as sought higher interest rate alternatives. Certificates of deposit were affected by less public fund deposits as well as management's efforts to reduce single service certificate of deposit customers where wholesale funding presented a substantially attractive alternative. Growth occurred in noninterest-bearing and interest-bearing demand deposit accounts, up $1.5 million and $19.2 million, respectively, and savings accounts, up $2.5 million from December 31, 2007. Borrowings increased by $31.1 million from year end 2007 to $140.3 million at September 30, 2008 as wholesale borrowing costs declined below competitive rates for certain deposits as noted above.

Shareholders' equity declined by $27.6 million from $99.0 million at December 31, 2007 to $71.4 million at September 30, 2008. The majority of the decline was the result of the net loss recorded. The net loss included $23.9 million in expense recorded as the result of the review of goodwill for impairment and the subsequent charge to fully impair goodwill on the Company's books. Shareholder's equity was also negatively impacted by recording the decline in the fair market value of available-for-sale securities as of September 30, 2008. Accumulated other comprehensive loss grew to $4.5 million at September 30, 2008 from a loss of $.4 million at December 31, 2007. Several "trust preferred" securities were responsible for a substantial amount of the increased loss in accumulated other comprehensive loss. The carrying value of these securities total $13.4 million with a market value of $7.9 million. Management has specifically reviewed these securities, along with other securities in a loss position, and determined, at this time, no other-than-temporary impairment exists. As of September 30, 2008 management has both the ability and the intent to hold these securities until recovery. Management does classify these securities as "available-for-sale" under the definition of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities so certain circumstances, such as changes in market interest rates and related changes in the security's prepayment risk, needs for liquidity (for example, due to the withdrawal of deposits, increased demand for loans), changes in the availability of and the yield on alternative investments or changes in funding sources and terms could change management's assessment of its ability and intent to hold these securities.

Comparison of Operating Results for the Three Months Ended September 30, 2008 and 2007

Net loss for the quarter ended September 30, 2008 was $23.5 million, or $4.64 for both basic and diluted earnings per share. This compared to net income for the comparable period in 2007 of $521,000, or $.10 for both basic and diluted earnings per share. As noted above an impairment charge for goodwill was recorded during the period ending September 30, 2008 that totaled $23.9 million, after tax.

Net interest income for the second quarter of 2008 was $6,152,000 compared to $5,501,000 for the same period in 2007. Net interest margin improved to 3.11% for the three-month period ended September 30, 2008 compared to 2.69% for the same period in 2007. The average yield on earning assets declined only 83 basis points for the third quarter of 2008 compared to the same period in 2007 while the average cost of interest-bearing liabilities declined 141 basis points in 2008 compared to 2007. Interest rate spread increased from 2.22% for the quarter ending September 30, 2007 to 2.80% for the like quarter in 2008. Falling rates have allowed the Bank to benefit from a liability sensitive position. In addition, a more "normal", positively sloped yield curve has allowed the Bank to support slightly longer asset maturities with cheaper, somewhat shorter term, liabilities. Our deposit environment has been one where competition has kept certain types of interest bearing deposit account costs higher than wholesale funding that has been available. We have deliberately reduced certain higher cost funding sources, primarily public fund certificates and certain single service customer certificate relationships in areas where competition seems irrational. As noted above, maturities of investments, a slight decline in loans and growth in certain other deposit categories has provided the funding for this strategy.

The Bank's provision for loan losses for the third quarter of 2008 was $357,000 compared to $150,000 for the same period in 2007. The increase in the provision expense was primarily the result of continued concern about the economy and its effect on our borrowers as well as increases in nonperforming assets. Much of the nonperforming increase had been expected and taken into account in our large provision recorded in the first quarter of 2008. At this time, no charge-offs are deemed necessary for these credits. Non-performing loans to total loans at September 30, 2008 were 2.08% compared to 1.22% at December 31, 2007, while non-performing assets to total assets were 1.71% at September 30, 2008 compared to 0.95% at December 31, 2007. The allowance for loan losses as a percent of loans was 1.31% at September 30, 2008 and 1.02% at December 31, 2007. During the third quarter of 2008, the Bank incurred $230,000 in net charged off loans compared to net charged off loans in the same quarter of 2007 totaling $114,000. Although management believes the allowance for loan losses is appropriate to absorb probable future losses inherent in the portfolio as of September 30, 2008, further deterioration in either the economy or our borrowers' individual financial conditions may necessitate additional provision expense in the future.

Other income for the three months ended September 30, 2008 was $1,727,000 compared to $1,577,000 for the same quarter of 2007 or a increase of $150,000 or 9.5%. The largest increase in noninterest income was service charges on deposits, up $103,000 to $724,000 or 16.6%. Our direct mail and premium marketing program has increased our transaction accounts and, as a result, our service charges have risen. This increase in accounts has also benefitted our point of sale income which increased $61,000 or 25.6% to $299,000 for the quarter ended September 30, 2008. One additional notable increase was gain on sale of loans which increased by $26,000 or 12.2% to $243,000. We continue to see steady production of traditional, conforming mortgage loans with the majority of those loans being sold into the secondary market. Smaller declines in other categories made up the remainder of the net increase noted above.

Other expenses were $30,846,000 for the three months ended September 30, 2008 compared to $6,331,000 for the like period of 2007. As noted above, the September 30, 2008 results include an impairment of goodwill charge that totaled $23,907,000. In addition, certain merger related expenses totaling $549,000 were recorded during the quarter ending September 30, 2008. Excluding these two expenses (the merger related expenses and the goodwill impairment) for comparison purpose, other expenses would have totaled $6,390,000 for the quarter ending September 30, 2008. This adjusted three month total would have been an increase of $59,000 over the same period ending September 30, 2007 or an increase of less than 1%.

Salaries and employee benefits increased $160,000 to $3,169,000 for the three months ended September 30, 2008 or 5.3% when compared the same period in 2007. This increase included an increase in salaries, commissions and overtime of $94,000. This increase represented normal annual increases as well as the addition of several new positions in key areas, including business development, brokerage, mortgage lending and commercial Lending. Full-time equivalent employees were 234 for the third quarter of 2008 compared to 228 for the same quarter in 2007.

Excluding merger related expenses of $549,000, professional fees declined by $149,000 from $329,000 for the quarter ending September 30, 2007 to $180,000 for the same quarter in 2008. Lower legal costs were responsible for this decline.

Other significant variances in other expenses for the three months ending September 30, 2008 compared to the three months ending September 30, 2007 included a $41,000 decline in marketing and advertising that resulted primarily from a change in vendors for certain marketing services. Equipment expense and occupancy expense also declined, by $40,000 and $37,000, respectively. Occupancy expense was affected by the receipt of real estate tax bills that had been delayed by local government agencies. Previous accruals were adjusted once these bills were received. Other expenses increased from $715,000 to $847,000 with the Federal Deposit Insurance premium making up the majority of this increase.

Income tax expense for the three months ended September 30, 2008 was $184,000. This compares to income tax expense of $76,000 for the quarter ended September 30, 2007. In addition to the goodwill impairment charge during the quarter ending September 30, 2008 and certain merger expenses not qualifying for a tax benefit, the difference between the actual rate recorded and the statutory rates was primarily due to permanent, non-taxable income recorded such as qualifying municipal interest and increases in cash value of life insurance.

Comparison of Operating Results for the Nine Months Ended September 30, 2008 and 2007

Net loss for the nine month period ended September 30, 2008 was $22,364,000, or $4.43 for both basic and diluted earnings per share. This compared to net income for the comparable period in 2007 of $899,000 or $.18 for basic and $0.17 for diluted earnings per share. As noted above, during the first quarter of 2007, the Bank began a strategy to restructure its balance sheet and, as a result, incurred a first quarter after-tax loss. The total year-to-date effect of the restructuring was a net loss of $909,000, or $.18 for both basic and diluted earnings per share.

The following table summarizes by quarter the final results of the restructuring transaction and the financial statement income line affected. No further transactions affected third quarter 2007 results.